The selected commentary relates to Annaly Capital (NLY) and TBT, TLT, MREITS, Agency ABS, Treasuries, QE and Fed policy, and specifically ties in with prior blog posts “Still Twisting and Turning”, 24 May 2012, “Operation Twist Is Totally Skewed”, 22 March 2012. It's worth noting that Bernanke has, until very recently (in fact, more clarity was provided at yesterday's Fed meeting, but significant uncertainty remains), not defined concrete policy as it relates to QE.
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I was highlighting the term "value
investor" as it's not common to combine value investing with
being a technician. In your article you highlight chart patterns - no
one will miss that aspect of your analysis, but the "value
investor" aspect appears missing (at least in terms of a Ben
Graham inspired take on the term).
Your response to the "QE" issue is correct, at some stage it will end, but I'm sure you'd agree that the Fed's demand for agency paper drives up the price of these investments. No one is saying that 40 billion/month purchases is not affecting the agency paper market, and no one has succinctly identified the correlation between low agency backed mortgage rates and unemployment. Then again, maybe the Fed will proclaim "mission accomplished" if the unemployment rate hits 7.6% again, or maybe the program will be canned when Bernanke retires - who knows.
Now, your specific comment regarding QE 2 and 10 year yields... well, the purpose of the Fed's "Operation Twist", or whatever term people chose for it, was to reduce long term rates, so Fed open market activity favored longer term bonds. This explains the action of the 10 year versus the 30 year, and it'd be hard to avoid agreeing with the consensus - which is that the "twist" accomplished what the Fed set out to do (lower long term rates). That the economy rebounded is also true, but the interest rate environment was shaped by the Fed.
Back to QE 3. In a rate environment where the 30 year recently yielded less than 2.5% being happy with double digit yields is logical. But, we've seen that the Fed is a powerful force, and for the foreseeable future they've decided to decrease agency backed mortgage yields. While the Fed suppresses these yields they also engage in other substantial open market activities, but what it all amounts to, for MREITs, is a lot of uncertainty while they face increased reinvestment risks.
MREITs have been hurt by Operation Twist because mortgages tend to have long maturities, and QE "infinity" further damages their prospects as they have to compete for paper with the Fed.
Finally, is it logical to listen to MREIT senior management complain about the environment and trust that they've found a safe passage protecting shareholders' expectation of a double digit return? It seems like there's ample scope for hoping that things turn out well for MREIT investors - I'll leave you with a George Savile quote:
"Hope is generally a wrong guide, though it is good company along the way."
Your response to the "QE" issue is correct, at some stage it will end, but I'm sure you'd agree that the Fed's demand for agency paper drives up the price of these investments. No one is saying that 40 billion/month purchases is not affecting the agency paper market, and no one has succinctly identified the correlation between low agency backed mortgage rates and unemployment. Then again, maybe the Fed will proclaim "mission accomplished" if the unemployment rate hits 7.6% again, or maybe the program will be canned when Bernanke retires - who knows.
Now, your specific comment regarding QE 2 and 10 year yields... well, the purpose of the Fed's "Operation Twist", or whatever term people chose for it, was to reduce long term rates, so Fed open market activity favored longer term bonds. This explains the action of the 10 year versus the 30 year, and it'd be hard to avoid agreeing with the consensus - which is that the "twist" accomplished what the Fed set out to do (lower long term rates). That the economy rebounded is also true, but the interest rate environment was shaped by the Fed.
Back to QE 3. In a rate environment where the 30 year recently yielded less than 2.5% being happy with double digit yields is logical. But, we've seen that the Fed is a powerful force, and for the foreseeable future they've decided to decrease agency backed mortgage yields. While the Fed suppresses these yields they also engage in other substantial open market activities, but what it all amounts to, for MREITs, is a lot of uncertainty while they face increased reinvestment risks.
MREITs have been hurt by Operation Twist because mortgages tend to have long maturities, and QE "infinity" further damages their prospects as they have to compete for paper with the Fed.
Finally, is it logical to listen to MREIT senior management complain about the environment and trust that they've found a safe passage protecting shareholders' expectation of a double digit return? It seems like there's ample scope for hoping that things turn out well for MREIT investors - I'll leave you with a George Savile quote:
"Hope is generally a wrong guide, though it is good company along the way."
