There was a development this week in the land of the high-yielding mortgage REITs.  Wealthy and income oriented investors have been flocking to these for years because of their high dividends which are often up in the double digits as these entities are forced to pay out almost all of their income as a dividend to be taxed at the investor level.  With low taxes on dividends and with a promise from Ben Bernanke to keep rates exceptionally low out to mid-2013, the path was set for clear skies ahead.  Until this last week…

On Friday came a sector downgrade from Bank of America’s Merrill Lynch.  This might have been considered a valuation call or that the dividends were unsustainable if you just looked at the summary.  It is worse.

Mortgage REITs underperformed the market this week because of the possible impact of changes in how the Securities Exchange Commission interprets mortgage REITs and their exemption from the Investment Company Act.  The only potential saving grace is this: “The SEC has not made formal recommendations, so any specific outcome is unclear at this time.”

BofA/Merrill Lynch downgraded 6 of the 12 mortgage REIT stocks in its coverage universe to Neutral from Buy, and the research calls with the implied dividends are below:

Annaly Capital Management, Inc. (NYSE: NLY) was downgraded from Buy to Neutral; indicated yield is 15%. American Capital Agency Corp. (NASDAQ: AGNC) was downgraded from Buy to Neutral; indicated yield is 20.5%. Hatteras Financial Corp (NYSE: HTS) was downgraded from Buy to Neutral; indicated yield is 15.3%.  Chimera Investment Corporation (NYSE: CIM) was downgraded from Buy to Neutral; indicated yield is 18%. Invesco Mortgage Capital Inc. (NYSE: IVR) was downgraded from Buy to Neutral; indicated yield is 23%.

Redwood Trust Inc. (NYSE: RWT) was maintained as Underperform; indicated yield is 8.3%.

PennyMac Mortgage Investment Trust (NYSE: PMT) was maintained Buy; indicated yield is 12.1%.  Dynex Capital Inc. (NYSE: DX) was downgraded from Buy to Neutral; indicated yield is almost 13%.  Apollo Commercial Real Estate Finance, Inc. (NYSE: ARI) maintained Buy; indicated yield is 11.1%.  Starwood Property Trust, Inc. (NYSE: STWD) maintained Buy; indicated yield is 10%. Colony Financial, Inc. (NYSE: CLNY) maintained Buy; indicated yield is almost 8.5%. CreXus Investment Corporation (NYSE: CXS) maintained Buy; indicated yield is about 11%.

The newly launched Market Vectors Mortgage REIT Income ETF (NYSE: MORT) fell almost 2% Friday to $23.26 after having been around $24.50 on Wednesday.

The Bloomberg Mortgage REIT index fell 1.7% on the week.  BofA/Merrill Lynch noted another form of caution even if the SEC action dies out, “The weak employment markets are consistent with our view that many mortgage borrowers will continue to struggle to qualify for refinances barring additional government intervention.”

BofA’s belief is that now these shares will be tied to fair value movements in the underlying asset classes.  The net effect of the SEC consideration and speculation that the government could intervene in mortgage markets only add to the issue.  As a result, Merrill Lynch’s call is that some of these stocks may reflect a discount to book value now.

Here is where this gets very interesting.  You know now that BofA has had enough with its mortgage losses that it is exiting the sector just about entirely.  Bye-bye Countrywide.  The problem is that the bank is under fire from more states, pensions, and agencies for misrepresentation and losses tied to mortgages.  It is endless.  Our take is that Merrill Lynch might know even a bit more here about what could happen to some of the mortgage-backed securities out there that are being held by these REITs.  That sounds a bit like a conspiracy theory, admittedly, but think about it for a bit…

JON C. OGG

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