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April 2014 FOMC minutes: Why focus on normalization?

Part 7
April 2014 FOMC minutes: Why focus on normalization? (Part 7 of 7)

Must-know: Will the Fed’s exit affect mortgage REITs like Annaly?

Implications for mortgage REITs

For mortgage REITs, the tapering wasn’t a surprise, and they had a chance to prepare. Big agency REITs like Annaly (NLY) and American Capital Agency (AGNC) took the chance after the warning last spring to de-leverage their balance sheets.

MBA Refinance IndexEnlarge Graph

In terms of the footprint in the markets, it makes sense for the Fed to taper anyway, even in the absence of better employment data. Why? The end of the refinance boom. MBS (mortgage-backed securities) issuance has been declining since summer, as refinance activity has fallen off a cliff. Take a gander at the MBA refinance activity index above. It fell 70% peak-to-trough ever since rates started going up. When you consider that 64% of the mortgage market is refinance activity, that’s a big drop. What that means is that the Fed’s $40 billion a month of MBS purchases is a lot more significant (because it’s a larger percentage of MBS issuance) than it was last spring. In other words, by doing nothing, the Fed is actually increasing its footprint. For that reason alone, the Fed had to reduce MBS purchases.

We’ve seen MBS spreads to Treasuries tighten over the past few months, presumably due to the Fed’s increased footprint. At this stage, the Fed’s purchasing is almost equal to new issuance. REITs like Annaly (NLY), American Capital Agency (AGNC), MFA Financial (MFA), Hatteras (HTS), and Capstead (CMO) could get hit with a double-whammy when the Fed ends QE—the ten-year will drop in price and MBS spreads to Treasuries could widen. This would mean its book values take another hit. That said, pretty much everyone has de-leveraged in a big way since rates started going up. Any further increases in interest rates will have less of an effect than they did during the second quarter, when the entire sector got taken out to the woodshed.

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