The cheapest home loans in a lifetime may be history, but please don’t let the media’s and the market’s fixation with interest rates derail any plans you have to buy a home in the near future. And with mortgage finance stocks priced for the end of the world, investment opportunities also abound.
Buzz around the housing market has turned from passive resignation to fear, but even a casual look at the long trend will show that the risks are overstated.
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The latest numbers from Freddie Mac show that the average 30-year fixed mortgage signed last week is just about back to 4% a year. So yes, it’s getting incrementally more expensive to buy a home, but neither mortgage shoppers nor investors should be letting media pessimism force them out of the market at this early stage.
Buying: The lending window is still wide open
Let’s start on the loan origination side. Despite some of the reporting on other sites, if you find a house you like and can afford, now can still be an attractive time to buy.
Calling 4% mortgage rates any kind of “barrier” rising against borrowers is absurd, even with the economic and employment struggles in recent years. Going back over the last 42 years, the average 30-year home loan cost 8.64% a year – more than double today’s supposedly “dangerous” level – and the housing market never starved.
There is a long, long way to go before we even approach the 5% to 7% territory that fueled the mortgage boom in 2002–2005, so Ben Bernanke and his colleagues at the Fed have plenty of room to turn the liquidity spigot before it even gets close to closing.
Besides, mortgage rates haven’t exactly spiked in the last few weeks. They’ve only edged up about 10 basis points -- each worth a hundredth of one percentage point -- month to month since hitting a lifetime low last November.
And remember, this interest is usually deductible, so the federal government is absorbing a significant slice of that added interest. On an after-tax basis, a middle-class family that didn’t push the button on a new house last year is now looking at paying a whopping $40 a month more on every $100,000 they borrow. In scenarios where that $40 is a budget breaker, odds are good that the application will raise a few more red flags at the bank.
Another positive right now is that the days when you needed flawless credit to qualify at any price are over. That was the case after the financial crisis and housing collapse five years ago, but even at today’s “elevated” rates and stricter underwriting standards, people with sub-prime credit scores below 640 are still getting loans. According to scoring agency Fair Isaac, those sub-prime loans are still significantly cheaper than those with perfect scores got in the boom years.
And while home prices have recovered somewhat in some parts of the country, buying is still more affordable than renting just about everywhere. To even budge that simple equation, mortgage rates will have to climb back to levels we haven’t seen since the gloomy summer of 2009.
Investing: The sky is not falling in the mortgage group
Likewise, when it comes to the mortgage finance stocks, sentiment seems to reflect a lot more fear than the real risks justify.
Out of 21 mortgage REITs and home finance companies on my screen, no less than nine are trading below book value. Five of the nine -- Invesco Mortgage Capital (NYSE:IVR), KKR Financial Holdings (NYSE:KFN), Ellington Financial (NYSE:EFC), Arlington Asset Investment (NYSE:AI) and Western Asset Mortgage Capital (NYSE:WMC) -- are nominally undervalued at price-to-earnings multiples of 1.7 to 6.6.
These are profitable companies doing high-margin business and paying rich dividends. Leverage is significant but nowhere near what their gigantic peers at Fannie Mae (NASDAQ:FNMA) and Freddie Mac (NASDAQ:FMCC) are carrying.
But while the government-backed giants have seen their share prices sextuple year to date, most of these smaller stocks have suffered from the market’s anxiety over rising interest rates ravaging their asset books and endangering their forward cash flows.
Here’s how I look at it: In general, we should expect these companies’ rate-sensitive loan portfolios to weaken going into a tightening cycle. However, not all portfolios were created equal, and a sound management team will adapt to fit evolving macro conditions and protect their share price.
Take WMC as an example of what happens when the fear follows the headlines and not the fundamentals. The last few months have been brutal to the company, which essentially operates as a REIT (real estate investment trust) that holds mortgage-backed securities. As mortgage rates climbed 40 basis points in the last 11 weeks, the stock was absolutely savaged, falling 26% from a recent peak of $23.80 to under $18.
The headline catalyst is fairly obvious, but as it happens, the company reports its rate sensitivity under various scenarios, so investors who take the time to dig down into the reports can see exactly what every basis point change will cost.
It turns out that WMC’s mortgage portfolio is already geared to benefit from what the media are trumpeting as the worst-case scenario in the lending markets. Should 5-year Treasury yields tick up 100 basis points in the current quarter, the company said back in mid-May, the value of its loan book will deflate 0.98% and its net interest income – the core driver of its earnings and ability to pay dividends – will decline 1.98%.
Yes, that’s a potential decline, but it’s hardly a financial meltdown worth driving these shares down so far that the yield is now well above 20%! The payout ratio here is barely 50% of earnings, so that dividend should survive a 2% retreat.
And should 5-year bond rates climb only 50 basis points between now and the end of the quarter, the WMC loan book declines 0.43% but the portfolio will actually generate an extra 2.21% in income.
So far this quarter, the 5-year bond has moved 56 basis points, so we are now right in that sweet spot and still well outside pain territory. For WMC’s hedges to unravel enough to cut into its interest income, we would have to see yields surge another 33% in the next week.
In that rather unlikely event, we will have other things on our minds. So unless you think housing is perched right on the edge of an abyss -- and the evidence strongly indicates it is not -- the irrational fear over interest rates is providing some attractive investment possibilities. Instead, I expect mortgage rates and related stocks to climb that wall of worry, making the near-term rewards look worth the risk.
Hilary Kramer is the editor in chief of the subscription newsletters: Game Changers, Breakout Stocks Under $10, High Octane Trader, Absolute Capital Return Portfolio and Inner Circle. Formerly, Hilary was the CIO of a $5 billion global private equity fund. She has an MBA from the Wharton School at the University of Pennsylvania and began her Wall Street career as an analyst at Morgan Stanley. Hilary is the author of The Little Book of Big Profits from Small Stocks (Wiley) and Ahead of the Curve: Nine Simple Ways to Create Wealth by Spotting Stock Trends (Free Press). To learn more about Hilary Kramer visit: http://GameChangerStocks.com.
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