Opportunities in Mortgage Markets


Astonishingly, with all the headlines scaring investors to death about the demise of the mortgage market, a company called Annaly Capital Management (NLY $14), which invests solely in mortgagebacked securities, enjoyed a blowout stock offering last week. Maybe it should be called Anomaly Capital.

Annaly Capital is a real estate investment trust (REIT) that invests in U.S. residential mortgage-backed securities issued and guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. These poolings of mortgages are either rated triple-A or carry an implied triple-A rating.

The company's earnings come from the spread between their cost of capital and the yield on their assets. Annaly uses leverage of about 10 to 1 to enhance the portfolio's returns. Like all REITs, the company pays out virtually all of its income as dividends, and is mainly attractive to investors looking for income. The stock currently yields 7.33% according to an estimated dividend rate of $1.00 from analysts at Keefe, Bruyette & Woods who rate the stock "outperform."

Notwithstanding the ominous sound of the business model (talking about leverage and mortgages in the same sentence may spook investor confidence today), Annaly went to the market last week and raised $641 million. If the bankers exercise the overallotment, as seems likely, the company could end up taking in close to $735 million from the sale.

At the same time, another REIT investing in mortgage-backed securities, Impac Mortgage Holdings (IMH $5), saw its stock struggle to recover from a drop of more than 50% this year. It closed yesterday down from $8.72 at the beginning of the year but up from its low of $4.05 on March 5.

mpac buys so-called Alt-A residential mortgage loans. These are the shaky loans we have all been reading about. Initially Alt-A loans were made to good credit prospects that for various reasons were attracted to the category's lesser documentation requirements or the greater loan-to-value allowances. In the past year or two, however, such loans were increasingly offered to people with poorer credit. The delinquency rate on Alt-A loans is climbing. At the end of last year some 2.38% of such mortgages were delinquent by at least 60 days, up from a low of 0.93% in 2005.

That the stocks of these two REITs are moving in opposite directions is not so surprising, given the differences between the two companies' investment profiles. The market is appropriately distinguishing between the two, and has not tossed the baby out with the bath water.

What is interesting, though, is that the bullish case for Annaly rests in part on the continued deterioration in the kinds of loans in Impac's portfolio. That is, the divide is likely to widen. The logic goes like this: if defaults rise further in the mortgage markets, credit would tighten, home prices would drop further, and the resulting damage to the economy would eventually cause the Fed to lower rates.

Annaly and similar companies have suffered narrowing spreads due to a flat yield curve. The company would benefit from a period of declining rates, since their cost of capital drops faster than the return on their investments. Consequently, this prospect creates a "best-case" picture for the company and its investors.

How likely is this scenario? The most influential connection between the housing market and the economy is the level of mortgage equity withdrawals (MEW) and the impact of this source of funding on consumer spending. Over the past decade, homeowners have been taking advantage of the escalation in home prices and of historically low interest rates by taking out an ever increasing amount of home equity loans. Most of this borrowing was done by homeowners with good credit ratings. The amount of money provided to consumers in this fashion has been, simply put, huge; in the third quarter of 2005 MEW reached a record $180 billion.

Alan Greenspan has estimated that half of MEW has flowed into personal consumption. Others put the figure as high as two-thirds. That is, the bulk of the monies raised from taking out a home equity loan has not gone to pay down other sorts of debt or into other kinds of investment, but rather into dining out, new autos, or trendy apparel.

The folks at Guerite Advisors cite Freddie Mac data that indicates prime mortgage borrowings grew from an average 0.55% of GDP between 1993 and 2000 to 1.93% in the past six years. In the second quarter of last year such financings reached 2.93% of GDP. In other words, such borrowings financed a good share of the country's growth last year. The calculus suggests that over the past five years, MEW has lifted GDP growth by 2.2% a year on average.

Freddie Mac is forecasting the level of prime mortgage equity withdrawals will fall 20% in the current year, and another 30% next year, to a level 43% below that of 2006. The drop stems from an expected ongoing slowdown in house price increases.

Freddie Mac figures indicate that in 2006 home prices rose 6.1% — the slowest rate since 1999 and less than half the rate of 2005. Because of the method used to gather such data, the actual trends are probably worse than this. Data from the National Association of Homebuilders shows that prices of existing homes rose only 1.3% in 2006, after a hefty 12.2% gain in 2005. In August of last year, comparisons turned negative, and by January prices were off 3.4%.

Freddie Mac is forecasting a further slide this year. If the current softening of housing prices continues, consumer spending will almost certainly be impacted further. Another step down the growth ladder and the Federal Reserve may well be pressured to ease interest rates by mid year, or by year-end at the latest.

If such an easing takes place, it will be welcomed by companies like Annaly, and by those who braved the prevalent mortgage market horrors and participated in the recent stock sale.

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