Nov
3 08:37 AM
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A
Low-Risk, High-Reward Way To Play American Capital Agency Now That
It Has Broken Down [View article]
The
strategy can be altered... but the problem you're up against is that
there aren't many options on MREITs which trade efficiently - you're
left buying the shares (entitling you to collect the dividends),
buying a put (to limit your risk), and selling a call (to reduce the
price of buying the put) as the most obvious strategy, but when you
look at the huge bid/ask spreads... Anyone who firmly believes that
these companies are not in peril, could try simply selling an
in-the-money call to mitigate some downside risk, but there's no way
to escape the fact that it's a minor and inefficient hedge.
Nov
2 09:32 AM
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A
Low-Risk, High-Reward Way To Play American Capital Agency Now That
It Has Broken Down [View article]
Also,
thinly traded options on AGNC makes this company, over time, a worse
vehicle than NLY. Even NLY is thinly traded... in fact, there's no
"efficient" MREIT options play - where positions can be
rolled with minimal slippage. MREIT options are for position traders.
Nov
1 07:35 PM
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Take
it to its logical extreme.. don't fight the Fed: liquidate the entire
portfolio, don't buy back any shares but wind up operations and
return the proceeds to shareholders, then delist and go
golfing.
"Managing" an agency portfolio right now equates to fighting the Fed. Share buybacks, expensive hedging strategies, lobbying in DC etc etc is not serving shareholders - only preserving management's pay packets. The Fed's program is a gift to managers ethical enough to cash up and exit the sector.
MREIT managers can easily protect shareholders interests - these are not large "head-count" firms, and they're not managing illequid assets (it's not like winding up GM).
"Managing" an agency portfolio right now equates to fighting the Fed. Share buybacks, expensive hedging strategies, lobbying in DC etc etc is not serving shareholders - only preserving management's pay packets. The Fed's program is a gift to managers ethical enough to cash up and exit the sector.
MREIT managers can easily protect shareholders interests - these are not large "head-count" firms, and they're not managing illequid assets (it's not like winding up GM).
Oct
31 06:16 PM
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Have
to add this... cashing up provides the best "risk adjusted
return" - maybe this term will get some people to look at the
situation again.
Oct
19 09:44 AM
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The
financially right thing to do is to sell out to the Fed (as per my
above comment - I wasn't joking).
The distortion caused by the Fed's current program is, right now, helping agency investors, tomorrow it will hurt these same investors as they try to find new paper.
Chances are that non of the MREIT managers will cash up, but that remains the right thing to do. Investors like picking through the rubble of failed industries, dreaming of the good old days and wishing for their return, but it's no way to professionally manage money. Gambling on the end of QE "Infinity" is an obvious mistake.
Finally, the reason the MREIT managers should sell out and exit the market is because they "can". These managers aren't employing tons of people, they're not loaded up with goodwill, intangible assets, glorious corporate headquarters and other illiquid assets. They have the option to wrap up, cover their repos and outstanding hedges, and return the cash (plus the "Fed" incentive bonus) to shareholders. The fact that they won't protect shareholders' interests we'll all put down to managerial greed and incompetence, but, in the final analysis, we won't say that they were powerless to do so.
The distortion caused by the Fed's current program is, right now, helping agency investors, tomorrow it will hurt these same investors as they try to find new paper.
Chances are that non of the MREIT managers will cash up, but that remains the right thing to do. Investors like picking through the rubble of failed industries, dreaming of the good old days and wishing for their return, but it's no way to professionally manage money. Gambling on the end of QE "Infinity" is an obvious mistake.
Finally, the reason the MREIT managers should sell out and exit the market is because they "can". These managers aren't employing tons of people, they're not loaded up with goodwill, intangible assets, glorious corporate headquarters and other illiquid assets. They have the option to wrap up, cover their repos and outstanding hedges, and return the cash (plus the "Fed" incentive bonus) to shareholders. The fact that they won't protect shareholders' interests we'll all put down to managerial greed and incompetence, but, in the final analysis, we won't say that they were powerless to do so.
Oct
19 09:35 AM
[Today's snapshot]
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The
NLY buyback is a mistake - the reasons "why" are too
numerous to count... almost.
Seriously, a leveraged agency MREIT with the right management would take the Fed's higher bid (above current book value), cash out and hand over the proceeds to shareholders.
