Since the "great recession," yields on low risk fixed income
instruments have plunged to near zero levels. This is the result of
the Fed's ZIRP (zero interest rate policy), which was intended to
provide liquidity to the economy and stimulate growth. Liquidity
for the housing sector and small businesses is a goal of ZIRP.
Congress has also provided favorable tax treatment for REITs and
BDCs (business development corporations) in an effort to provide
liquidity to those sectors. The zero interest rate policy has
helped the U.S. economy to resume growth, although tepid.
As ZIRP has reduced the costs of some borrowing, it has deprived
lenders, including retirees who live on the yields of their
savings, of meaningful income from interest. The graph below
illustrates the severity of the drop.
(click to enlarge)
Yield-starved investors unwilling to accept a 90% reduction in
income have been forced to look elsewhere for yield. One sector
that still provides double-digit returns is mortgage REITs, known
as mREITs. While yields on fixed income instruments have plunged,
the mREIT sector has provided excellent returns to income-seeking
investors for the past several years.
mREITs buy mortgages using ZIRP-fueled low cost short-term
funding and substantial leverage. Many articles on Seeking Alpha
explain the basic economic model of the mREIT sector, so I won't
recap here. The major risks relate to changes in interest rates,
flattening of the yield curve and exposure to the value of the
underlying real estate assets.
Given the Fed's public commitment to continuing ZIRP until
employment levels improve, many investors chose to accept those
risks and collect the double-digit yields. The mREIT sector has
grown at a torrid pace with many companies raising new capital
through frequent secondary offerings. Dealogic reports that after
averaging annual equity issuance of $4.9 billion from 2005 to 2010,
they raised a record $16.5 billion in 2011 and $13.4 billion last
[[REM]], the iShares NAREIT Mortgage ETF, is a basket of mREITs
designed to track the leading index for the sector. It shows that
mREITs provide double-digit yields with moderate volatility. REM
currently trades at $15.25 and yields 11.4% with a beta of .79.
REM's holdings are market cap weighted, so 38% are in Annaly
Capital Management ( NLY ) and American
Capital Agency ( AGNC ). Total return
for the trailing twelve months is a gratifying 29.96%. Those
numbers are typical of leading players in the sector such as NLY,
Two Harbors ( TWO ),
AGNC, etc. REM is directed by Blackrock, which acts as investment
advisor. There is also a new mREIT that offers double leverage.
This new entrant is [[MORL]], ETRACS' Monthly Pay 2XLeveraged
Mortgage REIT ETN, which offers an amazing 19% dividend yield. MORL
may raise concerns that the sector is getting too speculative,
since it piles leverage upon the already heavily leveraged
These attractive mREIT yields are now facing a threat. On
Friday, April 19th, the Wall Street Journal ran two articles that
suggest the mREIT sector is about to face regulatory action. In an
article titled " Regulators Worry Mortgage REITs Pose Threat to
Financial System ", Deborah Solomon wrote:
A panel of top financial regulators is targeting mortgage
real-estate investment trusts as a potential risk to the U.S.
financial system, the latest example of Washington's growing
concern with market bubbles.
Next week, the Financial Stability Oversight Council, a panel
comprising the top U.S. financial regulators, is expected to cite
mortgage REITs as a source of market vulnerability in its annual
report, according to people familiar with the matter, a distinction
that could set the stage for stricter oversight of the
Eager to avoid the mistakes of the past, regulators are
attempting to identify overly frothy activity before it poses
problems. Even though the economy continues to recover only slowly,
regulators see potential bubbles forming in a range of financial
markets, in part because of the Federal Reserve's easy-money
policies, which have driven interest rates to near-record lows and
prompted investors to seek higher returns elsewhere.
These warnings are repeated and expanded upon in another
article , which begins with "Regulators are casting a skeptical
eye on a fast-expanding corner of Wall Street amid worries about
the risks posed by mortgage real-estate investment trusts."
My belief is that mREITs provide useful liquidity to the housing
market and do not pose a threat to the financial system as a whole.
In fact, they move risk from the "system" to individual investors
because nobody would say that mREITs are "too big to fail."
Nonetheless, regulators and legislators who were burned by the
housing crash and subsequent great recession are apparently on a
path to increase regulatory requirements on the industry which
could derail the mREIT gravy train.
Disclosure: I recently sold my portfolio of
nine mREITs. I have no positions in any stocks mentioned, and no
plans to initiate any positions within the next 72 hours. I wrote
this article myself, and it expresses my own opinions. I am not
receiving compensation for it (other than from Seeking Alpha). I
have no business relationship with any company whose stock is
mentioned in this article.
See also Johnson & Johnson: Blue Chip Chaser Vs. The
Value Hunter on seekingalpha.com