Mortgage-Backed Trade May Reach Retail Portfolios

Hoefer said that as mortgage-backed securities decline in value, a number of banks will have to take big writedowns or will see their earnings reduced. "If you're talking about a thrift, which has got roughly 55% of its assets in mortgages of one type or another, earnings could drop 10%, 15% or 20%, though that will take years to happen."

During periods of rising interest rates, thrifts typically sell at a discount to book value because investors recognize that the value of mortgage-backed securities is overstated on the balance sheet, Hoefer said, adding that he expects thrifts to fall 30% over the next 12 months. "You're definitely going to see the impact grab hold and negatively impact the value of these stocks," he said.

Jim Ackor, an analyst at RBC Capital Markets, said the impact on banks is often more optical than fundamental. Many banks hold bonds and mortgage-backed securities in their portfolios without marking them to market. In other words, they don't have to change their balance sheet to reflect the drop in the value of the bonds or mortgage-backed securities.

In 1999, Ackor said, rising interest rates slashed the value of Astoria Financial's bonds, but the company didn't sell a single security. "They basically said, 'OK, the bond portfolio is under water by x amount, the securities continue to produce good interest income for us and we don't have to realize these losses.' They held on and rode out the interest rate cycle," he said.

Of course, that doesn't mean investors will be kind to companies in this position. "Just look at New York Community Bancorp(NYB)," Ackor said, noting that the stock has fallen 34% since the end of March on concerns that the firm's bond portfolio is underwater by as much as $450 million on a pretax basis.

While the mortgage-backed securities market is dominated by institutional players and can often seem obscure or irrelevant to retail investors, its impact on Treasuries and on bank stocks can be far-reaching, and fluctuations in this market are definitely worth watching as the period of ultra-low interest rates comes to an end.

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