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Weakened Mortgage Market Activity Creating Benefits for mREITs

Monday - 4/8/2013, 5:14pm  ET

Compared to the fourth quarter of the prior year, mortgage activity has weakened during the first quarter of the current year. Overall, mortgage applications plunged 8% over the linked quarter and 3% over the prior year. This decline in the Market Composite Index is largely due to an 11% decline in refinance application volumes, partially offset by a 10% improvement in purchase volumes compared with the fourth quarter of the prior year. Refinancing has also slowed down over the same time frame. The share of applications filed for refinance averaged 78.5% during the first quarter of the current year, compared to 81.8% during the fourth quarter of the prior year.

The overall weakness in mortgage applications was due to a January drop-off and somewhat flattish activity in February. However, March saw improvement in mortgage application activity, which was up 11% over the prior month.

Besides, mortgage rates have climbed since the beginning of the current year. The 30-year fixed mortgage rate is averaging 3.54%, up 20 bps since the beginning of the year. Similarly, the 15-year fixed rate averages 2.74% after it climbed 10 bps over the same time period.

Given increasing interest rates during the first quarter of the current year, you can expect a modest improvement in the mortgage servicing rights (MSR) valuations. Higher interest rates drive prepayments down, causing improved delinquencies and lower overall servicing costs.

Inflation Forecast

The Fed’s updated economic forecasts, which were released alongside the latest Federal Open Market Committee (FOMC) meeting, reveal that the Fed can contain inflation within the range of 1.3% - 1.7% during 2013, while during 2014, it will stay within the range of 1.5% - 2.0%.

Impact on Mortgage REITs

Mortgage REITs like American Capital Agency , Annaly Capital Management and ARMOUR Residential have suffered a lot at the hands of the government’s quantitative easing programs. However, I believe the environment is becoming less challenging for mortgage REITs as the markets begin to reject the stimulus.

While overall mortgage application activity during the first quarter of the current year may be 8% below the prior quarter, it is still improving. If we look at the March figures, activity jumped 11% from the prior month. This, coupled with the climbing interest rates, may lead the mortgage REITs to fly higher in the coming quarters. Further, the inflation expectations of the Fed are just about right for mortgage REITs. While little inflation can prove to expand the net interest spreads, a lot could have the effect of reducing mortgage affordability, actually causing the spreads to contract eventually.

The net interest rate spreads for American Capital Agency, ARMOUR Residential and Annaly Capital contracted 26 bps, 64 bps and 60 bps since the second quarter of the prior year, while Annaly Capital and ARMOUR Residential were forced to cut dividends 18% and 27%, respectively.

Further, Newcastle Investment and PennyMac Mortgage Investment are expected to benefit from improved revenues on mortgage servicing. Newcastle Investment invests in non-Agency distressed securities. The company has investments in real estate securities/assets including senior living, loans, excess mortgage servicing rights (MSRs) and other real estate related assets. Similarly, PennyMac seeks to invest in distressed mortgage backed securities. Besides investing in the mortgage loans, mortgage backed securities, mortgage servicing rights and real estate acquired in the settlement of loans (REO), the company purchases originated mortgages for resale or further securitization.

Conclusion

Despite a weakened mortgage market, the overall trend will be assisting the mortgage REITs included in this investment thesis. Climbing interest rates and optimal inflation expatiation will help expand their spreads. Besides, MSR will add additional revenues. Therefore, I recommend investors consider the aforementioned stocks to increase their regular income.

This article was originally published as Weakened Mortgage Market Activity Creating Benefits for mREITson Fool.com

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