Description

MFA Financial (MFA) is a Hybrid mortgage real estate investment trust (mREIT) run by a highly experienced management team with a very impressive long-term track record.  MFA’s mortgage portfolio has a number of uniquely attractive characteristics given our view of near and intermediate term economic trends.  We also believe that the prices of a significant portion of the company’s holdings have been conservatively marked and that the process of revaluing these through reserve releases has only started, suggesting an upward bias to the stock’s book value over upcoming quarters.  Further, like most mREITs in today’s market, MFA pays an attractive dividend yield and trades at a discount to its most recently published book value.

I will spend a good part of this writeup looking at MFA’s comparables because I believe the VIC would benefit from a broader discussion about mREITs beyond this particular name, and the opportunities and pitfalls that abound in the sector.  I know mREITs are controversial, and agree that most of the biases against the sector are legitimate.  The most prominent detraction centers on the fact that these are highly levered vehicles that have gorged upon assets that have been artificially inflated for some time and that the bond bubble is just now beginning to burst.  Many mREITs are fairly recent creations, and some were obviously concocted solely to satisfy retail’s pining for yield in a ZIRP environment.  Since 2007, over $65 billion in equity capital has been raised in the sector. 

On the other hand, many management teams are touting how much better capitalized mREITs are than theU.S.banking sector, and that they may be the financiers to take up the slack as the GSEs withdraw from residential lending.  While the debate here makes interesting cocktail party discussion, I hope the posts to this thread will focus less on the unscrupulousness of Wall Street, the stupidity of politicians, etc., and more about timely ideas and insights on specific names in the sector. 

I think it’s clear that there will be some carnage here as the great bond unwind progresses, and as always this comes with the opportunity to generate decent money from good research.  This sector is much more diverse than the armchair commentators appreciate, and to dismiss mREITs as all just highly levered bond funds at the cusp of a secular bear market conveys ignorance of the varied nuances of the names in the sector and the opportunity that lies here.  Apologies for the lengthy preamble, now on to business…

First, at the risk of losing the attention of those familiar with the sector (if I haven’t already), I want to be clear about the terms I am going to use.  The mREITs can be broadly classified into two major categories:  those that focus on “Agency” assets and those that focus on “Non-Agency” assets.  Agency assets are guaranteed by the GSEs (Fannie Mae, Freddie Mac, etc.) and are regarded as having an implicit guarantee from the U.S. Government.  Though there can be some debate about this, the vast majority of market participants believe that these have no credit risk and the incremental yield they offer is due to uncertainty about the timing of the principal prepayments (which is effectively an option in favor of the borrower) rather than the possibility of default.  Because prepayments tend to accelerate as rates go down (leaving the investor with more cash to reinvest than anticipated in a lower rate environment) and decelerate as rates go up (leaving the investor with less cash to reinvest in a higher rate environment), movement in rates in either direction are unfavorable to the MBS holder.  This challenge facing the manager of an Agency mortgage portfolio is referred to as “negative convexity”.  Negative convexity is especially problematic when rates have been trending down for some time because managers are holding assets that are trading well above par (recently average portfolio prices in many mREITs were above 108) that run the risk of substantial loss as they prepay at par.  Agency assets are often bought as securities collateralized by pools of mortgages with certain characteristics that can help the manager model expected potential prepayment rates.  For example, pools of unseasoned (i.e. recently issued), higher coupon fixed-rate mortgages tend to prepay more rapidly than pools of lower coupon, highly seasoned mortgages.  Adjustable-rate mortgages (ARMs) and fixed-rate mortgages that reset as adjustable-rate mortgages (usually referred to as “Hybrids”, but here I will refer to as “ARM-Hybrids”) also tend to have very high prepayment rates.

Non-Agency assets are mortgages that for various reasons (loan size, borrower’s FICO score, Loan-to-value restrictions, etc.) did not meet the criteria for a GSE guarantee, and therefore have credit risk.  These can be either residential or commercial mortgages.  They tend to trade at higher yields because the investor must be paid for both credit risk and negative convexity.  Typically the higher the credit risk perceived on the asset, the less the manager will be concerned about its negative convexity.  That is because highly credit intensive assets tend to trade at large discounts to par (often at 80 cents on the dollar or less) and thus prepayment at par is a very positive outcome that need not be hedged.

So to summarize, Agency mREITs own portfolios of Agency assets and focus on managing negative convexity, while Non-Agency mREITs own portfolios of Non-Agency assets and focus on managing credit risk and, depending on the asset, negative convexity as well.  To muddy the waters a bit, the mREITs that own both Agency and Non-Agency Assets are often called “Hybrid mREITs” - nomenclature clearly intended to confuse us with the ARM-Hybrid mortgage product mentioned above.

