MFA Financial’s risk transfer strategy pays off

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The more interest rates fall, the harder it becomes for Mortgage Real Estate Investment Trusts (REITs) to make a profit – and interest rates today are low and falling. As other mortgage REITs pursue ‘safe’ investments in vain that pay next to nothing, MFA Financial (NYSE: AMF) instead shakes up its holdings, pursuing riskier investments with the promise of greater rewards. While this might sound dangerous for a stock that attracts security-conscious investors, it could help the company maintain and increase its double-digit dividend yield over the long term.

How Mortgage REITs Work

Mortgage REITs invest in debt securities, earn interest and pass it on to investors via the dividend. They typically focus on residential mortgages (like the mortgage on your home) or commercial mortgages (the debt on office buildings and shopping centers). The MFA has historically focused on residential mortgage backed securities (MBS) guaranteed by the US government. These instruments carry no credit risk – if the borrower does not pay, the government will.

MFA changes portfolio

MFA Financial recently reported fourth quarter earnings of $ 0.21 per share, down from $ 0.19 per share a year ago. The profit for the previous year was affected by special charges, so it does not necessarily represent organic growth. The BPA count exceeded Wall Street expectations of $ 0.20 per share.

MFA’s profits were fairly stable in 2019. Over the past year, the company has reduced its investments in government-guaranteed mortgages and invested in more credit-sensitive instruments, particularly unsecured mortgages by the government. government. It’s not about adding more risk – it’s about adding the right kind of risk. This makes sense in today’s economic environment, where defaults are at their lowest level in 40 years and the yield on government guaranteed mortgages is approaching the cost of borrowing. When an asset’s potential returns get too low, it’s time to deploy that capital to something better. This is what the MFA does.

Image source: Getty Images.

The problem with new residential real estate loans is the sourcing of investments. Mortgage-backed securities are very liquid: it’s easy to buy or sell $ 100 million in a single transaction, and a dozen major banks specialize in their trading. This is not the case with whole residential loans. They are sold in smaller quantities and do not trade on any stock exchange. It can be difficult to get enough exposure to generate a significant return.

MFA solved this problem by investing $ 148 million in five mortgage lenders, who then sell some of the loans they make directly to MFA. Most of these loans are in the non-qualifying mortgage space – typically loans that don’t fit perfectly in the subscription box for Fannie Mae Where Freddie Mac. These loans are high quality loans designed for professional real estate investors and independent borrowers who cannot report W-2 income. These loans often carry higher interest rates to offset the credit risk.

MFA’s non-QM loan portfolio has an average loan-to-value ratio of 67% and an average FICO score of 716, management said in the latest earnings call, meaning loans are underwritten quite conservatively. and have nothing in common with the bad quality loans taken out before the housing crisis. MFA also invests in fix-to-flip loans and rental loans, which are part of the overall loan portfolio.

Agency MBS versus full loans

The table below compares the desirability of whole loans versus agency mortgage-backed securities, which is why MFA is strengthening its entire loan portfolio.

Metric MBS Agency Residential mortgage loans
Assets $ 1,665 million $ 6,066 million
Leverage 14.6 2.3
Yield 2.38% 5.31%
Cost of funds (2.33%) (3.59%)
Broadcast 0.05% 1.72%

Data source: Company deposits.

Look at the differences between agency MBS and whole residential loans in terms of yield. Find out the difference between the return and the cost of funds (the spread) on the agency MBS portfolio. It’s almost nothing. Now compare it to the residential real estate loan portfolio. See the difference? The yield is much higher and the gap between yield and borrowing costs is much larger.

The number of levers is also important. Leverage is like margin – it magnifies gains and losses, and the more you have, the riskier the portfolio. With the agency MBS wallet, even though the government guarantees that you will get paid, you can still lose money. The interest rate risk is very real. In 1994, after the unexpected interest rate hike from the Fed, Orange County in California was forced to file for bankruptcy due to losses on its mortgage-backed securities investment portfolio. Just like normal bonds, when interest rates rise, bond prices fall. It is therefore logical that the AMF turns to assets with better risk / return characteristics.

MFA takes the right steps to protect the dividend

The current economic environment is favorable to credit risk, as payment defaults are at their lowest for 40 years. MFA has paid a dividend of $ 0.20 for 25 consecutive quarters. That’s a double-digit return on the current stock price. By shrinking the agency’s MBS portfolio and redeploying capital to whole loans with much better returns and more favorable risk characteristics, MFA secures its dividend. Income-seeking investors should take a look at Mortgage REITs in general, and MFA’s history of stable income makes it a good candidate in particular.

This article represents the opinion of the author, who may disagree with the “official” recommendation position of a premium Motley Fool consulting service. We are motley! Challenging an investment thesis – even one of our own – helps us all to think critically about investing and make decisions that help us become smarter, happier, and richer.

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