2013-08-12prudentbear.com

One such [QE-driven] correlation involves a massive effective subsidy to residential mortgage real estate investment trusts (REITs). Short-term interest rates are held down artificially near zero, while long-term interest rates are prevented from rising substantially by Fed quantitative easing (at least mortgage REIT sponsors think so). Thus for the last five years mortgage REITs have been able to leverage themselves in the short-term market and buy government-guaranteed home mortgages, leveraging the spread between the two interest rates. If that spread is 2.5%, and a mortgage REIT is leveraged 10 to 1, it can make a return of 25% on its capital, plus whatever return it gets on the mortgages purchased with its equity.  That in turn allows it to pay dividend yields above 10%, and leads the shares to trade well above their book value--that in turn allows the mortgage REIT to carry out repeated stock issues, growing exponentially by doing so.

Normally this silly game would be defeated by an eventual rise in long-term interest rates, which would cause mortgage bonds to decline in price until the mortgage REITs capital was wiped out (because with a 10:1 leverage ratio, a 10% bond price decline, occurring after a rise in long-term rates of only about 1%, would have this effect.) However with the Fed capping long-term interest rates through bond purchases, the mortgage REITs' silly but profitable game can be carried on adfinitum.


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