Wall Street REIT Success Gives Investors Hangover Part II

Wall Street REIT Success Gives Investors Hangover Part II

Investors in companies buying mortgage bonds are discovering that coming late to the party can still leave them with the biggest hangover.

Mortgage real-estate investment trusts raised $7.4 billion in the first quarter by selling new shares, the most in two years, just before a plunge in the value of the firms. American Capital Agency Corp. (AGNC) has declined 17 percent since offering $2 billion in February and Armour Residential REIT Inc. (ARR) has slumped 24 percent after raising $444 million that month.“It was the absolute wrong time to raise money,” said Julian Mann, who helps oversee $6 billion in bonds as a vice president at Los Angeles-based First Pacific Advisors LLC. “Rather than turn money away, these asset gatherers chose to double-down.”

Mortgage REITs, after luring investors with returns of 46 percent over the previous three years and dividends exceeding 10 percent, are declining this quarter by the most since 2008 as Federal Reserve officials signal they’re weighing plans to reduce their purchases of bonds. The underwriters that helped the REITs grow to hold more than $400 billion of debt, led by Credit Suisse Group AG and Bank of America Corp. (BAC), earned an average of 2 percent in fees on the share sales in the first quarter, according to data compiled by Bloomberg.

Fed Taper

A Bloomberg index of mortgage REITs has declined 13 percent this quarter, including reinvested dividends, as bond prices have dropped amid speculation the central bank will begin to taper the pace of its $85 billion of monthly debt buying, including $40 billion of government-backed housing debt.

REITs are plunging partly because the government-backed mortgage securities they purchased, mainly with borrowed money, have done even worse than Treasuries, negating their attempts to hedge against rising interest rates.

The decline comes less than six years after an earlier generation of mortgage REIT imploded. The Bloomberg index shows mortgage REITs slumped 68 percent in 2007 and 2008, with companies including New Century Financial Corp., American Home Mortgage Investment Corp. and Luminent Mortgage Capital Inc. filing for bankruptcies.

The worst performers have been firms such as American Capital and Armour that target Fannie Mae, Freddie Mac and Ginnie Mae securities. REITs that buy other mortgage debt are also suffering because Internal Revenue Service rules that allow them to pay out untaxed earnings mean they also hold sizable amount of agency notes. Non-government debt, such as subprime securities, is also being roiled as investors seek to reduce risk.

‘Hang In’

Annaly Capital Management Inc. (NLY), the largest REIT with $126 billion of assets as of the end of March, has dropped 16 percent since then. American Capital, the second biggest, and Armour have both slumped 23 percent in the period.

“It’s going to take a couple years of dividends to make up for the decline in stock prices,” Merrill Ross, an analyst with Baltimore-based Wunderlich Securities Inc. said in a telephone interview. “If you can tolerate it, I’d say hang in there — realizing that loss is painful and the stock could claw its way back. But you know you are being paid to wait.”

Bond markets have stabilized on speculation that the Fed will keep “the punchbowl in sight” this afternoon after a two-day meeting, according to a June 14 report by Barclays Plc analysts including Moyeen Islam. Investors have also predicted higher rates in the past only to be proven wrong. Bill Gross’s Pimco Total Return Fund reduced Treasuries early in 2011, leaving him to miss a rally and have what he called a “stinker” of a performance.

Record Sales

Mortgage REITs had benefited as the Fed held short-term borrowing costs near zero since 2008. After record sales of $16.9 billion of common, preferred and equity-linked notes in initial public offerings and secondary offerings in 2011, they followed with $16.3 billion in 2012, according to data compiled by Bloomberg, which includes firms that invest in commercial property debt or products such as loan servicing rights.

Investors were drawn by dividends in excess of 13 percent last year, almost twice the average yield on company junk bonds.

Firms that had virtually no assets five years ago were able to expand by using borrowed money and now hold more assets than some regional banks. American Capital, based in Bethesda, Maryland, increased its assets to $100.5 billion at the end of last year from less than $5 billion three years earlier.

Compensation Arrangements

Typically, the more money they raise, the more their managers get paid. American Capital’s external management company, which includes President Gary Kain and Chief Executive Officer Malon Wilkus, is paid 1.25 percent of the REIT’s shareholder equity.

Last quarter, mortgage REITs issued $5.8 billion of new common stock, even as a Bloomberg survey released Feb. 14 showed the median forecast from economists was for 10-year Treasury yields to reach 2.51 percent at the start of 2014, from 2 percent.

“Because of the way they get paid, there’s a strong incentive for the management to continue to raise more permanent capital, and clearly an underwriter is not exactly going to be jumping up and down and saying, ‘I don’t want your business,’” said Brad Golding, managing director at Christofferson, Robb & Co., a New York-based firm overseeing $1.9 billion in assets including investments in mortgage REIT preferred stock.

