RuthMantell

WASHINGTON (MarketWatch) — Home buyers aren’t the only ones struggling with interest-rate volatility.

Shares of real estate investment trusts that invest in mortgage-backed securities have decreased in recent months as rates increased, cutting the value of these firms’ assets. Shares of mortgage REITs began a sharp drop in early May as market speculation about the Federal Reserve starting to scale back its asset-purchase program pushed up rates.

Take mortgage REIT giant Annaly Capital Management NLY, +1.07% for example. Since the end of April, Annaly shares have dropped about 28%. Annaly recently lowered its quarterly dividend, announcing a third-quarter per-share distribution of 35 cents, compared with 40 cents in the second quarter. Elsewhere, shares of American Capital Agency AGNC, +1.15% another large mortgage REIT, have fallen about 32% since the end of April. American Capital also recently cut its dividend, announcing a third-quarter distribution of 80 cents per common share, compared with $1.05 per share for the second quarter.

“A lot of the holdings of mortgage REITs have declined in value. The book value of mortgages has decreased quite dramatically at some companies,” said Sam Carr, an analyst at the Charlottesville, Va.-based SNL Financial, which provides financial data and analysis.

Investors like mortgage REITs because they can offer high yields. But they are exposed to rate fluctuations, a relationship that can be difficult to handle.

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“We hedge the vast majority of our interest-rate exposure,” Rich King, chief executive of Invesco Mortgage Capital IVR, +0.84% an Atlanta-based mortgage REIT, told MarketWatch. “We see great opportunities.”

There was a recent reprieve from rising rates after Fed officials surprised markets with a no-taper announcement. But analysts say the central bank is merely delaying the inevitable, injecting volatility for a few more weeks or months, and that rates will eventually head higher.

Like home-builder stocks. shares of mortgage REITs closed up after the no-taper announcement. But mortgage REIT investors traded the shares back down within a couple of days.

“Tapering expectations will likely continue to hang over the sector,” according to a research note from analysts Michael Widner and Sean Tillman at investment bank Keefe, Bruyette & Woods. “The question for the sector remains: ‘Where do rates go from here?’”

Unfortunately for mortgage REIT investors and others, it’s just not clear what central bank officials plan to do.

“The challenge is [the Fed’s quantitative easing program] has destroyed market confidence that anyone knows where rates ‘belong,’ so it seems unavoidable that until rate manipulation ends rate volatility will remain. That can be very difficult for mortgage REITs to hedge,” according to KBW analysts.

Some experts say a taper announcement could come this year, while others expect the Fed to hold off until 2014 to start reducing asset purchases. Also, even when the Fed does move forward with tapering, it’s not clear which purchases will be cut. The Fed buys large amounts of Treasurys and mortgage-backed securities. It’s possible that officials looking to avoid curbing the housing-market’s rebound will taper Treasury purchases first, and cut MBS buying later. Indeed, there’s reason to think the Fed has yet to announce tapering plans because it was “spooked” by the spike in mortgage rates and drop in home-buying plans.

To complicate matters, partisan discord in Washington is dragging out debate among U.S. lawmakers about funding the government and the country’s debt ceiling. A debt default would shock economies across the globe, and U.S. officials recently warned that even just the prospect of a default could be damaging. Although Fed officials try to maintain their distance from politics, there’s no way to ignore the stalemate in Washington and its potential consequences for markets, companies and consumers.

Before the recent government spending strife, John Dalena, chief strategy officer at Winston-Salem, N.C.-based Atlantic Capital Advisors, which manages mortgage REIT Hatteras Financial HTS, +0.97% said the market may have overreacted in recent months to Fed taper speculation.

“The rapid rise in interest rates is more driven by the Fed than fundamental economics,” Dalena said.

Looking at the big picture, there’s concern among officials about the possible systemic risk posed by mortgage REITs and other entities that use repo markets for short-term funding. A new financial-stability report from the International Monetary Fund cited vulnerability to risks from rising and volatile rates if collateral is liquidated, leading to fire sales and funding interruptions, among other problems.

“Given that the repo funding of the two largest mREITs is comparable to Lehman Brothers’ precrisis repo book, at the very least the mREITs point to a microcosm of fragilities in the shadow banking system that deserve closer monitoring,” according to the IMF.

A separate report from U.S. regulators reported similar findings, according to the Financial Stability Oversight Council. a federal watchdog created by the Dodd-Frank bank-reform bill.

“A shock to agency REITs could induce repo lenders to raise margins or pull back funding, which in turn could compel agency REITs to sell into a declining market, potentially impacting MBS valuations significantly,” the FSOC’s report says.

However, both reports noted that the mortgage REIT industry’s holdings are a relatively small part of the mortgage-backed security market. Also, mortgage REITs’ leverage has declined since the financial crisis.