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More Than Just Home Finance, Mortgages Make You Money

December 12, 2018

The mortgage market is one of the cornerstones of US economy. The majority of homes and related properties are bought and funded by mortgage loans. And as we saw in the run-up of the property markets in the 2000’s, mortgages can fund rampant expansion to the point of a bubble. When that bubble bursts, as we saw starting in 2007, it can cause drastic harm to the economy and the general stock market.

Mortgages are originated by banks and brokers. They are either held and owned by banks and investment companies or they are packaged together to become bonds known as mortgage-backed securities (MBS).

MBS are in turn bought by insurance companies, pension funds and investment companies. These investors, if they’re smart and disciplined, pore over the underlying mortgages to analyze the collateral of the homes as well as the payment of interest and principal.

As investors sort through their MBS portfolios, they also project what will happen to the collateral values and what borrowers will do, including refinancing, paying them off and moving or, heaven forbid, defaulting.

If they aren’t smart and disciplined, then they might just go along with rating agencies’ reviews and traders’ recommendations. This is a recipe for disaster, as we all saw in the 2007-2008 financial crisis.

One of the best in the business of investing and managing MBS is MFA Financial (MFA). MFA is structured as a real estate investment trust (REIT). It avoids corporate income taxes by paying the majority of its income through to shareholders just like any other REIT, but MFA holds mortgage investments instead of properties. This is a recipe for lots of regular dividends for savvy investors.

MFA has consistently turned in profits for shareholders, and even did so during the 2007-2008 crisis. And even through shares dipped briefly with the most recent broad stock market correction, it has been a strong and consistent stock for investors. Since June of 2006 to date, MFA has turned in a total return of 330.58% for an average annual equivalent return of 12.36%, as shown in the graph below.

The company continues to generate positive returns which dwarf traditional lenders, with a return on assets of 3.0% against lending banks with returns on assets in the 1% range.

The return on shareholder’s equity is also healthy, at 10.2%.

Despite the intensive skill levels of management overseeing the MBS portfolio, which many would expect would require MFA to pay top dollar for their management payroll, the company runs relatively lean, with the general and administrative expense ratio to operating income at a low rate of 24.60%, a figure that’s improved over the past four years by more than 50%.

Dividends are paid quarterly from cash flows from the MBS portfolios and the underlying mortgages. And at a steady 20 cents per quarter, MFA generates a yield of 11.24%.

Yes, that is a big yield. But the company has a proven record of turning in profits and paying the majority of that profitability to shareholders as it’s required to as a REIT.

What could go wrong? Well, there’s a chance we could see a string of failures and missteps from management, even though many of the senior management team at MFA have been with the company since before it came to the public market back in 1998. I don’t think they’re likely to lose that edge.

Shocks to the mortgage market, including a major spike in US interest rates or a major fall in real estate values, would impact the company. But since it has been tested by these conditions to the extreme, it should weather these threats well going forward.

The shares are also a bargain. Trading at a discount of 0.05 of the book of MBS assets, the shares are cheap not just for the current value of the mortgages but also for how they are managed by MFA and their attractive dividend yield.