NLY and other leveraged agency investors are up against the Fed, and they'll keep being up against the Fed every single day until the Fed decides unemployment has hit some undefined target level. Linking unemployment with agency rates is beyond problematic - let's put it this way, there's probably not a single hedge fund manager out there who'd dream up the correlation (and these guys are used to dreaming up some pretty unusual and unsound correlations).
So back to NLY, management is supposed to work for shareholders - not scramble for a way to support the share price while they pursue an against-the-odds lobbying campaign in DC. Perhaps they're gambling on Romney getting in and all of QE Infinity being canned.... well, guess what, it doesn't change what they should do today: cash up and surrender - the leveraged agency industry has been nationalized!
Seriously, a leveraged agency MREIT with the right management would take the Fed's higher bid (above current book value), cash out and hand over the proceeds to shareholders.
NLY and other leveraged agency investors are up against the Fed, and they'll keep being up against the Fed every single day until the Fed decides unemployment has hit some undefined target level. Linking unemployment with agency rates is beyond problematic - let's put it this way, there's probably not a single hedge fund manager out there who'd dream up the correlation (and these guys are used to dreaming up some pretty unusual and unsound correlations).
So back to NLY, management is supposed to work for shareholders - not scramble for a way to support the share price while they pursue an against-the-odds lobbying campaign in DC. Perhaps they're gambling on Romney getting in and all of QE Infinity being canned.... well, guess what, it doesn't change what they should do today: cash up and surrender - the leveraged agency industry has been nationalized!
Oct
18 02:36 PM
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Anyone
quoting five year returns are going to be posting good numbers during
the next one to two years. We all recognize that historical returns
aren't a guarantee of future performance, but, in the "game"
of presenting performance, five year data sets have certainly been
more robust/representative than they're now - perhaps we need to look
at two and ten, or more, year data sets to develop a more balanced
view of performance. No doubt, 2013 will be a year offering the
marketeers fantastic five year statistics with which to mislead the
sheeple.
Back to the agency MREITs, now that the Fed is in the process of nationalizing the agency paper investment industry, its tempting to figure out some shorts... Best to wait for the halo effect of portolio appreciations to diminish first though.
Back to the agency MREITs, now that the Fed is in the process of nationalizing the agency paper investment industry, its tempting to figure out some shorts... Best to wait for the halo effect of portolio appreciations to diminish first though.
Oct
9 04:59 AM
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1.
Banks earn fees sourcing loans.
2. The Fed has effectively nationalized the agency mortgage investment industry.
3. MREITs will post higher book values, thanks to the Fed bid.
4. Fed action now, "QE3", is focused on the agency market - watch the other yields drift up and be thankful you're not under a mandate to invest in agency paper (like some MREITs).
The author's insights, concerns and analyses are all spot on, and he can probably afford to hold on for his last dividend payments. Let's see if any of the agency MREIT managers have the integrity to cash up (sell out to the Fed at the new higher bid).
2. The Fed has effectively nationalized the agency mortgage investment industry.
3. MREITs will post higher book values, thanks to the Fed bid.
4. Fed action now, "QE3", is focused on the agency market - watch the other yields drift up and be thankful you're not under a mandate to invest in agency paper (like some MREITs).
The author's insights, concerns and analyses are all spot on, and he can probably afford to hold on for his last dividend payments. Let's see if any of the agency MREIT managers have the integrity to cash up (sell out to the Fed at the new higher bid).
Sep
27 05:45 PM
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Mr
Schilling, thanks for posting and giving us a quick summary. If you
have the chance, in a report with comparisons, it'd be valuable to
look behind the headline numbers, have a look at the cash flow
statements, and, since your main worry is spread compression - assess
how you think profits will shape up under different conditions
(basically do a quick sensitivity study).
My contention is that the ongoing business of making leveraged investments in agency paper has effectively been nationalized. The Fed's $40 billion/month market action will cause MREITs to have negative spreads (the Fed's clearly stated that their focus is agency paper, and they've more than hinted at the fact that they'll tolerate higher inflation indicators). Agency MREITs will face higher finance costs, higher hedging costs, and lower yields on agency paper.
If we only faced spread compression then all would be good, relatively speaking.
I'm not short any MREITs... yet; it's probably worth holding off until their portfolio appreciations, thanks to QE3 have been processed, then have a look through their statements to analyze cash flow.