In addition to the variation on the asset side, mREITs can also differ widely in their funding, leverage, and hedging strategies.  Agency mREITs tend to be more levered because Agency yields are quite low and a fair amount of leverage must be used to generate returns that can compete with equities.  There is an active funding market for Agencies, and Agency mREITs often use repurchase agreements (“repos”) that can be as short as overnight and as long as several months.  Because of the short-term and price-sensitive nature of their leverage, Agency mREITs employ hedging strategies to mitigate the impact of rate changes on the price of their assets.  Those with longer-term, more volatile assets tend to be more sophisticated in hedging out the impact of moving rates on their book values.  The better-hedged ones will often purchase swaptions, which have positive convexity, to offset the negative convexity of their portfolios, as opposed to merely using swaps, treasuries, or other interest rate shorts to hedge out the portfolio’s rate risk for a single point in time.  Some with shorter term assets tend to be more concerned with hedging their funding costs with the view that book value will be less volatile given how quickly their assets pay down.

By now it should be clear that mREITs should not all be tarred with the same brush, and the sector offers a great variety of ways to express one’s view, or lack thereof, by taking long or short positions in different names.  Our intermediate-term view is to take the Fed at its word that it will reduce its outright purchases of longer maturity securities in a halting and data-dependent fashion but will continue to anchor the short-end of the curve near zero for perhaps somewhat longer than is necessary.  This implies a fairly steep curve for the next two years at least, with the tail risk being that rising inflation forces the Fed to reluctantly abandon its ZIRP sooner than anticipated.  With this as a backdrop, the following is why we like MFA using various criteria, both on an absolute basis and relative to comparables.

Management

As we transition to perhaps a secular bear bond market, management quality is paramount.  This management team appears to us to be among the best in the business.  MFA first listed on the NYSE in April 1998.  Stewart Zimmerman, the Chairman and CEO, has been a director of the company since 1997.  Ronald Freydberg, an Executive VP, has been at MFA since the beginning as well.  They have more experience than virtually any team in the sector and they have navigated through several major interest rate cycles.  These guys think and operate like value investors.  If you listen to their calls and presentations, they are understated but highly confident that they know a cheap asset when they see it and they know how to manage around the risks.  Rather than write more about this, let’s save a thousand words and put a picture up:

This is not the hourly on Unipixel over a two week short squeeze.  This is MFA over 13 years.  At the time they presented at the KBW conference in June, they were up 728% since January 2000, or 17.3% annualized.  Note that it’s important to focus on total return if you wish to verify this, as regular and special dividends are a significant component of the performance (something that the VIC seems unable to measure properly when computing the total return on our ideas!).

Strategy

With improved housing fundamentals so widely evident, Non-Agency credit risk seems to be one of the few places remaining where home price recoveries have not been fully priced in.  We like MFA’s Hybrid strategy, which allows them to shift between Agency and Non-Agency product as opportunities present themselves, but we think the U.S. is only in the middle stages of the improving residential mortgage credit cycle and that credit risk will be easier to manage than negative convexity over the next year or so.  We are therefore biased toward the Hybrids with a large Non-Agency representation in their portfolios.  The table below lists comparable mREITs trading at similar discounts to book and their apportionment of equity capital to Non-Agencies as opposed to Agencies.

Importantly, MFA has historically held off from accreting the discount on its $5.3 billion in Non-Agency assets by holding the discount amount in credit reserve.  As housing appreciation has decreased the loan-to-value ratio of the collateral in this portfolio from 105% at the beginning of 2012 to 90% recently, they have been releasing these reserves so that the discount can begin accreting toward par.  This had the effect of raising the unlevered Non-Agency yield from 6.8% to 7.15%.  Over the past 12 months they have released $224.3 million from credit reserve to accretable discount.  There is still another $1.3 billion remaining in credit reserve that could potentially be released.  Even a modest percentage of this would be very significant relative to MFA’s $2.5 billion equity value.

MFA’s $7 billion Agency portfolio is 63% Hybrid-ARMs with less than 33 months to reset and 37% 15 year fixed rate MBS.  The Hybrid-ARMs tend to prepay very fast, and this combined with the very short average time to reset makes the duration of the majority of their Agency portfolio very, very low.  Note that the 15-year fixed paper amortizes at twice the rate of a 30-year fixed rate and with prepayments the average life of even the longest part of MFA’s Agency portfolio is inside of 5 years.

Portfolio Risk

If we had to choose only two data points for measuring an mREIT’s risk, the first thing we would look at is the “shock table” that estimates its portfolio loss (offset by hedges) given specified shifts in the yield curve.  The second thing would be portfolio leverage, which really gives us an idea of the quality of the shock table’s estimates.  The higher the leverage, the more likely it is that the shock table will differ from reality.  Summarized below is the estimated loss to book value for each comparable assuming a parallel 100 basis point rise in rates, along with their portfolio leverage (debt/equity) at June 30, 2013.

As the table indicates, while MFA is not the least exposed of the comparables to further rate volatility, it has the lowest leverage and it is more likely than most to be right about its estimate of risk.  Apollo Residential does have lower sensitivity and also fairly low leverage, and we like that one as well.  However, it is important to note that Apollo only lowered its rate exposure by selling assets and increasing hedges after rates had already risen during the second quarter.  Apollo’s book value per share fell from $21.72 to $18.63 between March 31 and June 30.  Net of the 70 cent per share dividend, that is an 11.5% drop in book value.  They then dutifully closed the barn door after the horse had already run away. 

