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An online advertisement raises the following question often asked by your clients: Can you find me more income? In a nutshell, that is the dilemma facing high net worth investors.
The Desperate Search for Yield
As I have explained in several articles, high net worth investors and institutions are in a desperate search for yield. Ben Bernanke and the Federal Reserve have driven down interest rates to levels that have made it impossible to obtain acceptable rates of return for fixed income investments.
Because of this foolish policy, wealthy investors and institutions have felt compelled to look at riskier investments which might provide higher rates of return. There is solid evidence that for a year and a half, they have plunged into residential mortgage-backed securities (RMBS).
High net worth investors and institutions have poured enormous sums of money into REITs which invest in mortgage-backed securities. A recent report showed that these mortgage REITs increased their holding of RMBS by an incredible 47% in 2012 to more than $357 billion.
The largest of them – Annaly Capital Management – expanded its MBS holdings to $124 billion by the end of 2012. American Capital Agency expanded its MBS portfolio from $5 billion to nearly $100 billion in three years.
What makes these REITs almost irresistibly attractive to investors is their double-digit dividend yields. Because REITs must distribute at least 90% of their taxable income as dividends to shareholders, the cash flow they offer to investors is huge. However, what most investors and many investment advisors do not know is that the amazing yields they promote come with high risk.
Why? Mortgage REITs pay for their RMBS by financing them primarily through short-term repurchase agreements. Not much different than banks, their income is derived from the positive spread between their cost of borrowed money and the cash flows which are provided by the MBS.
How do they offer their double-digit dividend yields? It's very simple. They arehighly leveraged. Most have debt-to-equity ratios of 6 to 1 or higher. Apparently, this high leverage has not concerned investors in the least.
That complacency is not surprising. Most of these mortgage REITs invest in RMBS which are issued either by Fannie Mae or Freddie Mac. Since both agencies are now under conservatorship of the U.S government, investors are very confident that the guarantee which Fannie Mae provides in the event of a mortgage default means, in reality, that Uncle Sam will cover losses no matter how large.
Fannie Mae and the Risky Mortgages It Guarantees
Is this confidence justified? On its website, this is how Fannie Mae describes the guarantee:
| Fannie Mae guarantees that the holders of its MBS will receive timely payments of interest and principal. Fannie Mae alone (and not the United States government) is responsible for making payments on this guaranty. |
They make it explicitly clear that the guarantee of timely payment of principal and interest doesnot come from the U.S. government.
Of course, the optimists will point out what happened during the credit crisis of 2008. In return for senior preferred stock in the company, the Treasury provided a funding commitment to enable Fannie Mae to handle its enormous losses and maintain a positive net worth. Through the third quarter of 2012, a total of $116 billion had already been provided.
The Treasury's remaining commitment is a maximum of $124.8 billion. You may believe that this is sufficient to handle any losses on its guarantees. Perhaps you will be right. I am not so confident. If you are an investor or potential investor in mortgage REITs -- or if you advise clients who invest in them -- it is imperative to know what is the quality of the mortgage portfolio which Fannie Mae has guaranteed.
Spokespersons for Fannie Mae are continually boasting of the low delinquency rates on the mortgages which they have guaranteed. Its Credit Supplement Report for the second quarter of 2013 showed seriously delinquent mortgages to be only 2.77% of their total loan portfolio.
To understand the enormity of the risky loans guaranteed by Fannie Mae, we need to dig deeper. No one has done this more thoroughly than Ed Pinto, who was Fannie Mae's chief credit officer until the late 1980s. In his view, you cannot comprehend the riskiness of the MBS guaranteed by them simply by reading quarterly 10-Q reports filed with the SEC.
Fannie Mae's Credit Supplement for the second quarter of 2013 reveals that they had outstanding guarantees for $728 billion of higher risk mortgages. These included mortgages such as interest-only loans, mortgages where the borrower had a FICO credit score of less than 660, mortgages with a loan-to-value (LTV) ratio over 90% at the time of origination, and so-called Alt A loans which often had little or no documentation of income and assets.
These riskier mortgages are very similar in nature to the poorly underwritten sub-prime mortgages that had caused the housing bubble to come crashing down in 2007. Those guaranteed by Fannie Mae have a serious delinquency rate more than twice as high as its entire guaranteed loan portfolio.
What's even worse is that according to Fannie Mae, the percentage of these high risk loans that is "underwater" -- with a loan-to-value ratio (LTV) of more than 100 -- is nearly three times as high as that of the entire $2.7 trillion loan guarantee book.
You must keep in mind that Fannie Mae's LTV figures areonly for first liens. If the property has a second mortgage on it which Fannie Mae does not own, then the LTV percentage does not include the second lien. Since there are more than 14 million second liens still outstanding around the country according to Equifax, the true LTV for millions of these properties ismuch greater than Fannie Mae's reported figure.
