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Mortgage banking world begins to unravel
Rising rates sapped profitability in Annaly Mortgage's portfolio. It's only a matter of time before other players in the mortgage-backed securities market come forward with their own problems.
By Jim Jubak
One shoe dropped last week, but it wasnt the footgear that most investors were expecting.
For months, investors have been waiting for a collapse among the red-hot home builders. But the shares of companies such as Lennar (LEN.B, news, msgs) and KB Home (KBH, news, msgs), while off their highs, have shown no signs of plunging thanks to continuing strong orders for new homes. Despite the surge in mortgage rates, Lennar and KB Home reported order growth for the fiscal third quarter ended Aug. 31 of 22% and 16%, respectively. Third-quarter home deliveries rose 13% and 6%, respectively, the companies announced Tuesday in their earnings reports.
Mortgage rates are higher than they were in June, for sure, but the increase has come from a level that represented a 40-plus-year low. The rise has been enough to put an end to the rush to refinance, but even at the current 6.11% average for a 30-year mortgage, money remains cheap enough to keep home sales growing.
While the sharp rise in interest rates in June and July hasnt caused the collapse of the housing market, it's creating problems for the stocks of the mortgage bankers that financed the boom.
The first measure of how bad those problems might be came Sept. 10, when Annaly Mortgage Management (NLY, news, msgs) cut its third-quarter dividend in half. Annaly is a real estate investment trust (REIT) that owns and manages a portfolio of what are called mortgage-backed securities.
Cutting the dividend
Instead of paying 55 cents a shares to investors in the third quarter, as investors expected, Annaly will pay 25 cents to 30 cents, management said. Even at the lower level, the companys third-quarter earnings, estimated at 27 cents a share by USB Piper Jaffrey, will barely cover the dividend.
What are the problems at Annaly?
The run-up in interest rates has put an end to gain-on-sale earnings. Companies such as Annally can package mortgages and sell them as bondlike securities. When interest rates are falling, as they did reliably for months until May, holders of these securities can sell at a profit because older mortgage-backed securities, paying higher yields, become more valuable. In the second quarter, about 21 cents, or one third, of Annaly Mortgages 61 cents in earnings came from gains on the sale of securities in its portfolio, according to JMP Securities.
The interest-rate run-up has turned portfolio profits into losses. As a REIT that actively buys and sells the securities in its portfolio, Annalys bookkeeping responds to shifts in market prices more quickly than those of many mortgage banks: Annaly marks the prices of most of the securities in its portfolio to market, or reprices them based on market moves. That produced losses of about $50 million in the second quarter. The damage has been even more extensive in the third quarter. JMP Securities estimates that the mark-to-market losses are $150 million to $200 million, enough to reduce the book value per share to $12.35 in the third quarter from $14.35.
Annaly isn't in danger of collapsing, as I read its books. Even if it were, the company is such a small player in the huge mortgage-backed securities market that its troubles would barely create a ripple.
Why Annaly matters
So why is Annalys recent announcement so important to investors? Because everybody on and off Wall Street was doing what Annaly was doing during the housing financing boom. The likelihood is that somebody was much less skilled or lucky than Annaly.
Making money in Annalys business has been remarkably simple, in principle, for the last few years. An investment company would borrow money at the short end of the yield curve to invest in long-dated mortgages. If you remember that the 90-day Treasury yield is just 0.8% now and the average 30-year mortgage yields 6.11%, youll understand why this strategy was so profitable.
Yet often whats simple in principle on Wall Street is complicated in practice. Thanks to the run-up in the prices of mortgage-backed securities, many investment companies were buying these securities at a premium. That meant that if the homeowners who'd taken out the original underlying mortgages refinanced, the mortgage-backed securities would take a hit and investors in them wouldnt get back all the money they'd put in.
To protect against this refinancing risk, investors in mortgage-backed securities bought 10-year Treasury notes. The idea was that if interest rates declined enough to produce a big bulge in refinancings, 10-year Treasury note prices would climb enough to offset mortgage-backed losses. This hedge was solid insurance against volatility as long as only a few investors were using it. But ironically, once everybody began to use it, the insurance policy designed to reduce risk actually produced more of it.
So as refinancings increased in 2002 and 2003, investors in mortgage-backed securities loaded up on 10-year Treasuries as insurance. In June, however, as rates hit what was widely expected to be a bottom, investors decided that they didnt need the Treasury hedge any longer. In fact, they figured holding a large position in Treasurys would produce significant losses if interest rates crept up. So everybody sold Treasuries.
A vicious cycle
All that selling drove Treasury prices lower, which increased investors desire to sell, and also by raising yields drove down the prices on mortgage-backed securities.
The Treasury hedge actually wound up increasing volatility in the bond market and produced bigger-than-expected losses in the mortgage-backed securities market. The interest rate move to 4.5% by the end of July from 3.1% in June was the sharpest in any three-month period since 1927, according to BankStocks.com.
Remember that much of the buying of both mortgage-backed securities and Treasurys was done with borrowed money. Such leverage increases the downside volatility in these fixed-income portfolios.
Other investors in the huge mortgage-backed securities market will show lower earnings and bigger losses than expected in the quarters ahead. And some company among this group will have guessed so wrong on the direction and timing of interest rates and used such dangerous levels of leverage that its portfolio will be far deeper trouble than Annaly's.
It should make for interesting third-quarter earnings reports from mortgage banks and the Wall Street investment companies that trade mortgage-backed securities for their own accounts.
As I said, the first shoe has dropped.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. At the time of publication, Jim Jubak didn't own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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