Mortgage incentives

A Morningstar analyst once opined that "if traditional banks are like Volvos, mREITs are like race cars - without seat belts or airbags." That may be the best one-sentence description ever written on mortgage REITs.

The mREIT business model is quite simple in that it's very bank-like. Mortgage REITs borrow money at a low interest rate to invest in mortgages that pay a slightly higher rate. The spread between their borrowing costs and investment returns create routine income that's paid out to shareholders. That's very bank-like, indeed, along the lines of the classic "borrow at 3%, lend at 6%" description of banking.

It's the features of banks that mortgage REITs don't have that really sets them apart - things such as cheap deposits, strong customer relationships, or fee-based business models to prop up their income statements when credit cycles turn and interest rates ebb and flow. All the attributes famed investor Warren Buffett loves about his favorite bank investment, Wells Fargo, are simply nonexistent in the mREIT model.

But what mREITs do offer is yield - lots of it. Lacking the regulatory scrutiny of the banking industry, mREITs are free to pay out all their earnings as dividends, resulting in double-digit dividend yields on an annual basis. For years following the financial crisis, fat dividend yields were simply good enough reason for mortgage REITs to issue more stock to grow their balance sheets.

Industry behemoths Annaly Capital and American Capital Agency, which traded at persistent book value premiums in the years following the financial crisis, now trade at 13% and 17% discounts to book value, respectively. As the tailwind of falling interest rates no longer buoyed their investment performance, share price premiums of 2013 have turned into the discounts of 2016.

Easy fixes
Perhaps the most unfortunate thing about share price discounts is that there are easy levers for correcting a low valuation.

First, the "extreme" option. Undervalued mortgage REITs could simply liquidate their portfolios, pay off their creditors, and return the balance to shareholders. Winding down is not difficult to do. The industry's preferred asset - mortgage-backed securities - ranks among the most liquid securities in the world. Taken at face value, mREITs' below-book valuations indicate that they are simply worth more dead than alive.

If you prefer a less-dramatic alternative, there's an option just for you. Through the normal course of business, mREITs receive principal payments that are typically reinvested into new mortgage-backed securities. Diverting this cash toward debt reductions and share buybacks would drive up their respective book values per share. Call it what it is - a slow liquidation. Under this scenario, the underlying portfolio would slowly shrink, but the number of shares outstanding would shrink at a faster rate. Shareholders end up wealthier, as book values per share grow incrementally with each share repurchased.

Liquidation, fast or slow, benefits shareholders of undervalued stock. Mortgage REIT managers wouldn't enjoy the same prosperity, however. Industry insiders are paid largely based on the size of their balance sheets than the returns they generate for their shareholders. If you're an insider, performing poorly is preferable to giving up a dime of assets.