“Still, not all of the guys decided to party,” he said, citing firms including Anworth Mortgage Asset Corp. (ANH) and MFA Financial Inc. (MFA), which have different compensation models. MFA’s executives, for example, get paid bonuses tied to meeting profitability targets.

Share Sales

Justin Cressall, a spokesman for American Capital, declined to comment on its share sale, while Armour Chief Financial Officer James Mountain didn’t respond to telephone messages and e-mails seeking comment. Jay Diamond, a spokesman for Annaly, which hasn’t sold shares since 2011, declined to comment on its stock performance.

John Yiannacopoulos, a spokesman for Bank of America, and Jack Grone, a spokesman for Credit Suisse, declined to comment on their underwriting of mortgage REIT’s stock sales.

Mortgage REITs, mostly commercial-mortgage investors, sold an additional $3 billion of shares this quarter. Ellington Residential Mortgage REIT, which trades under the stock symbol EARN (EARN), raised $126 million in a May 1 IPO led by Credit Suisse, shortly before comments to lawmakers by Fed Chairman Ben S. Bernanke started the bond slump. The firm, which was formed last year by Ellington Management Group LLC and Blackstone Group LP to buy home-loan bonds, has fallen 11 percent from its initial price.

‘Attractive Opportunities’

“We launched EARN because we saw attractive opportunities in the marketplace in both the short and long term,” Mark Tecotzky, its co-chief investment officer, said in an e-mail. “We still believe that to be the case.”

Two Harbors Investment Corp. (TWO), a mortgage REIT that sold $774 million of stock in March, saw opportunities in agency mortgage bonds after a widening of spreads against benchmark bonds following their collapse at the start of the Fed’s latest round of buying in September, Chief Executive Officer Thomas Siering said. It also benefited existing shareholders by issuing equity at a premium to its book value, a measure of the value of its asset minus its liabilities, he said.

The company, which has returned 30 percent over the past year even after an approximately 9 percent drop since the sale, has grown more defensive, he said in a telephone interview.

“For three-and-a-half years we’ve been on offense, which has been a great benefit for our shareholders,” said Siering. “But sometimes in the market you’ve got to go to the ropes a little bit and play defense and be in a position to go back on offense when others aren’t so fortunate.”

‘Historical Averages’

American Capital’s Kain said last week at an investor conference that the worst of the rout in government-backed mortgage bonds may be over after spreads widened “to levels relatively consistent with historical averages” and there is a smaller volume of loans as fewer homeowners refinance.

Still, while the firm is prepared to increase its 8-to-1 leverage when volatility subsides, it sold bonds last quarter to keep the ratio from rising and added hedges to reduce its risks from higher rates, he said at the conference.

“It will tend to reduce our earnings potential in the current environment to some extent because let’s face it, hedges do cost money and our asset size is a little smaller,” he said. “There also may be less upside to book value if interest rates fall quickly or MBS spreads tighten back to where they were.”

The company will pay a quarterly dividend of $1.05 a share, down from $1.25 in the prior period, according to a June 18 statement.

Book Values

Firms that buy agency mortgage bonds were trading at “unusually large” discounts of 14 percent to their book values as of June 12, after a 5.8 percent decline this quarter, Michael Widner, an analyst at Keefe, Bruyette & Woods wrote in a report.

The rise in interest rates that’s punished mortgage REITs will continue as the Fed pulls back, investors withdraw money from bond mutual funds and Wall Street dealers facing new rules prove less willing to provide liquidity, according to First Pacific’s Mann.

“The whole thing is a perfect storm coming together and the regulatory environment is not helping at all,” Mann said.

Even if mortgage REITs continue to make enough money to pay high dividends, it may not provide as much protection as it once did for their share prices. The firms have drawn in large institutional investors as they’ve grown who care more about the value of the assets, said Jason Stewart, an analyst at Compass Point Research & Trading LLC.

“Retail investors thought they could own them for 10 or 15 years and didn’t care where book value went since they wanted the dividend yield,” he said. Now, “nobody cares about what dividend yields are, they care about what book value is. People want to know where it bottoms.”

To contact the reporters on this story: Heather Perlberg in New York at hperlberg@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net

CMBS Sales Face $15 Billion Drop on Interest-Rate Jump, S&P Says

Rising interest rates may trim issuance of commercial-mortgage bonds by $15 billion this year, according to Standard & Poor’s.

An increase of 55 basis points on 10-year Treasury yields coupled with a rise of 30 basis points on relative yields on top-ranked securities linked to property loans will put a damper on the resurgent market, S&P analysts led by Howard Esaki said yesterday in a note to clients. The analysts estimate 2013 sales of $65 billion after adjusting for the rising rates.

