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Invesco Mortgage Capital Inc. Message Board

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  • marklibera marklibera Aug 14, 2011 6:38 PM Flag

    Mortly fool says IVR will be hurt with the U.S.

    Motley Fool has been wrong in the short term. The premise for their article was that the downgrade in US debt would result in a downgrade in the agency securities (Fannie/Freddie) that mREITs own thus resulting in their repo lenders marking the value of those securities down and requiring mREITS to post more collateral (e.g. a long way of saying that mREIT borrowing costs would go up as a result of the downgrade). However, what we saw since the downgrade is that borrowing costs did not rise much, and now, because of the weakness in the economy, the Fed has pledged to keep short interest rates (which are the basis for mREIT borrowing costs) near 0% for the next 2 years. Because of the Fed's moves, the following could occur.

    First, most mREITs hedge their borrowing costs by buying interest rate swaps that attempt to lock in their low borrowing costs. These hedges are a cost in two ways: there's a price to buy these hedges and they have to pledge collateral to secure the hedge, thus the hedges add to the rate of borrowing, but it locks it in. With the Fed on hold for 2 years, the question is whether the repo lenders will allow the mREITs to take those hedges off. Taking the hedges off, would reduce borrowing costs after subtracting any gain or loss from unwinding the hedge. Someone on the AGNC board suggested that mREITs could switch from interest rate swaps to swaptions, which are options on swaps in order to reduce the cost of hedges.

    The second reaction to the US downgrade and bad economic news was that Treasury securities rallied big such that the 10 yr is around 2.26%. As rates decline, mortgage securities should increase in value, which is good for mREIT's book value; however there is a downside. As mortgage rates decline, those that can refinance their mortgages most certainly will, meaning that the MBS that mREITs own with higher coupons could be called away from them unless the mREITs sell them first. Usually mREITs pay over par for their MBS so if those securities are called away at par, they could sustain a loss. Not only will higher paying securities get called, but the mREITs will have to replace them with lower yielding securities, meaning that their spread will shrink. To maintain their spread, mREITs will typically switch their investments to higher yielding products, like nonagency securities or CDO's and/or increase their leverage to compensate for the loss of spread.

    No one really knows how this will all play out. The US could end up being like Japan, with the Fed keeping short rates low for a long time and the economy being so weak that long rates never rise much. Many of the mREITs have been through many different interest rate cycles, so they know how to adjust their portfolios for many different scenarios, but no one can tell if they've been through a cycle like the one we are now experiencing.

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