As you can see, you can buy these REITs at a good discount to the value of their assets.
The other thing you'll notice above is the extremely hard to ignore dividends. As mortgage REITs were able to get their heads above water in late March, they increased their dividends significantly, which is a bit enticing.
Ultimately, there are two types of mortgages that REITs invest in. There are agency loans and non-agency loans. Agency loans are backed by the U.S. government, so they are free from default risk. As with all investments, the reduced risk also means lower returns.
Non-agency loans are not backed by any federal agency, so there is a risk of loss from default. However, these loans also provide a higher return in exchange for the risk.
REITs that have been focusing on agency loans have benefited with some relief from the Fed, as they announced that they will be buying these agency-guaranteed mortgage-backed securities. This has been allowing them to make their margin calls and giving them liquidity as they need it to have room to move during the current uncertainty.
The move into agency loans, and the Fed offering to buy as many as needed, sounds promising. The problem, however, is that this is just a short-term solution while they hope to solve their long-term problem. The issue they're facing is that the Fed dropped interest rates as a measure to protect the economy. This rate drop created a demand for mortgages for home purchases and refinancing.
The mortgage REIT model basically involves the REIT taking on short-term debt at a low interest rate, then buying mortgages at a higher interest and profiting from the margin.
The low interest rates aren't hurting the REITs in the present, because they're also able to borrow at a discount and keep the same spread. For example, a REIT takes out a loan at 1.5% to fund a mortgage at 4%. They earn their profit from the 2.5% spread.
The problem comes as interest rates begin to rise, which they inevitably will at some point. By this point, the Fed will likely cut back on buying, and very few people will be refinancing into a higher-rate mortgage. Other investors aren't likely to be buying low-rate mortgages, either.
Since the REITs use short-term debt, it has to be paid well before the 15 or 30 year terms of the mortgage. This means they have to keep replacing their debt. As rates increase, they're paying more for the money they're using to hold onto their mortgages.
Consider the example above, but with the REIT now paying 2.5% for the money. Their margin gets squeezed down to 1.5%. If the rates continue to rise, they just keep getting squeezed tighter.
Interest rates are always a risk for mortgage REITs, so this is nothing new. They often hedge against rate increases with strategies like a rate-swap. Without going off track to discuss rate swaps, I'll just say that they're not likely to offer as much protection against the lower-return agency loans, especially since everyone is staring down the barrel of the same economic outlook.
Rising interest rates aren't the only imminent threat mortgage REITs are facing. We can't forget that we're just in the beginning of a serious economic crisis and none of us can really say with much certainty how the next couple of years will play out. The lower returns on the agency loans aren't going to give them as much room to handle an increase in default rates.
I've been seeing a lot of people who are still optimistic about mortgage REITs and have laid out scenarios that could make them a real winner. However, these scenarios are best case, with everything working out exactly as everyone hopes. Every other scenario looks ugly.
I think there's some money to be made in the short term with the high dividends and a likely rise in the share prices. I would just be cautious about trying to ride it out too long. Personally, I'll stay on the sidelines and hope it works out for everyone who decides to take the risk and go for it.