My contention is that the ongoing business of making leveraged investments in agency paper has effectively been nationalized. The Fed's $40 billion/month market action will cause MREITs to have negative spreads (the Fed's clearly stated that their focus is agency paper, and they've more than hinted at the fact that they'll tolerate higher inflation indicators). Agency MREITs will face higher finance costs, higher hedging costs, and lower yields on agency paper.
If we only faced spread compression then all would be good, relatively speaking.
I'm not short any MREITs... yet; it's probably worth holding off until their portfolio appreciations, thanks to QE3 have been processed, then have a look through their statements to analyze cash flow.
Sep
26 04:13 AM
[And now, today, one chart tells the story:]
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The
Fed has nationalized the mortgage investment industry.
Driving agency debt values higher and yields lower via a constant purchase program until unemployment is lower leads to spread "compression" below zero.
Driving agency debt values higher and yields lower via a constant purchase program until unemployment is lower leads to spread "compression" below zero.
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"Yield
compression" is a term that implies constant positive numbers,
but in this headline dominated market "compression" may
result in a net negative yield - try that on for size if you're a
leveraged MREIT. Portfolio appreciation is great if you're a flexible
portfolio manager (you take your gains and move on), but if you're an
MREIT manager you're faced with a well defined mandate and no exit
(forced to stick with your core business of investing in mortgages)
options. Fed action in the mortgage market, until unemployment
numbers are down, may, depending on how much they distort the market,
create carnage. Finally, while the Fed recognizes that they're about
to massacre private mortgage investors, and while they'll agree that
this is a shame, an unemployment solution is the number one priority
- it's just unfortunate that their analyses have led them to link
nationalizing the mortgage market with getting people back to work.
Sep
18 03:00 PM
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The
term "spread compression" implies a squeeze, but perhaps
these terms are wrong, as they don't allow for a negative spread
environment.
The Fed is, no doubt, aware of what a negative interest rate equation would do to leveraged mortgage investors. The two questions are:
1. Will Fed intervention lead to a negative spread scenario for MREITs? As the Fed competes for mortgage books with other investors, yields will decrease (stated Fed objective); the concern is that the focus of the latest Fed action will drive these yields below the cost of shorter term debt finance.
2. Considering the Fed's mandate and current intentions, is it likely to act to preserve/respect the interests of leveraged mortgage investors? A mortgage market without private investors seems like a surreal situation, but if the Fed's open ended commitment, both in terms of time and funds, translates into flattening the mortgage paper yield curve while simultaneously creating yield parity with any and all forms of other paper, then there's no spread (and for private companies subject to a market which imposes a risk premium, a negative spread).
I'm wondering if the Fed has just told us that they're going to buy mortgage debt, come-what-may, until unemployment is lower... this is what they've said isn't it?
The Fed is, no doubt, aware of what a negative interest rate equation would do to leveraged mortgage investors. The two questions are:
1. Will Fed intervention lead to a negative spread scenario for MREITs? As the Fed competes for mortgage books with other investors, yields will decrease (stated Fed objective); the concern is that the focus of the latest Fed action will drive these yields below the cost of shorter term debt finance.
2. Considering the Fed's mandate and current intentions, is it likely to act to preserve/respect the interests of leveraged mortgage investors? A mortgage market without private investors seems like a surreal situation, but if the Fed's open ended commitment, both in terms of time and funds, translates into flattening the mortgage paper yield curve while simultaneously creating yield parity with any and all forms of other paper, then there's no spread (and for private companies subject to a market which imposes a risk premium, a negative spread).
I'm wondering if the Fed has just told us that they're going to buy mortgage debt, come-what-may, until unemployment is lower... this is what they've said isn't it?
Sep
17 05:35 AM
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Bernanke
believes targeting agency paper will drive down costs in the mortgage
market. The proposition is simple and is simply that: anything that
reflates the housing market and causes increased velocity/liquidity
will, at this juncture, have a series of positive knock-on
effects.
Bernanke might be right or wrong, the price to pay later might prove to be too high, but, right now, this is what the Fed have decided to do. And, right now, this has created a whole series of short and medium term trading/investment opportunities - and capital will be reallocated as fast as: 1. traders digest, 2. analysts analyze, 3. investment committees meet, 4. and investors are persuaded.
