Mortgage Market Drop Requires Scrutiny

 | May 30, 2013 | 10:00 AM EDT  | Comments
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I wrote about Armour Residential (ARR) on May 20, and in the last two trading days the shares have been under heavy pressure. As an investor, the following steps need to be taken before any buy/sell actions:

Find out what is causing the decline. In this case the culprit was a sharp decline in Treasury prices Wednesday morning, continuing Tuesday's decline. Strong economic data reignited fear the Fed will taper its QE3/QE4 bond-buying regime. That drove a decline in the mortgage-backed market, as MBS prices followed the trajectory of the swoon in Treasuries (see Chart). ARR's portfolio is composed entirely of Agency MBS.

Source: Mortgage News Daily

So, the sudden spike in Treasury rates "freaked out" the mortgage markets, despite the fact that there is no default risk (Fannie and Freddie's survival in 2009 proved the "implicit guarantee") and prepayment risk is mitigated when premia are declining.

But in this case there are two risks:

1)     Benchmark risk: A 30-year FNMA 3.5% coupon mortgage-backed securities may look attractive when the 30-year UST is yielding 2.75%, as it was at the end of April. But when it's yielding 3.38% one month later, the price of the "benchmarked" securities has to come down to match the prices of the benchmark and they have.

2)     Incremental Buyer risk. Essentially a supply/demand concern. If the Fed tapers its program of buying $45 billion of MBS and $40 billion of USTs per month, then the incremental buyer is removed from the market, so pressure on prices.

Fixed income textbooks define the phenomenon of negative convexity in mortgages--prepayment speeds increase as rates fall -- lowering the implied option value of a pool of mortgages. Rising rates are better for mREITs in that regard, but the market action in the last two days shows that, in the short run, fear trumps analysis.

Look at comps: Check comparable companies' share prices to differentiate between a company-specific issue and industry malaise. In this case ARR comps American Capital Agency (AGNC), Annaly Capital  (NLY) and Anworth Mortgage (ANH) hit 52-week lows on Wednesday between 10 a.m. and 12 noon, as did ARR. That it's not a company-specific problem is not fully reassuring, but if something affects only one stock in an industry and that is the one you own, then you shouldn't own it.

Follow Insiders: Later Wednesday it was revealed via Securities and Exchange Commission filings (Form 4) that ARR co-CEOs Scott Ulm and Jeffrey Zimmer had purchased 5,000 shares of ARR at about $5.00 per share. Not huge transactions, at $25,000 each, but a reassuring sign of management confidence.

Check fixed-income alternatives. ARR common has performed poorly in 2013, as fear of the Fed has stricken mREIT share prices, but ARR's preferred shares (ARR.A and ARR.B) had been immune until the last two days. ARR-A had not traded under a 2% premium to face value for the preceding six months, but started to fall Tuesday and the swoon Wednesday took it to a low of $24.50, a 2% discount, and an 8.4% effective yield.

At Portfolio Guru, LLC we buy panic, and we were buying ARR-A for clients Wednesday. Lower mortgage-backed security pricing pressures Armour's book value and that will continue to impact ARR's common stock price, but is largely irrelevant to the value of its preferred. 

ARR-A's fixed payment is really a question of solvency and lower prepayment speeds actually increase Armour's ability to pay preferred dividends. And in terms of benchmark risk, it's hard to imagine a world where ARR-A's 8.25% coupon is not attractive versus treasuries, especially since ARR's holdings are 100% guaranteed by Fannie, Freddie or Ginnie.

So, the valuation of ARR's common stock is controversial -- I'll delve into that tomorrow -- but ARR-A is a safe bet here, and if it declines we will buy more.

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