By contrast, MFA’s book value per share fell from $8.84 to $8.19 during Q2, which represents less than a 5% drop after adjusting for the 22 cent dividend they paid.  Since we view rates as more likely to stabilize at these higher levels over the next couple of quarters than to rise yet another 100 bps, we are willing to accept the moderate amount of rate risk that MFA currently has.  In our view, the fact that MFA was already at its low duration level and didn’t feel forced to buy insurance after disaster struck provides further evidence of management’s competence and ability to stay disciplined through the cycle.  Apollo only went public in April 2011 and here perhaps is where the difference in experience becomes meaningful and that is why we see MFA as a good potential long-term, compounding investment.  Finally, if one wanted to speculate on rates stabilizing or going down, the more rate sensitive mREITs might be good candidates.

Dividend and Income

Dividends are only as good as the income that supports them.  A 15% dividend yield without income support can actually be worse than a 10% dividend that is fully supported.  We focus on the income yield and view dividends in excess of that yield as potential negatives for at least two reasons:  one is that an unearned dividend will eventually have to be cut and the market doesn’t like surprise dividend cuts, and the other is that it says something about management when the don’t recognize or try to fool the market about the earnings power of their business.  The table below summarizes the last quarter annualized income and dividend yields of the mREIT comparables.

The higher income yielding mREITs are Western Asset Mortgage (WMC), AG Mortgage (MITT), and CYS Investments (CYS).  Coupling this with the prior table, CYS offers its high yield with concomitant interest rate risk (a 22% loss to book on a 100 bps rate rise).  WMC and MITT are very well hedged but have high leverage (8.9 times for WMC and 6.9 times for MITT).  This means the hedges could easily go awry in a disruptive rate environment and we could see larger than expected hits to book value.  MITT might be an interesting speculation for its high yield, full current coverage of the dividend, strong hedging, and relatively modest leverage.  The next step would be to research whether the prospective income on its portfolio is as high as the most recent quarter’s was.  We believe MFA can maintain its current earnings level for the foreseeable future and therefore continue paying its dividend at the current rate.  Since risk management trumps yield in our view, we are content with the lower 10.3% yield offered by MFA. 

Price to Book

All things being equal, we of course always want to pay the lowest price possible for our assets.  The mREITS are now trading at historically low price to book multiples, even though their assets currently offer better spread income than they have in years and one could not easily recreate most of these portfolios from scratch today.  The discount to book value for each comparable is listed below.

Note that we have adjusted MFA’s book value down by the 28 cent special dividend they paid earlier this month.  MFA trades at the lowest discount to book value of all of these comparables.  It may be, though, that the market is onto something and you get what you pay for.  Long term quality at a modest discount may be better to own than a potential donut at a huge discount.  It is important to note that since the value of the assets and the hedges for each of these portfolios changes from moment to moment, the book value at quarter end may be very different from where it is right now.  Our sense is that things have not changed meaningfully from June 30 for these names, but we have only checked a few of these.  Interestingly, many mREITs provide enough disclosure to estimate book value fairly accurately at quarter end, and yet the market does not seem to price it in until the number is actually reported.  This is an exercise that can be very profitable immediately following volatile quarters and an insight that we suggest VIC members consider sharing for profitable short term trades.

Expense Ratio

We have a strong bias against high expense ratios (our definition is management fees plus other expenses over common equity).  High expenses tend to be correlated with poorer long-term performance.  AAGold offered a very interesting insight on one of the VIC topics threads.  Referring to closed end funds, he pointed out that since expenses are a virtual certainty no matter what the assets are in the underlying portfolio and how they perform, they should be capitalized using a low discount rate, with the result that high expense ratios should confer surprisingly large discounts to fund NAVs.  Thus, an expense ratio that is 1 percentage point too high should be capitalized at a lower risk, say 5%, rate and confer a 20% discount to NAV.  This concept should reasonably apply to mREIT portfolios as well as closed end funds (and, for that matter, operating companies whose management teams consistently destroy even a small amount of value each year, but that is another discussion).  The last quarter’s annualized expense ratio for each comparable is presented below.

MFA has one of the lowest expense ratios despite the quality of its management team.  Note that Capstead has the lowest “basic” expense ratio, but it also charges an incentive fee equal to 10% of income above a hurdle rate of 10% on equity capital (they include preferred shares in this equity capital).

Conclusion

While we typically put a price target on our names, it’s not clear that this is appropriate here, given the constant flow of dividends.  MFA is a high quality, well managed mREIT that has delivered impressive returns for over 13 years.  If you buy this below book and hold it for 10 years, we expect you will earn a very nice return.  

Risks

Rapid rise in rates

Crisis in repo funding market

Home prices fall back down

Catalyst