But back to Bernanke and the Fed again, if you've got their mandate what would you do (never mind the politicians, global agendas etc - as these are obviously nothing but wild cards in any game)? What I'm suggesting here is that the Fed move was basic and simple, and merely reflected 1. what they could do, and 2. something they've not already tried (the lack of skew shows us that this is not a "one, two" combo move).
Bernanke might be right or wrong, the price to pay later might prove to be too high, but, right now, this is what the Fed have decided to do. And, right now, this has created a whole series of short and medium term trading/investment opportunities - and capital will be reallocated as fast as: 1. traders digest, 2. analysts analyze, 3. investment committees meet, 4. and investors are persuaded.
But back to Bernanke and the Fed again, if you've got their mandate what would you do (never mind the politicians, global agendas etc - as these are obviously nothing but wild cards in any game)? What I'm suggesting here is that the Fed move was basic and simple, and merely reflected 1. what they could do, and 2. something they've not already tried (the lack of skew shows us that this is not a "one, two" combo move).
Sep
16 12:08 PM
In
the MREIT arena there's the concept of spread compression to
reconsider.
The Fed just verified that the basic business premise is sound (borrowing short term to buy longer term debt), but if the Fed targets the purchase of agency backed mortgage paper, then we can expect these assets to appreciate in value (in this current "risk on" environment, the "appreciation" may only be apparent in relation to other similarly rated and dated debt) - making it harder for the MREITs to continue benefiting from their basic business. In the medium term, this headwind will be offset by portfolio appreciation, but nobody is going forecast a maintenance of the spread.
It'd be interesting to do a few sensitivity studies to determine various spread compression vs asset appreciation scenarios. At a guess, the "mechanics" would look like this:
1. higher leverage = greater appreciation
2. longer duration = greater appreciation
3. fixed rate > ARMs appreciation
4. shorter term financing > longer term/hedged spread
Most of the MREITs have a mix of the above, plus, to outsiders, proprietary/"black box" repo/hedging programs... and then there'll be the people saying that a mere $40BN/month by the Fed in the agency market is irrelevant.
No MREIT exposure currently.
The Fed just verified that the basic business premise is sound (borrowing short term to buy longer term debt), but if the Fed targets the purchase of agency backed mortgage paper, then we can expect these assets to appreciate in value (in this current "risk on" environment, the "appreciation" may only be apparent in relation to other similarly rated and dated debt) - making it harder for the MREITs to continue benefiting from their basic business. In the medium term, this headwind will be offset by portfolio appreciation, but nobody is going forecast a maintenance of the spread.
It'd be interesting to do a few sensitivity studies to determine various spread compression vs asset appreciation scenarios. At a guess, the "mechanics" would look like this:
1. higher leverage = greater appreciation
2. longer duration = greater appreciation
3. fixed rate > ARMs appreciation
4. shorter term financing > longer term/hedged spread
Most of the MREITs have a mix of the above, plus, to outsiders, proprietary/"black box" repo/hedging programs... and then there'll be the people saying that a mere $40BN/month by the Fed in the agency market is irrelevant.
No MREIT exposure currently.
Sep
16 10:04 AM
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Not
taking sides here... but it's interesting to see that NLY have
recently increased their leverage. This is the same as admitting that
they've been wrong about the interest rate environment for the last
two, call it three years perhaps. NLY has been a conservatively
managed MREIT, of that there can be little doubt (though some might
argue any leveraged MREIT is not conservative enough), and they've
paid a price for their conservative stance: high share/FFO ratio (as
pointed out in this article), and high losses on all their hedges.
This might come across as a bit perverse, but if NLY shows a decrease
in their share price/FFO ratio combined with a reduction in hedging
losses (which would feed in to the ratio) then it has become a less
attractive proposition.
Now, here are the outstanding questions:
Have NLY management finally decided to adopt the consensus view on low interest rates "forever" (which would be evidenced by reduced hedging losses - nothing said about this will be as important as what's actually done)?
Have NLY management increased their leverage to coincide with a new interest rate model, or are they simply trying to maintain profits in a low margin environment (and will "pay the piper" by increasing their exposure to hedging losses)?
Now, here are the outstanding questions:
Have NLY management finally decided to adopt the consensus view on low interest rates "forever" (which would be evidenced by reduced hedging losses - nothing said about this will be as important as what's actually done)?
