How Mortgage REITs Work

The housing bubble expanded because of easy access to mortgages. Many of the companies that have provided the mortgages are mortgage REITs. Over the past few months, a number of mortgage REITs have been forced to cut their dividends suggesting that their cash flows are not what they were earlier in the year.

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[Annaly makes money on the difference between its cost of funds and the yield on its mortgage securities, which is generally higher. It invests in both fixed-rate mortgages, which follow long-term interest rates, and adjustable-rate mortgages, which follow short-term rates, though with a lag.

Since June 2004, the Federal Reserve has raised the federal funds rate 10 times. That has caused a sharp rise in short-term rates, raising Annaly's cost of funds. Usually, when short-term rates rise, long-term rates also rise, although not as quickly. This time around, long-term rates have actually dipped since the Fed began raising rates, resulting in a yield curve that is nearly flat.

That has narrowed the gap between Annaly's cost of funds and the yield on its mortgage securities, and thus its profit. Because REITs pay out 90 percent of their earnings, it has been forced to slash its dividend.

"That REIT is a fairly transparent view into what is happening in hedge funds sitting on a lot of fixed-rate assets financed with short-term assets," says Jim Fowler, director of research with JMP Securities. "You are going to see significant issues in any type of company that has this type of trade on."]

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