The U.S. mortgage market has had a wild year due to the intense economic volatility. During the initial phase of the COVID-19-related crash, many mortgage-owning REITs (“mREITs”) lost well over half their value, as investors feared a 2008 repeat. This period also saw residential mortgage rates spike, which led to a wave of book value-deteriorating margin calls for levered RMBS investment companies.
To review, residential mortgage-backed security is essentially an ETF, i.e., pool/fund of residential mortgages. Most often these are backed by a government-associated agency like Freddie Mac (OTCQB:FMCC) or Fannie Mae (OTCQB:FNMA). These can be invested in directly through a residential mortgage ETF like the iShares MBS ETF (MBB) or, if you’re looking for much more attractive yields, a mortgage REIT which usually uses 7X-10X leverage (with short-term low-rate borrowing) in order to deliver double-digit yields. However, not all that glitters is gold.
The March plummet led to extreme over-selling of many mREITs like Orchid Island Capital (ORC), as I bullishly described in early April in my article “Assessing Survival Potential: Orchid Island Capital Has A Major ‘Fed Put’“. However, the stimulus that I saw as saving REITs ended over summer, which caused me to take profits on ORC. This is detailed in “Orchid Island Capital Has Short-Term Risks Due To Slowing Stimulus“. Moving to today, it seems ORC is likely headed lower and may even be a short-term short opportunity. This is predominately due to growing credit and rate stress in its portfolio, which is almost entirely concentrated in 30-year fixed-rate residential mortgages.
Economic Data Spells Mortgage Market Stress
Today, the data and trends have shifted further, making the downside risk ORC greater than its upside potential. The Fed is not purchasing mortgage-backed securities at their past rate and has even gone as far as to warn that “in the not-too-distant future”, mortgage evictions will rise if there isn’t another round of fresh fiscal aid.
Powell made this statement last month, and still around 6% of mortgage loans remain in forbearance, and likely a similar delinquency rate. Still, about 28% of homeowners did not make an on-time housing payment in September, showing almost no improvement since the crisis began. Further, over 60% of renters have taken actions that lower net worth (using savings, borrowing, etc.) to make rental payments from March to October 2020. The data is not available for homeowners, but it is likely at a similar, but slightly lower, level.
Fortunately, Orchid Island has some protection against the steady high levels of non-paid mortgages. This comes from guarantees from Fannie Mae and Freddie Mac, which are currently in government conservatorship. These companies have about $230 in assets for every $1 of shareholder equity (which is almost entirely preferred shares), giving them extreme leverage. Despite this, they are expected to be reprivatized soon, causing Pimco to warn that they will “likely not be able to fulfill their statutory obligations (without direct government backing)”.
Given their extreme leverage and the high figure of deferred, delinquent, and delayed residential mortgages (not to mention those paying the last of their savings), this is a very reasonable assumption. Unless the economy quickly and rapidly turns around (which it is not expected to), it is difficult to see how Fannie and Freddie will meet their obligations. Despite popular opinions, the data suggests this is not an “ultra-low probability event” – it may be far more likely than many currently believe.
Importantly, Orchid Island’s equity value could collapse even if there is a perceived risk of this happening, since its assets are publicly traded and subject to margin calls. This is essentially what occurred in March, which caused Orchid’s book value to plummet in a matter of weeks. If it does occur, a government bailout is possible, but they may also opt to just call a spade a spade. I can’t imagine a second bailout done in order to save the equity value of banks/mREITs would be popular in the current political environment.
Beware Rate Volatility
Excluding the possibility of another GSE failure, interest rates are Orchid’s predominant risk. A rise in short-term rates directly increases its borrowing costs, while a rise in long-term rates decreases the value of its assets. However, a rise in long-term rates also increases the yield on its new assets and decreases prepayment losses.
The past few months have seen a few interesting trends in these important measures. See below:
The 30-year mortgage rate minus LIBOR is a strong proxy for the net interest margins on the market value of Orchid’s assets. This has risen since 2019, but has declined slightly in recent months due to continued declines in mortgage rates. Speaking of which, the spread between 30-year mortgages and 30-year Treasuries has declined, which is likely due to the Federal Reserve’s ongoing support of the mortgage market. This support is key, since it is what saved Orchid from being margin-called into bankruptcy.
Still, the 30-year mortgage rate will almost certainly rise soon, since long-term Treasuries have been selling off. This is exemplified in the rising yield curve (bottom chart). This could cause ORC’s book value to decline if it occurs at too rapid a pace, but a slow rise is generally beneficial.
The most important risk to consider is inflation, since it would cause both short-term and long-term rates to rise. With gold and food prices rising, an inflationary wave is certainly possible. Orchid is currently benefiting from essentially free money in the repo market, but this will not last long if inflationary forces continue to rise.
Bottom Line: Government Dependence Best Avoided
The core issue with Orchid and other residential MBS mREITs like ARMOUR Residential REIT (ARR) and Cherry Hill Mortgage Investment Corp. (CHMI) is that they are entirely dependent on the U.S. government. They have high leverage, which requires virtually zero credit risk perception (Orchid current has over 10X assets-to-equity). A very large number of mortgages are not being paid, which puts extreme strain on Fannie and Freddie, and that may soon cause many to question their ability to guarantee. Even under conservatorship, the government need not bailout the GSEs, and the political will to do so a second time appears weak.
With the traditional branches of government in deadlock, the Federal Reserve has been Orchid’s saving grace. This is through rate reductions and mortgage-backed-security purchases. The Fed now owns over one-third of all U.S. mortgages. At this rate, they’ll likely own the majority of the market, unless mortgage rates rise such that their credit risk is accurately priced in. Again, they carry far more credit risk than people believe due to non-payments and an unsound Fannie and Freddie.
Fundamentally, much of this situation is similar to those in July, when I covered Orchid last. However, technically, ORC appears to be in a solid short setup. As you can see below, it has been unable to break above $5.2 (its book value per share):
There is little chance that Orchid’s book value will rise (since it would require additional 30-year mortgage rate declines – deflation needed). However, I believe there is a significant probability that its book value declines by $1-3 due to instability in Fannie and Freddie. Most investors do not know about this instability, and it is not priced in to mortgage rates. Once it is, it could cause another round of MBS panic-selling.
I’m sure most investors love ORC for its 15% dividend yield and the perception of government protection. However, it is important to keep in mind the very significant risks that come with extremely high leverage, particularly considering the unstable economic, political, and social environment. If 2020 is teaching us anything, it is that nothing is truly guaranteed.
Interested In More Alternative Insights?
If you’re looking for (much) more research, I run the Conviction Dossier here on Seeking Alpha. The marketplace service provides an array of in-depth portfolios as well as weekly commodity and economic research reports. Additionally, we provide actionable investment and trade ideas designed to give you an edge on the crowd.
As an added benefit, we’re allowing each new member one exclusive pick where they can have us provide in-depth research on any company or ETF they’d like. You can learn about what we can do for you here.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in ORC 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.