For investors who still tremble at the thought of investing in companies that rely on mortgage-backed securities to earn a buck, fear not, says Rich Eckert, an analyst for B. Riley & Co. LLC who initiated coverage of six agency mortgage REITs on Aug. 2. As the former CFO and risk manager of the hedge fund Lahde Capital Management, which shut its doors shortly after making investors a bundle in the subprime mortgage meltdown, Eckert watched the MBS market collapse in 2007 and 2008 but now sees an opportunity for MBS REIT investors, he tells SNL.
Interest rates have scraped bottom for months now, and as economic indicators continue to lag, they will likely remain low "at least through the next presidential election and maybe beyond," he says in a report initiating coverage. He explains why mortgage REITs make a tempting investment and what impact a U.S. government default would have had on the industry.
The following is an edited transcript of the conversation.
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Rich Eckert: Even with the pedal to the metal, the economy only grew at an average rate of about a point and a half in the first half of this year: 1.3% in the second quarter and 1.9% in the first quarter. Unemployment's back above 9%, and the Fed knows with all of this deficit-reduction talk, we're going to get no new fiscal stimulus soon. So why would [Chairman Ben] Bernanke not act?
Is he afraid of inflation? He's never exhibited that fear before. In fact, he is more obsessed with deflation and making sure it doesn't happen, which is the title of a 2002 speech he gave. He's a self-professed student of the Depression, and he's convinced that in 1937, the Fed took its foot off the accelerator, and the economy went back into depression, and he's not going to be accused of withdrawing stimulus too early. He would rather have you wheeling dollar bills to the grocery store to buy a loaf of bread than be accused of withdrawing stimulus too early.
Given your view that rates will remain low and the fact that many analysts share your view, why isn't the market valuing these stocks appropriately?
I think that they're underpriced. First of all, equity investors are dumb. These are basically synthetic bonds, and they obviously don't understand the bond markets. There is a fear of rising rates, and a fear, especially last week, that they would have a hard time borrowing money, or it wouldn't come as cheaply, or the terms wouldn't be as generous as they are now, where the advanced rates are in excess of 95%.
So I just think there was a lot of fear priced into these stocks, and it just seems to me that they never get much respect. They always trade at high yields: People are always afraid that rates are going to rise, the yield curve is going to invert, or some other calamity is going to visit itself upon the market.
There are exogenous variables; there are things like 9/11; there are things like back in the late '90s, the Russians defaulting on their sovereign debt, and now we have all of Europe in what seems to be arrears. There are a lot of exogenous variables out there. But I have to contain my analysis to the most plausible scenarios. I can't think about a meteorite hitting Earth and knocking it off its axis. I really have to contain my analysis to a few of what I consider the most likely scenarios.
Congress in the past few months has proposed ways to wind down Fannie Mae and Freddie Mac. How long do you think the government will keep them around?
The agency MBS market is a $5.3 trillion market. Freddie and Fannie are issuing $300 billion in new MBS per quarter, and they are the only game in town right now and will be for a long while. Even their most outspoken critic, Rep. Jeb Hensarling, R-Texas, contemplates closing them down in no less than five years. And even at the end of five years, there is always going to be some type of security out there. Whether you call it a Fannie Mae or Freddie Mac pass-through, or something else, there's going to be a security out there that finances 60% to 70% of this nation's housing stock, and the Republicans may call it something else, but it's going to look like a Fannie/Freddie pass-through, it's going to smell like a Fannie/Freddie pass-through, it's going to taste like a Fannie/Freddie pass-through, and for all intents and purposes, it will be a Fannie or Freddie pass-through. But because those names have taken on a negative connotation, they'll call it something else, and take credit for inventing it.
Right now, it looks like a default has been averted. But how would mortgage REITs have been affected had a default occurred?
In a default, with regard to the value of mortgage REITs' securities, I believe lenders would have withdrawn their advance rates and would have increased their borrowing costs. They also would have had to delever some, and they would have suffered some margin compression. I don't think it would have killed them. But delevering and seeing your margin compressed reduces your taxable income and the dividend you pay.
If, say, interest rates do rise before you anticipate, would MBS REITs still make an attractive investment?
Small increases in rates I don't think will make a huge difference in the dividends mortgage REITs can pay. But once you get beyond a 50-basis-point rise, particularly the rates at which they borrow, they can get hurt. I don't think they would be impervious to rising rates, but I do think that several of them — particularly the ones that have been around, like Capstead Mortgage Corp. and Anworth Mortgage Asset Corp. and even Hatteras Financial Corp. — these guys have made money in good markets and bad; they've made money in markets where the yield curve is inverted, when CPRs are in the mid-80s. They still managed, even though it was small, to pay a dividend.
So I'm just saying that while they wouldn't be impervious to a rise in rates, they would as a group — or the better-run members, the better-managed members — survive, continue paying dividends and come out at the end of the tunnel ready to generate 15%, 16% yields again. I guess I'm trying to say, if you're willing to hold them — and there are certain ones that you can't hold, certain ones that you can — but if you're willing to hold them, these stocks are not going to go out of business. They can generate, over time, a very competitive, if not superior, return to the equity markets in general.
I'm not saying they can't get hurt with a rise in rates. I'm just saying it won't necessarily do them in; it won't force them into bankruptcy. If you're willing to see your dividend go from 25 cents to 2 cents and wait for the light at the end of the tunnel, you can be handsomely rewarded.
The Mortgage Bankers Association says refinances of mortgages are going down even as the borrowing rate is kept low. Why is this happening?
Everybody who can refinance has been exposed to multiple opportunities. Since the crisis broke in September 2008 and the Fed pushed the overnight rate down to zero, mortgage borrowers have had multiple opportunities to borrow at record low rates. So you're reaching a burnout, you're reaching exhaustion among eligible borrowers.
And then there are large segments of the borrower population that aren't eligible. They're underwater on their current mortgage, so they'd have to bring substantial cash to the closing table to refinance, so what's the purpose? Then there are large cohorts of borrowers that are effectively underwater. These are the people who normally move every three to eight years: the mover-uppers. They want to move to a nicer neighborhood, better school district, bigger house, but they only have 5% to 25% equity in their homes. And if they have to pay a realtor 6% and put 20% down on a new home and another 3% to 6% in closing costs, in moving costs and other transition items, they too have to bring substantial sums of cash to the closing table, and they're unable to do so. So where, pray tell, are refinance volumes going to come from?