The year 2022 was marked by a substantial increase in mortgage rates, which have almost doubled, rising from 3% at the beginning of January to almost 6% today. As rates rise, mortgage-backed securities decline, creating immense pressure on the book value of many mortgage REITs. I first warned against this important risk factor last July in “AGNC: Rising mortgage spreads signal trouble for agency REITs“, where I explained how, as the Federal Reserve ended purchases of mortgage-backed securities, mortgage rates would rise dramatically and could cause many mortgage REITs to go bankrupt. popular mortgages.
I last warned specifically about the most popular mREIT, Annaly Capital (New York stock market :NLY), in February in “Annaly: Skyrocketing mortgage rates could prove disastrous for mortgage REITs“By measuring changes in mortgage spreads and interest rates, I estimated that NLY’s book value per share in the first quarter would likely be around $6.7. A few days ago, this prediction has been confirmed as Annaly reported that its book value slipped from $7.97 to $6.77 during the first quarter.
Today’s immense “greed for yield” zeitgeist has blinded most investors to the simple facts that are driving mortgage REITs down. However, mortgage REITs, like Annaly, are simple companies that operate on relatively predictable mechanisms. They borrow money short-term to buy long-term (usually 30-year) mortgage-backed securities “guaranteed” by Fannie Mae (OTCQB: FNMA) and Freddie Mac (OTCQB: FMCC). As I have tried to communicate, this “guarantee” does not make them risk-free, as it is unclear whether these institutions can meet their obligations in the event of a general increase in mortgage defaults. More importantly, due to the immense leverage of Annaly (and its peers), a rise in mortgage rates relative to Treasury rates can lead to a massive drop in book value.
Looking ahead, there have been notable shifts in market dynamics that alter my outlook for Annaly and the mortgage market as a whole. Mortgage rates have continued to rise dramatically as the market is no longer artificially supported by Federal Reserve purchases. In addition, rising mortgage rates are slowing the domestic housing market. This could soon lead to lower house prices, push up loan-to-value ratios and potentially increase pressure on agencies. After experiencing a notable drop in GDP in the first quarter, the US economy could be back in recession, potentially helped by recent declines in the stock market and savings rates. Overall, this does not bode well for Annaly or other mortgage REITs. However, many of the specific risks faced by mortgage REITs (such as the tightening effect on mortgage spreads from the end of QE) are no longer significant factors weighing on the business.
Predict Annaly’s book value
To some it may seem like a coincidence that I predicted the first trimester of Annaly final book value two months ahead within a range of approximately 1%. Indeed, I did not expect my estimate to be as close to reality as it was. Even still, it’s worth pointing out that no guesswork or additional information was needed to do this, as the NAVs of mortgage REITs are highly predictable based on publicly available information. To demonstrate this, see Annaly’s most recent interest rate sensitivity table:
After all of Annaly’s leverage, positioning, and hedging, this chart allows us to see roughly how her net asset value will change with changes in Treasury rates and mortgage rates. “Interest rate change” exposure relates to changes in Treasury rates (with a maturity close to that of Annaly’s portfolio) which also affects mortgage rates. The “MBS spread shock” relates to changes in mortgage rates that are not observed in Treasury bills. Generally speaking, higher mortgage spreads weigh on the book value of mortgage REITs as it is difficult to hedge against the mortgage market. It should also be noted that approximately 97% of Annaly’s total securities (and 85% of its total assets) are agency mortgage-backed securities, the lowest yield level of mortgage loans. The vast majority of them are at fixed rates with maturities ~30 years.
As a result, Annaly’s book value declines in proportion to the increase in the spread of 30-year mortgage rates relative to the spread of 30-year Treasury bills. This measure has fallen from near zero to 2.17% over the past year as US commercial banks and the US Federal Reserve stopped buying mortgage-backed securities (and became net sellers). See below:
Banks and the Fed collectively own nearly all of the mortgage-backed securities market, so it’s no surprise that mortgage spreads have skyrocketed as their buying slowed and reversed. As shown in the table above, a 25 basis point increase in this spread causes Annaly’s net asset value to fall by approximately 9-12%. Since last summer, the spread has increased by approximately 1.5% and has significantly reduced NLY’s net asset value as the value of its assets has declined while its liabilities have remained virtually unchanged. Notably, a decline in assets relative to liabilities means more leverage, and as leverage increases, its NAV sensitivity to MBS spreads also increases. In other words, generally speaking, the higher the MBS spread, the greater Annaly’s sensitivity to MBS spreads. This fact can be seen by the increase in sensitivity to Annaly’s MBS spreads over the past year.
Luckily for the company, MBS spreads have remained roughly flat since March 31, so this factor may will no longer drive down Annaly’s book value. At nearly 2.2%, the mortgage spread over Treasuries is slightly above typical levels, so mortgage spreads are unlikely to widen much further unless there is a shock to the real estate market or a liquidity event. That said, as last happened in early 2020, we may see an increase in fears regarding outstanding mortgages and matters regarding Fannie and Freddie’s ability to secure the mortgages in the event of a general decline in the value of American homes. In the crash of 2020, the spread of MBS skyrocketed for a few days and forced many mortgage REITs will suffer from margin calls. A similar chain of events could play out again soon if investors turn bearish on the US economy and housing market and if so, this could create disastrous downsides for Annaly since she is already in a precarious position. .
Either way, Annaly’s book value has likely declined slightly since the end of the first quarter. While MBS spreads have remained stable, the 10-year Treasury rate has risen about 50 basis points since March 31 due to accelerating inflation expectations. See below:
The sensitivity table above shows that a 50 basis point increase in Treasury rates is associated with an estimated change of approximately 4.1% in Annaly’s net asset value. From a base of $6.77, that means Annaly’s book value per share is likely closer to $6.50 today. The company is currently trading at $6.47, so it is likely neither undervalued nor overvalued based on its estimated book value.
I remain bearish on Annaly and still sell the stock via put options. That said, the stock is now likely trading very close to its interest rate-derived book value. Given the significant increase in mortgage spreads this year, the main bearish catalyst I’ve seen for Annaly is now barely in effect, so it may not fall much further, if at all. Of course, suppose the Federal Reserve becomes preoccupied with the housing market and buys MBS securities again. In this case, Annaly’s book value could increase significantly as MBS spreads reverse. This is the biggest risk of shorting Annaly, but given that the Fed is keen on fighting inflation and is (in my opinion) generally slow to act on current information, I think a return to the QE is unlikely. Either way, commercial banks are now selling MBS assets, which could further increase MBS spreads, regardless of the Fed’s plans.
Although I’m not as bearish on Annaly as I was two months ago, I think the stock could still see some downside acceleration. if there is capitulation in the mortgage-backed securities market. Many banks, private investors and mREITs have lost substantial sums on MBS assets and, particularly in mREITs, have seen debt levels rise dramatically. As such, many, including Annaly, are at high risk of margin calls that could create hard sells in the MBS market.
This factor may also be catalyzed by the rapid slowdown in the US economy and home sales which could soon lead to lower house prices. Although Annaly has little direct credit risk (since its MBS assets are agency guaranteed), I highly doubt that Fannie Mae and Freddie Mac will be able to meet their obligations in the event of another general downturn in the housing market. As last seen in 2008, the mortgage market could freeze if investors question the guarantor capacity of these agencies. Thus, Annaly has significant indirect exposure to the precarious US real estate market. Overall, while Annaly is likely trading very close to its current NAV, I still think investors should avoid stocks and most other mREITs until it becomes clear how the real estate market, the stock market and the economy will react at much higher rates.