Top-Down Look At The RMBS Market Signals Bad News For ARMOUR Residential REIT (NYSE:ARR)

As is the case with most mortgage REITs, ARMOUR Residential REIT (ARR) was nearly destroyed by the March crash stemming from COVID-19-related measures. The mREIT owned a highly leveraged portfolio of residential mortgage-backed securities, as well as some non-guaranteed residential mortgage assets which fell dramatically in March. The rapid decline spurred a wave of margin calls, which forced the company to sell assets at significant losses as well as temporarily suspend its dividend.

As with its peers, ARR has made a slight but small recovery. According to the company’s latest quarterly report, its book value per share is now estimated to be $11.45, which is around 18% above its current price. The firm also has a $0.10 monthly dividend, which equates to a higher dividend yield of 12.3%.

ARMOUR’s Macroeconomic “Ripple Effect” Risk

The company recently sold all of its unguaranteed assets and now solely owns solely mortgage-backed securities issued or guaranteed by U.S. government-sponsored enterprises (“GSEs”), Treasury securities, and cash. These assets have very low credit risk, since they are backed by agencies such as Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). If it were not for this insurance, then ARR and other MBS owners would be in significant trouble, as 30% of homeowners did not make a full mortgage payment in July (18% made no payment at all).

Admittedly, I was a fan of residential mortgage REITs before the crisis. Fannie and Freddie were finally looking like stable entities, and rising consumer incomes enabled greater demand for mortgages. Unfortunately, history seems to be repeating. Remember, while these are government-sponsored entities under conservatorship, the government does not need to bail them out in case of a 2008 repeat. This is not true for Ginnie Mae assets, but those only constitute about 1.4% of ARR’s portfolio (Fannie Mae’s is over 75%) (10-Q pg. 15).

It is very likely that the serious delinquency rate (90 days past due) will skyrocket this month, as the non-payment rate has consistently been around 20% since May. The multifamily delinquency rate is still very low (sub 1%), but non-payment rates have been even higher for renters, which means that rate should soon begin to tick up (as many smaller apartment owners run low on cash).

This is a crisis that is not about the immediate data but the longer-lasting future ripple effects. Apartment renters are struggling to pay (particularly with $600 weekly unemployment checks being over), which will eventually cause landlords to struggle to make mortgage payments. This will eventually put pressure on multi-family mortgage-backed-securities. If enough of these securities struggle with revenue, Fannie and Freddie will have major difficulties making payments, and if they fail to, it will almost certainly be the demise of ARMOUR.

Some would say this risk is low, but it has happened before, and this time it is very possible mortgage delinquency rates will rise to a higher level than in 2008. This is considering the spike in non-paying households began in May and has persisted – many should fall into the >90 days late “serious delinquency” level this month.

Importantly, in May, the FHFA decided that Fannie Mae could stop doing yearly “adverse” scenario stress-testing (Q1 10-Q pg. 6), which means we don’t exactly know if the company can absorb such losses. This alone is a red flag. Fannie Mae’s guaranteed portfolio is worth $3.4 trillion with an equity value of only $11.4 billion, so something tells me this risk is very high given the percentage of homeowners currently missing payments.

The Federal Reserve Factor

Of course, there is an “implicit guarantee” that the U.S. government or Federal Reserve will bail out Fannie or Freddie in order to protect mortgage owners like ARMOUR. Indeed, the entire agency MBS market is worth around $8.9 trillion today, and the Fed currently owns just over 20% of the market. As you can see below, it is actually the Federal Reserve’s large QE MBS purchase program that rescued ARMOUR from being margin-called into bankruptcy:

Data by YCharts

Note, the iShares MBS ETF (MBB) is used as a proxy to demonstrate mortgage-backed security prices. The MBS ETF MBB rapidly declined in March, which caused ARR to be forced to sell its MBS assets. The Fed quickly stepped in and purchased a large number of these securities, which caused MBS prices to rise to a record high (see MBB), saving ARR’s book value from hitting zero.

This is important because it demonstrates ARR’s entire book value is dependent on the Federal Reserve. The rate of purchasing has faded, but there is an implicit guarantee that it will continue given another slide in the MBS market. That said, ARR’s leverage remains very high (total liabilities to assets is currently 85%), so a delay on behalf of the Fed (as was the case in March) could jeopardize ARMOUR.

Given the rise in mortgage non-payment, I believe it is very likely that Fannie and Freddie run into financial issues. Since it is an election year, I do not believe Congress would be keen on bailing them out again due to the negative public opinions of those GSEs. If that occurs, it is not guaranteed that the Federal Reserve will continue to support the MBS market, since doing so would mean large losses. Remember, the Fed uses very high leverage, so even they need to keep credit risk low or else risk causing the U.S. dollar to hyperinflate.

Bottom Line

At the end of the day, ARMOUR is only kept alive by a long chain of both explicit and implicit guarantees by the U.S. government and GSEs, all of which are very insolvent and cannot necessarily meet obligations without risking a currency collapse. The mREIT operates at high leverage, so if one of these entities flinch (as occurred in March), it could bankrupt the company in a matter of days or weeks.

At this point, it is far too early to tell whether or not Fannie/Freddie will fail or the Federal Reserve will stop supporting the MBS market. That said, investors seem to assume there is no chance of either outcome. In my opinion, ARR should trade at a larger discount given these significant risks.

Regardless of those existential risks, it is not clear if ARR can maintain its current dividend. The company currently has a net interest margin of 1.5%, which equates to an estimated annual net interest income of roughly $83 million given its assets today. ARMOUR generally has around $40 million in other annual recurring expenses (largely fees) as well as roughly $12 million in annual preferred dividend payments, leaving only an estimated $31 million in available cash. This is far less than its total forward dividend of $77 million, making a 50%+ dividend cut extremely likely.

Overall, I believe investors are best avoiding ARR and perhaps all mREITs for the time being. ARR may be slightly undervalued from a book value standpoint, but its book value is entirely dependent on the Federal Reserve’s MBS purchase program and unstable government-sponsored entities. It is too early to say if the mortgage market is headed back into the 2007-2009 scenario, but that is looking increasingly likely. Bailouts are possible, but at the end of the day, there is no such thing as a free lunch, and given it is an election year, investors may eventually find themselves at the short end of the stick.

My view regarding the impending trouble in the MBS market is speculative and uncertain, but it is clear that ARR cannot sustain its current dividend. It simply lacks the cash flow to continue to make such payments. ARMOUR may not cut its dividend soon, but the stock will likely drop considerably when it does. Due to the volatility of the situation, I do not have a price target and would not, at this time, short ARR. That said, I firmly believe the mREIT is more likely to decline than continue to rise over the next six months.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in FNMA, FMCC over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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