Betting Against the Fed

The Federal Reserve's Open Market Committee has been tightening the federal funds rate for two straight years. As usual, there is plenty of argument about whether it should continue raising rates. Bears point to rising prices of gold, copper, silver and oil as reasons why the Fed cannot stop raising rates. Others counter that investors have merely lost faith in the Fed, as the slumping dollar (combined with the rising commodity prices) might suggest.

But what if the Fed actually gets it right this time around and interest rates dampen inflation and rates begin to fall (or at least stop going up)? That appears to be the sentiment from insiders in the mortgage REIT and energy master limited partnership sectors. Company insiders — defined as executives with access to key corporate information who are, therefore, are closely watched — are buying shares of their own companies even though the securities of their firms would suffer if rates rose substantially higher or if the yield curve inverted.

The REIT Stuff

Particularly interesting are the bullish insider transactions at several mortgage-related REITs over the past six months. It's an interesting bet: Besides bucking interest-rate concerns, industry executives seem to be less impressed with the related thesis that the housing sector is about to implode. American Home Mortgage Chairman Michael Strauss invested over $8 million more in his firm last November, and executive vice president Richard Loeffler doubled his holdings with a 5,000-share purchase just this past March. (See table.)

If you don't trust the judgment of company executives (because you consider them to be an optimistic group), then consider that Hotchkis & Wiley Capital Management, Munder Capital and Morgan Stanley were also big buyers of American Home, beginning in late 2005. These institutions picked up stakes worth 5 percent, 6 percent and 7 percent, respectively, according to Schedule 13G filings.

There were insider purchases at numerous other mortgage REITs in recent months as well (see the table on this page). In fact, it's enough to make an obvious trend, if not an out-and-out consensus that last year's sell-off in the group was overdone. Of course, some weakness was warranted. “There was a lot of negative news last summer and fall for our industry,” says Clarence Simmons, CFO at Thornburg Mortgage. “The yield curve inverted, which ruined the carry trade many mortgage REITs rely on to make a return in their investment portfolios. And as rates rose, people worried that mortgage originations would slow down and create more credit concerns for potential borrowers.”

But for Simmons and others at his firm, the pummeling of their stock last year became a buying opportunity, especially when the yield rose to 12 percent. At American Home Mortgage, insiders locked in similar yields by buying in after their shares fell from a high of $40 last summer to $26 by last October. In both cases, company executives saw that their “active” REITs were being unfairly tarred with the same brush as “passive” peers like Luminent and Capstead.

Passive mortgage REITs invest in mortgage securities originated by others and have done well in past years when they were able to borrow at low short-term rates, and then turn around and invest that money at higher longer-term rates (the so-called “carry trade”). Active REITs, on the other hand, make money both from originating mortgages and building an investment portfolio out of them. This is an important distinction that makes Thornburg and American Home relatively safer bets in this sector right now.

Not Popped Yet

This is because — despite the conventional wisdom that the housing boom is done — mortgage originations remain strong. This is particularly true for the pay option adjustable-rate mortgages (ARMs) being offered by American Home and Thornburg.

Besides locking in origination fees, these REITs also end up feeding their investment portfolios with very attractive assets. The interest-rate risk of pay option ARMs can be offset with swaps, and the added credit risk in these instruments can be hedged with extra mortgage insurance. This makes these assets relatively safe income generators and good assets to borrow against. And the ability to leverage means the ability to increase return on equity. Other firms recognize the value of pay option ARMs, too, and when supply and demand metrics warrant, these active REITs can choose to sell these instruments for a quick profit.

And what if rates do end up rising so much that originations are choked off? That would surely hurt American and Thornburg in the short run, but also open up the opportunity for these strong players to buy up competitors at a discount.

That is not the scenario that the active REIT executives interviewed expected, however. Most simply feel that the Fed's rate-tightening cycle may be nearing its end. And, as James Ackor at RBC Capital Markets points out: “Historically, when we approach a peak in fed funds rates, stocks in the mortgage REIT sector tend to be under a lot of pressure. But when the peak is hit, they pop.”