Have NLY management increased their leverage to coincide with a new interest rate model, or are they simply trying to maintain profits in a low margin environment (and will "pay the piper" by increasing their exposure to hedging losses)?
Aug
8 12:55 PM
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There
are a few assertions that seem frequent enough for us to try to gain
more clarity.
First, the Fed has indicated low short term rates well into 2014. This is not an absolute undertaking by the Fed, but, barring a market dislocation, any short term increases in financing costs affecting MREITs are likely to be minimal.
Second, the current low interest rate environment is good for MREITs. This contention is incorrect. While low short term rates is good for MREIT financing operations, these rates are combined with low long term rates which negatively impact MREIT profits. Low long term rates reduce MREITs' spread.
Third, MREITs should take advantage of low financing costs to increase their leverage, and maintain profitability in a low spread environment. This is another misconception. While MREITs incomes depend on their leverage, MREITs values depend on their portfolios' interest rate coupons. In a low interest rate environment, MREIT portfolios are subject to refinancing risks, but, in the current low spread environment, this risk is second to the risk of portfolio devaluation caused by a rise in long term interest rates. While there may be agreement that short term rates will remain low for the foreseeable future, long term rates are now rising and the consensus is that these rates are likely to keep rising as the Fed's Operation Twist "unwinds".
Less Fed participation in the longer duration Treasury markets will provide a MREITs with a larger spread. This contention is correct; and, the MREITs best positioned to take advantage of a widening spread will be those with the lowest leverage. MREITs entering a period of widening spreads (where long term rates are rising faster than short term rates) will see their existing portfolios decrease in value. While MREITs with portfolios with lower average maturities will be less affected than peers maintaining longer duration portfolios - net MREIT performance will be most affected by leverage and the rate of change in interest rates.
First, the Fed has indicated low short term rates well into 2014. This is not an absolute undertaking by the Fed, but, barring a market dislocation, any short term increases in financing costs affecting MREITs are likely to be minimal.
Second, the current low interest rate environment is good for MREITs. This contention is incorrect. While low short term rates is good for MREIT financing operations, these rates are combined with low long term rates which negatively impact MREIT profits. Low long term rates reduce MREITs' spread.
Third, MREITs should take advantage of low financing costs to increase their leverage, and maintain profitability in a low spread environment. This is another misconception. While MREITs incomes depend on their leverage, MREITs values depend on their portfolios' interest rate coupons. In a low interest rate environment, MREIT portfolios are subject to refinancing risks, but, in the current low spread environment, this risk is second to the risk of portfolio devaluation caused by a rise in long term interest rates. While there may be agreement that short term rates will remain low for the foreseeable future, long term rates are now rising and the consensus is that these rates are likely to keep rising as the Fed's Operation Twist "unwinds".
Less Fed participation in the longer duration Treasury markets will provide a MREITs with a larger spread. This contention is correct; and, the MREITs best positioned to take advantage of a widening spread will be those with the lowest leverage. MREITs entering a period of widening spreads (where long term rates are rising faster than short term rates) will see their existing portfolios decrease in value. While MREITs with portfolios with lower average maturities will be less affected than peers maintaining longer duration portfolios - net MREIT performance will be most affected by leverage and the rate of change in interest rates.
Apr
18 08:00 AM
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At
crucial moments correlations break down. So, if you use ETF puts to
hedge against a position in one of the ETF components, then you're
not hedged. If you find another historic correlation, chances are,
when things get ugly for your long position the correlation
evaporates. People are always chasing the "best of breed"
and using broader indexes to hedge. Over time you'll do well if
you're properly diversified - if you're not diversified and blessed
with some years left to live, you'll probably get to witness a
correlation breakdown which will hamstring your non-diversified
portfolio.
One of the reasons certain companies become institutional darlings is because they can be hedged - either because there's an active OTC or exchange traded option market for them.
One of the reasons certain companies become institutional darlings is because they can be hedged - either because there's an active OTC or exchange traded option market for them.
Mar
19 10:47 AM
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TBT
is a depreciating asset. On any given day it's maybe a 2x inverse,
but over time it's not. Too expensive to operate to maintain value.
Not saying it's not a good instrument, but its prospects as a long
term hedge by being long is poor.
Mar
10 02:42 PM
[And here is today's update:]