The media did not even begin to recognize the seriousness of the second lien problem until a June 2011 article appeared in the Wall Street Journal. Using data from CoreLogic, the author of that article pointed out that nearly 40% of all properties with second mortgages were underwater, more than twice the rate of those with only first liens.
This means that the real percentage of underwater properties in this $728 billion non-prime portfolio of Fannie Mae issubstantially higher than the reported figures. As I will explain a little later, the risk of default for these underwater properties is extremely high.
American Capital Agency and Its Risks for Investors
American Capital Agency (AGNC) is the second largest mortgage REIT. Its founder and chief investment officer is former Freddie Mac executive Gary Kain. Their assets grew tremendously over the last three years as investors poured into this REIT in search of high yield.
Because few investors are aware of the risks to which they are exposed from AGNC, let's take a good look at this REIT. We can turn to their 10-Q report filed with the SEC for the second quarter of 2013.
What immediately struck me is just how highly leveraged American Capital is. At the end of the second quarter, it held $75.9 billion in MBS either guaranteed or insured by one of the GSEs – Fannie Mae, Freddie Mac or the FHA. Of this, $72.5 billion was financed by short-term repurchase agreements (repos). The company stated in the 10-Q that its "adjusted leverage" at the end of the quarter was 8 ½ to 1.
Because AGNC's income is derived from the spread between their cost of funds and the yield on their MBS portfolio, the rise in interest rates which followed Ben Bernanke's warning at the end of May has hammered this REIT. Its net interest expense (annualized) climbed from 1.08% in the second quarter of 2012 to 1.43% a year later. Part of this was due to the additional hedging they undertook to protect against a further rise in interest rates.
That translated into an additional $48 million in interest costs just for the second quarter. For the first six months of this year, this cost soared by $133 million. Although AGNC ended the quarter with $2.9 billion in cash on its balance sheet, you must understand that $1.8 billion of that came from the sale of new shares in early 2013. Because of its reduced cash flow, AGNC was forced to cut the quarterly dividend to $1.05 from the $1.25 dividend of a year earlier.
On October 28, they came out with more bad news for investors with release of third quarter earnings. The spread between their cost of funds and yield on the total portfolio plunged from $1.49 in the second quarter to only $1.20 in the third. They also suffered a loss of more than $1 billion on the sale of Agency and other securities. This forced them to cut the dividend again to a mere $.80 a share.
What about the mortgages in AGNC's portfolio? In the 10-Q report, 73% of the entire portfolio consisted of either 1) mortgages with balances no greater than $150,000 or 2) refinanced mortgages issued under the government's HARP refinance program.
It is the HARP refinance program which really troubles me. Although the HARP program began in 2009, the refinancing totals were quite disappointing until the government came out with its HARP II program in December 2011. To encourage underwater borrowers to refinance, this new program threw underwriting standards completely out the window.
Under the HARP II eligibility rules, there wereno limits to how far underwater a home could be. None whatsoever! No verification of income was required and the applicant did not even need to be employed. Totally overlooking the underwriting disaster of the housing bubble years, the designers of HARP II also permitted investment property and second homes to be refinanced.
What sane lender would offer terms like these after recalling what had happened during the lunacy of 2004 – 2006?
In 2013, what did HARP II refinancing look like? In August 2013, the Federal Housing Finance Agency (which oversees the GSEs) put out its Refinancing Report. Through the first eight months of 2013, 42% of all the HARP II refinancings were for underwater mortgages.
It was no surprise for me to learn that this percentage was even higher for states which had been hit the hardest by the housing collapse – 71% for Nevada, 64% for Florida, 59% for Arizona, and 54% for California.
What does this mean for AGNC's portfolio? Neither the second quarter 10-Q report nor the third quarter earnings release spelled out what percentage of their total portfolio was HARP II mortgages. Yet if 73% of the entire portfolio is comprised of either HARP II loans or mortgages under $150,000, it is safe to assume that a very substantial portion of that is HARP II refinancings.
In the second issue of my Capital Preservation Real Estate Report, I referred to a conversation that I had with a spokesperson for Standard & Poor's a little more than a year ago. He explained that for underwater mortgage loans where the loan-to-value ratio (LTV) was greater than 120%, S & P assumed that 100% of them would eventually end up in default. He did not say that many of them would default. He said all of them.
In several articles, I have shown hard evidence that the chances of a borrower defaulting rises steadily as the home becomes more underwater. If we apply that unequivocal assertion by the S & P spokesperson to AGNC's HARP II portfolio, a large majority of the underwater HARP II mortgages in their portfolio will eventually default.
As investment advisors with clients that may have exposure to American Capital or other mortgage REITs, you need to seriously consider what I have said about AGNC's portfolio. To the best of my knowledge, no other analyst is talking about this default risk. Take a good look at this one-year price chart for AGNC shares.
