Mortgage real estate investment trusts (mREITs) are in an interesting place right now. Record- high refinancing rates and demand for new loans due to a low-mortgage-rate environment have helped boost revenues for mREITs across the board over the past year. Yet at the same time 2.6 million Americans are in forbearance, 5.02% of all residential mortgage loans are delinquent, and millions of Americans are still unemployed. With forbearance protections expiring at the end of June 2021, that means mortgage REITs, particularly residential mREITs like ARMOUR Residential REIT Inc. (NYSE: ARR), could be in trouble.
ARMOUR’s business model
Unlike other mREITs, ARMOUR Residential doesn’t originate mortgage loans. Instead, it uses its brokerage, BUCKLER Securities, to invest in mortgage-backed securities (MBS). The MBS are issued and/or guaranteed by U.S. government entities such as Fannie Mae, Freddie Mac, or Ginnie Mae, which allows the company to not only make money off the interest collected on the loans but also participate in credit swaps. Credit swaps, also referred to as interest rate swaps, are a big part of ARMOUR’s business model, making up roughly 19% of its income in Q1 2021.
Credit default swaps (CDS) are a common practice in the financial markets and help large banks, lenders, and mREITs hedge against fluctuating interest rates in the market and potential defaults for borrowers while providing liquidity to the sellers now. ARMOUR buys and sells pools of government-backed loans in the repo market, earning a spread between the variable interest rates in relation to the interest rate associated with the company’s debt obligations. In Q1 2021, credit swaps provided $182.4 million in income and held a total swap notional of $6.0 billion in May of 2021.
Early payoffs of loans also hurts the bottom line for mREITs, particularly in a lower-interest rate environment like we’re seeing today. Thankfully, ARMOUR’s portfolio hedges against this:
- 25% of loans have prepayment penalties.
- 8% of loans are in geographic areas that charge additional taxes for refinancing.
Prepayments for the company have declined over the first quarter of the year.
Is ARMOUR in trouble?
mREITs are notorious for volatility and risk. While this model of investing has major upside potential, it also comes with significant market exposure in the event of a financial or economic crisis. Increased loan defaults put more pressure on companies like ARMOUR, especially considering their primary investment strategy is government-insured loans like Fannie Mae and Freddie Mac, which currently have some of the highest number of borrowers in forbearance. As of March 2021, a Black Knight report estimated 1.69 million FHA, VA, Fannie Mae, and Freddie Mac loans were in forbearance. One percent of the loans in ARMOUR’s portfolio have loan-to-value ratios above 95% and FICO scores less than 700, which is a strength. Low credit scores and high loan-to-value ratios mean less equity and greater risk for the debt holder in the event of default.
Uncertainty in the financial markets also results in less trading on the repo market and increased likelihood that swap buyers may not be able to maintain their debt obligations in the event of a credit default. Considering the amount of trading ARMOUR does on the repo market, the current environment, particularly as forbearances expire, means the company has a fair amount of exposure to decreased revenues and volatility in the repo market. However, considering the amount of government intervention the repo market has received over the past year, it’s unlikely the government will allow too much volatility or risk its collapse.
Its core income per share as of Q1 2021 was $0.23, which puts the company’s current dividend payout ratio at 130%, which is high for equity REIT ranges but not uncommon in the world of mREITs. As of Q1 2021, the company’s leverage ratio was 7.1x, with a debt to equity ratio of 4.1x. The company has $687 million in cash and cash equivalent, which isn’t enough cash on hand to settle the current total liabilities of 4.5 billion. However, since mREITs operate off leveraging debt, the amount of debt the company currently holds isn’t out of the norm.
In summary
Right now, the company appears to be doing okay. But if the market were to suddenly turn or if government intervention in the repo or financial markets subsides, ARMOUR Residential could be in a tough position and unable to maintain its dividend payout ratios. Investors in mREITs are often attracted to the higher returns, which right now is around 10%, but there is major risk and volatility in these markets. Investors need to understand that ARMOUR Residential may not be in trouble right now, but one swift move in the market and it very well could be.
