Liquidity Fears and Repo Flu Infect Agency mREITs

Bloomberg is reporting that agency mortgage-backed bond spreads have reached their highest levels since 1986. Meanwhile, Reuters is reporting that Dutch-listed affiliate of private equity firm Carlyle Group said it received margin calls totaling more than $37 million from seven financing parties on Wednesday and was unable to meet the demands for extra collateral to cover its market positions for four of them. This branch of Carlyle invests in agency RMBS.

This news has spread fear and doubt to the agency mREITs today, who are all off sharply in early morning trade. All the agency mREITs have thus far been virtually unaffected by the credit crunch, as their paper is implicitly guaranteed by the GSEs and has remained liquid throughout the credit freeze. However, as buyers remain on strike and the credit crunch continues to travel up the mortgage security food chain, investors are nervous that even the agency mREITs may receive significant margin calls under the terms of their repurchase agreements. Should spreads widen to the point where margin calls go out to the agency mREITs, the effect would be devastating, since this group of mREITs typically does not utilize term-financing. Their entire portfolios are funded by repo agreements and warehouse lines.

Should the crisis deepen to the point that GSE-backed paper is subject to forced sales, even Fannie and Freddie could be seriously crippled by the downward mark-to-market spiral that would result.

Agency mREITs Soar on Fed Panic

The Fed's panic-driven emergency 75 basis points sent the agency mREITs soaring, up 3.5% to 5.0% as last check. Annaly Capital (NLY) in particular looks to benefit as it holds a large portion of fixed-rate securities in its portfolio.

Meanwhile, Anworth Mortgage (ANH) had the good fortune of announcing a very timely 11 million common stock offering, which will raise about $90 million in net proceeds. Shares surged despite the news of the offering because the Fed rate action, so Anworth will benefit from attractive pricing for this issuance.

Fed Comment Undercuts Agency Investors

The Federal Reserve slashed its key fed funds rate by another 25 basis points Wednesday, but thoughts that the Fed may be done easing triggered a significant selloff among the agency RMBS investors.

"The committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth," the FOMC statement says. "The committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth."

That statement sparked selling in Annaly Capital (NLY), MFA Mortgage (MFA), Capstead Mortgage (CMO), and Anworth Mortgage (ANH). The agency investor group is all liability-sensitive, meaning that the impact of the change in its assets is smaller than the impact of the change in its liabilities after a change in prevailing interest rates. A liability sensitive entity’s economic value of equity decreases when prevailing rates rise or increase when prevailing rates fall. If the Fed stops lowering interest rates, these mREITs will have limited success investing long and borrowing short because the net interest spread available will not be as wide as they would like for it to be.

JMP’s Upgrade of Anworth Was Right On the Money

Anworth Mortgage (ANH), an agency RMBS investor, popped higher last week after JMP upgraded the stock to “Strong Buy”. The swift upward movement in the shares prompted some market participants to consider shorting Anworth on valuation.

Prior to the JMP upgrade, Anworth shares were trading at about 90% of September 30 book value of $6.25/share. Now the shares are trading as high as 106% of book value…and they’re still cheap. Consider the valuations of competitors such as Annaly, Capstead, and MFA Mortgage, which are trading anywhere from 130% to 160% of second-quarter book value, as they have yet to report third-quarter numbers. Right there, Anworth has a visibility advantage over its peers. Its third-quarter book value estimate includes all losses on sales of securities and the impairment charge for subsidiary Belvedere Trust.

Short-sellers point to the remaining credit risk of Anworth’s non-agency MBS, but the Company's remaining Non-Agency MBS holdings currently consist of AAA-rated MBS with a current face amount of approximately $52 million, and there are currently no repurchase agreement borrowings related to these holdings. Anworth’s remaining exposure to Belvedere is also limited in that Belvedere’s entire residential loan portfolio has been securitized. Thus the only losses in the near-term relate to the valuation of residual interests, which would be a mark-to-market adjustment that does not impact Anworth’s taxable income.

Another positive for Anworth is the increased rates of prepayments on its portfolio, which will cause the portfolio yield to continue to increase as lower yielding assets pay down and are replaced with higher yielding assets. Coupled with the impact of a lowered cost of funds thanks to the Federal Reserve, Anworth will almost certainly see an expansion in its net interest margin and be able to raise the dividend in 2008.

Anworth Mortgage Pre-Announces

Anworth Mortgage (ANH) pre-announced a miss on third-quarter earnings but maintained its $0.05/share quarterly dividend.

Anworth will write-off its $143 million investment in Belvedere Trust, as BT has been unable to obtain alternative financing for its remaining repurchase agreement borrowings. The related collateral is too small to complete a CDO deal, even until normalized market conditions.

Anworth also sold approximately $904 million of agency and non-agency MBS at a loss of $23.4 million.

Anworth expects net income to be positive, but much less than the $0.05/share it earned in the second quarter.

Including the expected write-off of our investment in Belvedere Trust and the sale of other securities, the preliminary estimate of Anworth’s book value per common share as of September 30, 2007 is approximately $6.25, a 13.6% premium to recent Anworth share prices.

It's difficult to get much visibility on Anworth's taxable income situation, though Anworth has a history of periodically declaring dividends that represent returns of capital. Given Anworth's outlook of improvement in costs of funds, I believe Anworth will be able to pay future dividends out of ordinary taxable income.