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Investments

mREITs fail to match earnings estimates

QE3 uncertainty, rising rates pressure market volatility

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Going into earnings season, many experts were cautious on the book values for agency and hybrid mortgage real estate investment trusts, fearing that significant volatility would spook the market into further deleveraging or hedging portfolios.

This came into play as book values dropped between 1% to 3%, and every mREIT missed earning estimates too, explained FBR Capital Markets analyst Dan Altscher.

"As we take a look forward, we would generally think these are good times to be buying mREITs from a contrarian point of view," Altscher noted.

He added, "Stocks are cheaper, while increased hedging programs should support value stability. Chairman Bernanke’s days are limited, and as a supposedly more dovish Janet Yellen comes into the Fed in early 2014, we would think QE3 taper would not be on the table until March 2014 at the earliest.”

However, last week’s surprising jobs report shocked the market, causing the 10-year Treasury yield to rise, as mortgage-backed securities sold off — igniting expectations for the central bank to begin tapering its asset purchases sooner than anticipated.

Consequently, the mREIT sector continues to be a rough one with investors remaining skittish, Altscher admitted.

While earnings reports were generally weaker than expected across the board, current valuations largely reflect this poor performance and in a constructive rate environment will prove an attractive entry point, explained Compass Point Research & Trading Group analyst Jason Stewart.

"Substantially higher interest rates would prove difficult from an operating and valuation perspective and the market is placing significant emphasis on the strength in the most recent jobs report," Stewart stated.

He added, "Even Bernanke acknowledged the significant increase in rates that occurred over the summer had a substantial impact on growth prospects."

Nonetheless, there are still some mREITs that investors should consider buying given that they will be catalysts to grow earnings and book value.

For instance, Two Harbors (TWO) recently announced an agreement to buy at least 50% of PHH Corporation’s (PHH) eligible conforming loan mortgage servicing rights for the next two years.

With return on equities in the high-to-low double digits, there could be additional room to improve by another 150 to 200 basis points by reducing hedges or adding in incremental long positions given the negative duration of the MSR, according to FBR Capital Markets.

"By our rough math, we think the MSR transaction from PHH could add an incremental $0.10 to earnings per share in 2014, but we don’t yet have this in our estimates, as we’d like to see a quarter or two of results first to better gauge the impact," Alstcher noted.

He continued, "We also think there could be substantial opportunities for Two Harbors to acquire a bulk MSR portfolio in the next few months."

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