Commercial-mortgage bond sales that Credit Suisse Group AG says are poised to climb as much as 50 percent to $70 billion are being checked by investor concern that the Federal Reserve will soon pare $85 billion of monthly bond purchases. The unprecedented stimulus has suppressed interest rates and pushed investors into higher-yielding assets.

Wall Street banks have arranged $37.6 billion of bonds linked to everything from strip malls to Hawaiian resorts this year, according to data compiled by Bloomberg.

Speculation on when the central bank will reduce its stimulus spurred a decline across credit markets last month, pushing the yield on the benchmark 10-year Treasury (USGG10YR) note to 2.29 percent on June 11, the highest since April 2012.

Sweetened Offer

JPMorgan Chase & Co. and Barclays Plc sweetened the terms on a $1.2 billion commercial-mortgage bond deal last week, paying investors 410 basis points more than the benchmark swap rate on BBB- bonds maturing in 9.97 years, according to people familiar with the offering who asked not to be identified because terms aren’t public. The debt was initially marketed to yield 375 basis points, or 3.75 percentage points, more than swaps, the people said.

A rise in rates should reduce lending volumes “on the margin,” according to Credit Suisse. The bank isn’t changing its issuance forecast, New York-based analysts led by Roger Lehman said in a report last week.

“Rates are so low now relative to historical levels that the recent backup still leaves mortgage rates very attractive,” the analysts said.

The yield on 10-year Treasuries has fallen back to 2.19 percent as traders await more signals as to whether the U.S. economy is strong enough for the central bank to curb its bond-buying. Fed policy makers gather today for the start of a two-day meeting.

To contact the reporter on this story: Sarah Mulholland in New York at smulholland3@bloomberg.net

Mortgage-Bond Auction Failures Reach Most in 2013 as Prices Drop

U.S. home-loan bonds without government backing are failing to trade at investor auctions at the fastest pace this year as prices tumble after a rally.

The share of non-agency bonds reported by dealers as not trading after being included in widely marketed auctions rose to 44 percent in the first half of June, up from 18 percent last month, according to data from New York-based Empirasign Strategies LLC, which tracks the information. A total of $9.5 billion of the debt was offered, about the same pace as in the first four months this year, after $32.3 billion in all of May.

Typical prices for senior securities backed by option adjustable-rate mortgages dropped to 68 cents on the dollar last week from 74 cents a month earlier, as concern that the Federal Reserve will curb its bond buying roils financial markets, Barclays Plc data show. Such declines are slowing trading as potential buyers offer bids that sellers consider too low, and Wall Street banks fail to take up the slack.

“The Street is long from a lot of customer sales in the last six weeks, and the move down in price has had an impact on their ability to provide liquidity,” Scott Buchta, head of fixed-income strategy at New York-based brokerage Brean Capital LLC, said today in a telephone interview. Potential buyers are being “much more opportunistic,” while some sellers are trying to “execute at yesterday’s levels.” Others are seeking bids simply to gauge current prices, he said.

Values Drop

Values in the $900 billion non-agency market are slumping after soaring through early May as the Fed’s stimulus efforts drove investors to seek potentially higher returns and housing rebounded with the fastest gains in prices since 2006, according to S&P/Case-Shiller index data on values in 20 cities.

The option ARM securities, which fell as low as 33 cents on the dollar in 2009, rose from 65 cents at the start of the year. The underlying loans can allow borrowers to pay less than the interest due by increasing how much they owe.

Investor auctions of non-agency bonds known as bids wanted in competition are slowing again. Volumes earlier this year were depressed by holders seeking to benefit from later gains. Trading was boosted last month by an $8.7 billion sale from Lloyds Banking Group Plc.

Trading Stifled

“The non-agency market continues to be impacted by wide bid/ask spreads, which stifled trading activity,” Bank of America Corp. analysts Chris Flanagan, Ryan Asato and Justin Borst wrote in a June 14 report.

Non-agency securities lack guarantees from government-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae. Bonds backed by the riskiest subprime mortgages issued to borrowers with poor credit before housing collapsed have fallen 3.7 percent this month, trimming their gains this year to 7.6 percent, Barclays index data show.

“Given the increased volatility in the markets and concerns over Fed policy, further price declines in non-agencies cannot be ruled out,” Barclays analysts including Jasraj Vaidya and Sandeep Bordia wrote in a June 14 report. “Despite that near-term possibility, we remain constructive on non-agencies over the medium term” because of the higher yields the debt offers relative to other risky assets and housing’s improvement.

To contact the reporter on this story: Jody Shenn in New York at jshenn@bloomberg.net.