Aggressive at Passives

The higher-yielding active REITs listed in the table on page 65 have already rebounded nicely from the lows they hit late last year — and still have relatively safe, high yields to offer new investors. Ditto for NorthStar Realty, a passive REIT whose high yield hasn't suffered due to its focus on investing in more stable commercial real estate debt. But what of the low-yielding, passive REITs that also had insider buying?

Unfortunately for the more established passive REITs, a straightforward steepening of the yield curve caused by long-term rates rising won't be a quick salvation for their earnings. Sure, such a state would once again offer decent spreads to borrow on the short end of the rate curve and to invest on the long end. But rising long-term rates also plunge the existing portfolios of these REITs deeper underwater.

Still, the smart money seems to be betting that earnings have reached their trough at these firms for this interest-rate cycle. Besides the insider buying in the group, this sentiment is backed by the closely watched — and ultimately successful — share offering by Annaly Mortgage in April.

The bet is that a healthy, steepening yield curve at least makes new investments more lucrative. And some passive REITs have a portion of their established investment portfolio in floating-rate instruments. As rates on these securities adjust, they should be much less of a drag on earnings.

What passive mortgage REITs really need to stage an earnings revival, however, is for a steepening of the yield curve to be prompted by the Fed lowering short-term rates. This seems quite a contrarian thought right now, but then the best time to bottom-tick a sector is often when the best scenario for the group appears remote.

Masters of Their Limited Domain

The insider optimism at several energy master limited partnerships (MLPs) also relies on a benign scenario for interest rates. Like REITs, when a company is organized as an MLP, it must distribute a significant portion of its income to unit holders.

So MLPs are generally purchased by income investors coveting their yields. As interest rates rise, fixed-income securities compete for these same investors and MLPs tend to sag in price. Also, any slowdown in the economy caused by the Fed overshooting would logically reduce the amount of energy that needs to be transported through the energy storage and transport operations that represent the bulk of most MLPs business.

The continued insider buying at several MLPs seems to indicate that they are not afraid of competition from rising bond yields and that the demand for energy will remain robust. At Martin Midstream, insiders have been steady buyers since the company went public in late 2002. But even though the stock has nearly doubled since then, both the CEO and CFO put up another $200,000 between them in March to buy their shares at over $30. Explaining his bullishness, CEO Rubin Martin simply says, “All the fundamentals look good for our business.”

In the end, business continuing to be good is what will make MLPs stay attractive relative to other high-yielding fixed-income investments. Improved operating performance leads to higher income distributions. And, as Mike Campbell at Inergy points out, “A record of increasing distribution rates is the best defense for MLPs in a rising interest rate environment.”

That is obviously what executives at Inergy and Enterprise Products Partners expect. As the second table shows, there has been significant insider buying in these securities over the past two quarters as well.

Of course, all this insider buying at these MLPs and mortgage REITs will be a boneheaded move if the Fed does end up overshooting with its serial rate increases — which now number 16 in a row. Certainly, insiders can be wrong. But when numerous executives in any sector better their own money in numbers, well, often they are right.

Inside Scoop: Putting Money Where Their Mouths Are

How do executives really view their company's prospects? Sophisticated investors follow the trades insiders — directors, officers, key employees or any one with access to important information — make in their company stock. Investors often take note of insiders' trades, since they would know more about a company's prospects than anyone.

Company	Ticker	Insider Purchases Since Q4	Average Purchase Price	Recent Price	Yield
American Home Mortgage	AHM	$8,434,136	$27.65	$34.40	10.5%
Luminent	LUM	1,735,323	7.96	8.00	2.5
Northstar	NRF	1,401,375	9.25	11.41	10.7
Capstead Mortgage	CMO	1,075,062	6.28	7.40	1.1
Thornburg Mortgage	TMA	734,480	23.69	37.76	9.8
Opteum	OPX	589,117	9.13	8.29	5.2
Annaly Mortgage	NLY	109,465	12.51	13.11	3.3

Insiders Buy at Energy MLPs

Company	Ticker	Insider Purchases Since Q4	Average Purchase Price	Recent Price	Yield
Enterprise Products Partners	EPD	$11,635,137	$23.94	$25.02	7.2%
Inergy	NRGY	540,200	27.01	25.89	8.2
Martin Midstream Partners	MMLP	325,875	31.49	31.05	7.9