But if I knew how to manage my portfolio safer and smarter than most hedge fund managers, I could realistically grow my wealth.
Elevated levels of consumer debt have been one of the reasons why the recovery has been so weak
Consumer debt as a percentage of gross domestic product (or GDP) has been growing inexorably since we began keeping track. From a low of 26% in the early 1950s, debt peaked at 98% of GDP in early 2009. Since then, the consumer has been paying off debt—a process known as “deleveraging.” This has depressed demand as well as consumer spending and has prevented the economy from experiencing the normal post-recession rebound in economic activity.
Addressing the consumer debt issue has been one of the major driving forces behind quantitative easing and ultra-low interest rates. Since the Great Recession began, the Fed has engineered a drop in interest rates in the hope of lowering the burden on middle-class households. In many ways, the Fed has succeeded. On one hand, mortgage rates have dropped precipitously. But on the other hand, credit card interest rates have not.
You can see from the chart that low interest rates have helped reduce debt service payments. This chart shows debt service as a multiple of disposable income. Debt service payments have been falling as consumers have been able to refinance their mortgages and pay off their debt.
The Fed has been hoping to create modest inflation. Modest inflation (around 2% to 3%) would allow debt to deflate relative to the economy without triggering large increases in interest rates. The Fed isn’t comfortable with inflation that’s too low. When interest rates are up against the 0 bound (in other words, they’re at 0 and can’t go lower), decreasing inflation means real (inflation-adjusted) interest rates are rising. In a weak economy, that’s the last thing the central bank wants. Japan has been struggling with this state of affairs for two decades—deflation in combination with 0% interest rates means rising real interest rates and very slow growth.
Implications for mortgage REITs
Until consumption demand and jobs return, the Fed will keep interest rates as low as it can. It has already given a numeric target for unemployment (6.5%) before it will consider raising interest rates. While it has yet to give a target for ending asset purchases, chances are it will err on the side of keeping rates low too long as opposed to tightening too early.
The net effect on REITs like American Capital (AGNC), Annaly (NLY), MFA Financial (MFA), Capstead (CMO), or Hatteras (HTS) will be low interest rates and higher prepayments. Low interest rates mean mortgage REITs will have to use more leverage than usual to generate acceptable returns. As long as there’s stability in the financial markets, their borrowing rates will remain low. They’ll benefit from having steady or rising prices for the assets on their balance sheet. The downside will be prepayments and delinquencies. For agency REITs, prepayment risk is their biggest worry. Prepayment risk occurs when borrowers refinance their mortgage, which removes high-yielding assets from the REIT’s portfolio and replaces them with lower-yielding assets. This lowers net returns.
© 2013 Market Realist, Inc.