Source: scotttrade.com
Share prices have plunged by 34% since May. I am convinced that the decline is far from over.
Non-Agency Mortgage-Backed Securities
Non-Agency mortgage-backed securities include mortgages which are not guaranteed by Fannie Mae or Freddie Mac nor are they insured by the Federal Housing Administration (FHA). Nearly all of them were originated prior to the spring of 2007 when the sub-prime mortgage market collapsed.
The vast majority of those still outstanding were issued during the bubble years 2005 - 2007 when underwriting standards totally disappeared. Many required little or no down payment. Borrowers could often qualify with debt-to-income ratios (DTI) of 50% or more – not possible in earlier years. With so-called "low-documentation" loans, fraud was rampant.
Let's take a good look at one of the other large mortgage REITs whose portfolio is loaded with these non-guaranteed RMBS.
Two Harbors Investment Corp. (NYSE: TWO) had allocated 20% of its portfolio – roughly $2.95 billion -- to these non-guaranteed RMBS as described in its latest 10-Q report filed with the SEC for the second quarter of 2013. The overwhelming majority were originated during the years 2005-2007.
In this 10-Q report, I also discovered that $2.1 billion of these mortgages were sub-prime loans – 87% of the entire non-guaranteed portfolio. Nearly 5% were considered so bad by the rating agencies that did not have any rating at all.
Because of the very high delinquency/default rate on these sub-prime loans, the REIT was able to buy the entire non-guaranteed RMBS portfolio at substantial discounts – an average of only 51% of the par value. Sounds good, doesn't it?
Here is the problem. The 10-Q report reveals that more than 35% of all the non-guaranteed mortgages in this portfolio were seriously delinquent by 60 days or more. That should come as no big surprise. However, let's dig deeper. In an important report published in September 2012, Standard & Poor's estimated that 100% of the non-guaranteed mortgages which are delinquent by 90+ days would default. Not most of them – all of them.
You need to understand that this serious delinquency percentage would be much higher were it not for the huge number of these mortgages that have been modified. Take a good look at this graph from TCW.
As of July 2013, more than 42% of all non-guaranteed sub-prime mortgages have been modified by the servicing bank. The media has endlessly stated that mortgage modifications are good for RMBS investors and for the housing market. Really? Look carefully at this next chart from TCW.
Let me explain this shocking graph. For those borrowers whose loans were modified right after the housing market collapsed – 2007 and 2008 -- nearly 80% of them have alreadyre-defaulted. Even those mortgages modified in 2010 and 2011 are seeing re-default percentages approaching 40%. For those who invest in mortgage REITs such as Two Harbors, they must expect huge numbers of the modified mortgages in the non-guaranteed portfolio to re-default.
Let me explain one more huge problem for Two Harbors which is not mentioned in the 10-Q report. The banks servicing these mortgages have agreements which require them to advance principal and interest payments to the investors for loans that are delinquent. They will get reimbursed when the house is eventually foreclosed. But there is an escape clause which enables them to avoid forwarding payments if they believe it is likely that they willnot be fully reimbursed after foreclosure.
Take a good look at this other chart from TCW. It shows the percentage of non-guaranteed loans delinquent by 60 or more days where the servicing bank hasstopped advancing the mortgage payment to the investor.
You can see that for nearly 40% of all non-guaranteed sub-prime mortgages delinquent by 60 days or more as of July 2013, banks wereno longer advancing the payments. It is very likely that the delinquent sub-prime portfolio of Two Harbors is in a very similar situation.
How can Two Harbors continue to pay out its dividend to shareholders if so many servicers are not forwarding principal and interest payments to them? They certainly do not discuss this problem in the 10-Q report. Could the dividend payouts be coming out of the new capital which this REIT raised by a new share offering in March 2013?
We do know that because of rising interest rates, the spread between Two Harbors' cost of funds and the net yield on its portfolio has plunged from 3.6% in the second quarter of 2012 to only 2.5% a year later. Because of this, they were forced to cut the quarterly dividend again to $0.31 from $0.55 in the 4th quarter of 2012.
As I have explained in numerous articles, the servicing banks cannot indefinitely play this game of kick-the-can-down-the-road for the millions of seriously delinquent borrowers. When they finally start to either foreclose on these properties or complete short sales in earnest, losses to Two Harbor and other mortgage REITs which own these non-guaranteed mortgages will almost certainly soar.
Is the stated yield that these mortgage REITs offer worth the credit risk that your clients clearly face?
Take a look at a chart of the share price decline of Two Harbors over the past year.
Source: scotttrade.com
I strongly urge you to advise your clients to unload their mortgage REITs now before they decline further in value. Any client considering purchasing any of them should be counseled to avoid them like the plague.
Keith Jurow is a real estate analyst and former author of Minyanville's Housing Market Report. His new subscription real estate report –Capital Preservation Real Estate Report– launched in June.
