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Mortgage REIT preferreds are simple balance sheet plays. Whereas the equities in mREITs can be a bit volatile, the C series preferreds at AG Mortgage (MITT) should be a stable asset to hide out in in order to weather any equity market declines.
Here are the basic terms of the preferred:
Source: Author Spreadsheet
As this is a balance sheet play, I thought I would copy that and go through the coverage offered to preferred holders.
From their recent 10Q, below is their balance sheet:
They basically have $3.8BB of assets, $2.1BB of which are Fannie or Freddie government backstopped bonds (aka Agency bonds), plus another $680mm of Non-Agency bonds. Non-Agency bonds are not guaranteed by any agency of the government, so carry credit risk. Their CMBS (Commercial Mortgage Backed Securities) book comprises another $281mm.
Then, MITT makes a variety of lower risk direct loans, essentially to consumers for mortgages and businesses in the form of commercial real estate loans. They also carry Mortgage Servicing Rights (MSRs) and a small single family home rental business. Industry analysts refer to MITT as a hybrid REIT (with a mix of credit and non-credit rate risk).
Their portfolio adds up to $3.8BB, and is marked to market every quarter. Of their Agency bonds, almost all are 30 year fixed mortgages. Again, principal and interest are backstopped by Fannie and Freddie Mae, which are government agencies. Any consumer defaults are covered by the issuing agency. They essentially have no credit risk with these bonds, but do have prepay and rate risk.
Against their assets, they have borrowed $3.0BB to finance the purchase of this portfolio, mostly through the REPO market. That is, they buy a 30 year agency bond which yields say 5%, and borrow at roughly 3% for a NIM of 2% (NIM=Net Interest Margin). The average duration of MITT’s liabilities is 138 days as of June 2019, with assets much longer dated. Like banks, they borrow short and lend long.
Now, MITT hedges their REPO rates with rate swaps (which is why they pay more than say the 2% fed funds rate for their liabilities). They also manage prepay risk and convexity with swaptions and MSRs. While those are outside the scope of this write up, or investing in the preferreds, the key is that MITT has a pretty good long term track record of managing rate risk and prepay risk since they went public in 2011.
Overall, the stock has returned 9.1% per year since its IPO, with the company generating ROE’s in the 6.3% ballpark over the past 5 years.
Below we can see NIM’s over the past few quarters, with the June quarter at 2.0%.
Source: Company presentation
NIM is impacted by the Fed Funds rate, as well as the yield they make on their loans and securities portfolio. 2% is well down from the 2.7% NIM a year ago, but not terribly relevant to the preferreds. With the Fed lowering rates now, their NIM should improve by 50bps (two rate cuts this summer) within a few months. When the fundamentals improve for an equity, it usually is good for the preferreds.
Leverage is an important metric for MITT. They typically run between 4.3 to 4.7x (debt/equity) as you can see above. In the 2000’s, 6-9x was typical mREIT leverage, with REPO haircuts in the 5% range (meaning they could lever up bond purchases by 20x).
Today, the industry runs much more conservatively. MITT is probably below average in terms of its balance sheet risk.
Below is their capitalization table:
Source: Author spreadsheet and Company Financials
The key above is that leverage is 5.45x through the preferreds. The table by the way is proforma for the newly issued C preferreds. The A and B issue preferreds are callable at par with 30 days notice, and given that they both are trading around $25.50 (well above par), there is actually a negative yield to takeout should they be called.
From the 7/31/2012 Prospectus:
On and after August , 2017, we may, at our option, redeem the Series A Preferred Stock, in whole or in part, at any time or from time to time, for cash at a redemption price equal to $25.00 per share, plus any accumulated and unpaid dividends to, but not including, the date fixed for redemption.
The same language can be found in the B series preferreds here. Owning them above par plus accrued ($25.13 roughly today with accrued) now that the company has cash to redeem them makes little sense.
While the value of their assets will move around based on rates and prepays as well as REPO rates, the company has $3.8BB of pretty safe assets, with $3.0BB of debt ahead of the preferreds. It would take a more than a $570mm hit to their portfolio to impact the asset coverage of the preferreds at MITT.
Said differently, the $3.8BB of mortgage bonds and loans would have to drop to 82c vs their current marks to impact preferred coverage.
That begs the question, could their portfolio fall to 82c on the dollar should we get another Great Recession?
Here is an important sensitivity table in the back of every single mREIT I have ever looked at. This is on page 107 of their latest 10Q:
Basically, this says that if interest rates rise by 75 basis points (0.75%), then their book value would fall by 4.8%, and their asset values would fall by 0.9%. This should apply to spreads too.
During the financial crisis, spreads on 10+ year Agency bonds spiked from about 30 basis points (that is, they yield about 30 bps more than a treasury of the same maturity), to 150 basis points.
So, along those lines of thinking, a 150 basis point move in spreads would likely impact their equity by 9.6% (2 x 4.8% or about $70mm), and their assets by about the same (on a dollar basis).
$70mm is not much potential impact here. With $570mm of common equity (ex the preferreds), it would take a move in spreads several times worse than the Great Recession (which was very much driven by low quality mortgages), to even come close to impacting the preferred’s coverage.
The risk is more likely that the management team at MITT decides to lever up ahead of the preferreds, or that the preferreds trade down should the market sell off. The counter argument is that in a sell off, rates and yields should fall, offsetting any spread widening risk.
There also is the risk that in five years, LIBOR is zero, meaning the dividend would fall to 6.5%.
I think a fair yield on this preferred is 7%, which would put them in the $26.06 price range. So, there seems to be a couple percentage points of capital gain left here, with another 8% of coupon looking out twelve months.
That is a 10% total return in a year on a well-covered, safe piece of paper.
By the way, Annaly (NLY) five year fixed to floating preferreds trade at a 5.86% yield, and carry leverage in the 6.3x range. That is quite a bit higher. It also floats at 499 in 2024, which is quite a bit tighter than the 648 spread for MITT here.
A 6.0% yield for the MITT preferreds implies a price of $27.16, adding another 4% of gains.
Finally, I have met many guys at Angelo Gordon in my career. They are the external manager here (AG=Angelo Gordon), and a pretty conservative, smart fixed income focused hedge fund.
I’m not so keen on the equity here. AG is taking 1.5%, and with NIMs at 2.0%, things are pretty skinny. Their $0.45 quarterly dividend isn’t covered by their recent quarterly core EPS figure, which was $0.36. They do have lots of Undistributed Taxable Income (UTI’S), and rates falling will help, but there is risk that they cut the dividend again.
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Disclosure: I am/we are long MITT C PREFERREDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.