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The Mortgage REIT Explosion

You might have heard of Annaly Capital Management (NLY) which has been the darling of income starved investors.  Annaly is one of the mortgage REIT’s, which is a fancy way of saying that they raise capital through an IPO, borrow enough money to leverage 5-7 times and then invest in mortgage backed securities.  By leveraging 5-7 times, they are able to pay out very handsome dividend yields to their investors.  In the case of Annaly Capital, they currently pay a 14.2% dividend yield.

The reason I bring them up today is that the business model is particularly perverse when the federal reserve is artificially keeping the front interest rates at or near 0%.  Since Annaly capital is able to reverse-repo their agency mortgage back securities (secured loan from a bank) and borrow money at .25%, they are able to make a spread of 3-4% on the mortgage back securities that they buy.  Borrow short, invest long, earn the spread.  The business model is particularly simple, but a few are getting handsomely rich from it.  What makes it particularly interesting is that Annaly invests exclusively in Agency backed mortgage securities, meaning that Ginnie Mae, Fannie Mae, and Freddie Mac guarantee the securities that they are buying.  The agencies are backed by the government which is backed by the taxpayers.  So in full circle, Annaly is borrowing short term from the Federal Reserve (through the Repo line) and investing in government backed securities.  The taxpayers are lending to Annaly at a near 0% rate and the taxpayers promise to pay Annaly full Par value if any mortgages in the pools default.  According to the recent filings, the heads of Annaly Capital are taking the Fed’s gift to the bank:

I cannot wait to see the 2010 comp

Who felt like they were being left out of the party?  Well, PIMCO of course:

PIMCO REIT plans to raise $600 million in its IPO to invest in residential and commercial mortgage-backed securities and other residential and commercial real estate debt, according to SEC documents filed Tuesday.

When the new REIT completes its private placement, it will acquire a portfolio of agency residential mortgage-backed securities.

PIMCO is not the only asset manager getting into the mix, plenty of issuance to sate the investors’ yield hunger:

The bright note is that with $3.5B of issuance shown above levered at 5x, we could theoretically see $17.5B of demand for mortgage securities.   Mortgage REIT’s could act as replacement buyers for the Fed.


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