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ARMOUR Residential REIT, Inc. Message Board

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  • jackhiller May 6, 2011 9:20 AM Flag

    Other Reits----Question

    The Fed generally manages the short rates. As an unusual measure to prop the economy and avoid a double did down or worse (Depression), under QE2 it took the unusual action to buy long dated treasuries to also reduce the long rates.

    Now, I assume you understand that the MREITs make most of their income by using their equity to borrow at the relatively low short rte (now being kept close to zero for an indefinite future by the Fed) to buy mortgages yield a much higher rate. Leveraging on the equity is running for the MREITs between about 8-9 times to increase profitability from the short to long (mortgages) rate spread.

    When finally the Fed believes the economy is strong enough to begin worrying more over inflation than recession/depression, it will star raising the short rates--and that's when your logic fails. At that time the long rates will have move even higher over inflation concerns to actually initially increase the rate spread and profitability.

    The risk for the MREITs is initially not so much from the short rate raising their borrowing costs as it is from the fact that the equity from their mortgage portfolio (their book equity) shrinks, and if it shrank quickly, they could be forced to sell out of their portfolio at a loss. Because of this risk, the market is requiring the high yield we see.

    To moderate the risk of portfolio losses, the MREITs take several steps, to include, deleveraging, using derivatives that gain in value when the short rates go up, and using derivatives that gain in value when the mortgage rates go higher (compensating for their mortgage portfolios losing mark to market book value).

    If you do not fully understand how the MREITs manage thru the interest rate cycles, you should not be investing or trading them.

    Based on your post, you should stay away.

    Best of luck

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    • If you do not fully understand how the MREITs manage thru the interest rate cycles, you should not be investing or trading them.

      Agreed with Jack comment here. Mreit as a group is very volatile (just check the price action for NLY between 05 and 06, it dropped from $20 to about $11+ in 3-4 months. We need a low rate environment to make it worth holding. The problem is that when it is time to exit, everyone will jam through a small door..;range=my;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=off;source=undefined

      • 1 Reply to xofruitcake
      • jackhiller May 8, 2011 11:28 AM Flag

        xo,Precisely--so you need to exit beforehand. To do that, you need to follow the national political discourse that will persuade the Fed to move the short rates up to be able to testify on the hill that they are fighting inflation.

        In advance of the Fed moving the short rate higher (after the 2012 election at the earliest), the long/mortgages rates will have moved higher to a level that will have created a high rate spread, and that enlarged spread will be narrowed, not terminated by the Fed increasing the short rates--so a good profit will continue to be earned from the rate spreads. If and only if the economy gets strong enough to power inflation (not the slow, dull power of inflating from deficit spending and monitizing the debt), then the Fed would be impelled to raise the short rates high enough the create an inversion (the short rates going higher than the long).

        But even before an inversion, with long rates having gone higher and higher, the mortgage portfolio values (book value) will go lower and lower. The AGNC CC recently explained that they spend on derivatives hoping the money spent is wasted, but if the long rates were to move significantly higher (as they will tend at the termination of QE2), then they make a profit that compensates for the book value loss.

        There are multiple variables at work that influence MREIT profitability: short rates, long rates, book value from mark to market accounting for the mortgage portfolios, and the use of derivatives for managing the possible moves in the short rates and long rates. The MREIT business is inherently complicated. If this tortuous explanation is not understandable, then you should not be investing or trading the MREITs.

    • ... "Because of this risk, the market is requiring the high yield we see." Yeild is not market driven -- they have not much of a choice as by law they are required to return 90% or more of profits. Someone going to kick your butt for that statement, can't say it not deserved!

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