How To Play The Mortgage Recovery Safely: Credit Suisse Group AG (ADR) (CS), American Capital Agency Corp. (AGNC)

There are many ways to play a recovery in the mortgage market, though some angles are more treacherous than others. Investors can choose between REITs (Real Estate Investment Trusts) that specialize in leveraged buying of mortgage debt, financial companies that invest in distressed residential real estate, or mortgage bond insurers.

Leveraged mREITs

American Capital Agency Corp. (NASDAQ:AGNC) raised $1.58 billion by selling approximately 50 million shares in February 2013. The underwriters have the option to purchase an additional 7.5 million shares in March. American Capital Agency Corp. (NASDAQ:AGNC) purchases residential mortgage-backed securities backed by federal agencies. The dividends paid out by mREITs are taxed as income, as opposed to the corporate dividend rate. The primary reason that mREITs like American Capital Agency issue equity through secondary offerings is because they are required to distribute at least 90% of their income. This allows them to avoid being taxed at the corporate level. American Capital Agency has a P/E of 7.32, which is below the average P/E for the industry, and a P/B value of 1.

Macroeconomic factors affecting mREITs

The holding of agency home loan securities by REITs has been increasing in the last few years, and this has caught the attention of the Federal Reserve. The total holding of mortgage securities by REITs has increased from $90 billion in 2008 to $340 billion last year. According to the governor of the Federal Reserve, growth of mortgage REITs in a credit market can be a symptom of excessive risk taking. According to many analysts, the Fed’s liberal monetary policy since the financial collapse of 2008 (with an aim of keeping the short term interest rate near zero) has created bubbles in many risk asset classes. Mortgage REIT’s have sold shares worth $3.5 billion this year. They also sold shares worth $16.3 billion in 2012 and a record $16.9 billion in 2011.

Mortgage insurers

Mortgage insurers like MGIC Investment Corp. (NYSE:MTG) are also evaluating the option of raising capital. MGIC Investment has been unprofitable for many years and the quarterly losses in the company’s latest results have increased to approximately $386 million ($1.91 per share) from approximately $135 million (67 cents per share) in the same quarter last year. Part of the poor financial performance can be attributed to the settlement charges of $267.5 million paid to Freddie Mac for a coverage dispute. The company has not had a profitable year since 2006. The main driver for raising capital for MGIC Investment is meeting the regulatory requirement of minimum risk relative to capital ratio of 25 to 1 (in December 2012, this particular ratio had declined to 44.7 to 1). MGIC currently has a P/B of 5.78. A rival of MGIC Investment, Radian Group Inc (NYSE:RDN), has already raised $689 million in a sale of stock and senior notes in the last week of February 2013. The mortgage insurance industry as a whole has been under a lot of stress since the housing prices crashed, as these companies have to cover losses to creditors when the homeowners default.

New mortgage originators

In another issuance related to home loans, Credit Suisse Group AG (ADR) (NYSE:CS) recently sold non-agency mortgage bonds worth $425.7 million. The top slice carries a loss buffer of 7.05%. DBRS, a rating agency, stated that the risks for the offering are poor the financial strength of some of the lenders and originators, the promise of Credit Suisse to repurchase the debt if the origination fails, and poor credit quality of a large percentage of borrowers. A positive attribute of the offering, according to DBRS, are the big down payments in the deal.

Unfortunately for investors, Credit Suisse Group AG (ADR) (NYSE:CS) is still being haunted by its past. The company will pay at least $400 million to settle investor lawsuits over its role in raising money for National Century Financial Enterprises, a healthcare financing company that collapsed back in 2002. Investors accused Credit Suisse of selling the financing company’s notes and supporting its creditworthiness. At the same time, investors claim that Credit Suisse was aware the company abused investor funds. Credit Suisse Group AG (ADR) (NYSE:CS) currently has a P/E of 27.35 and has a P/B value of 0.9.