As Expected

Capstead Mortgage (CMO) announced their second quarter dividend last night.

The dividend was cut to 36 cents from 50, and the stock got (marginally) punished.  At this moment, it’s trading down 29 cents at $11.19.  That’s higher than my last purchase, and lower than my average 2010 cost.

I haven’t sold, and I haven’t bought, either.  I’m still overweight the stock, and agree with the analysts that see the dividend being raised again, by a nickel or dime, later in the year.

They may still have a little bit of Fannie Mae buyouts ahead, but the storm of accelerated paydown is just about over.

CMO is the best duration-matched player in the group, a fact that would make it much safer for them to increase leverage than the others in the group, but they have been frustrated by the market, which continues to give very tight option-adjusted spreads to the MBS.

Just to review, an option-adjusted spread, or OAS, is the expected average spread over the benchmark yield curve (swaps or Treasuries) that the owner of a bond may get if the option to prepay the mortgage (or call the bond for muni’s and corporates) is exercised the way that option was exercised in the past.   Recently, OAS models have been less than accurate for two countervailing reasons.

First, decline in house values and decline in available credit to borrowers has slowed down the “natural” rate of refinancing and home sales.  On the other side the coin, prepayments have been accelerated by foreclosures, since a default is another kind of early resolution of the loan.  For Agency MBS, since defaults are paid out at 100% by the guarantor, a default is exactly equal to a prepayment.

The recent spate of buyouts of extremely delinquent loans by Fannie and Freddie has been the same as a sudden burst of prepayments.

So what does OAS have to do with the amREITs and the way they own MBS to extract the maturity spread via the carry trade?

Answer:  Prudent managers know that low or negative OAS implies potentially lower future earnings, when those pesky borrowers pay off their high coupon mortgages when rates fall, or worse yet, keep paying for decades on their low coupon mortgages after rates increase.

What surprised the boys at Capstead (and your lowly correspondent) was the stability of spreads after the Fed finished propping up the MBS market through its $1.25 trillion buying spree.  Just to be clear, it was a profitable trip in amREIT land for the Fed.  They reported net income of  $20.4 billion on what was essentially the biggest amREIT in the history of the world.

We can attribute these persistently tight spreads to two major forces:

  1. Fannie and Freddie were permitted to buy MBS once again, allowing them to supplement their income, such as it is, as they continue to suffer the losses the housing decline portends.
  2. Foreign investors are avoiding other major geographical regions for the time being, and at least MBS are a slightly higher yielding way to own US Government risk.

I have no doubt that the management at Capstead was keeping their leverage low and their powder dry to be active buyers in this time frame, under the assumption that they would get some bargains once Ben Bernanke wasn’t buying every MBS in sight.

At some point they will probably follow HTS and AGNC into the philosophy of “getting while the getting is good” and increase their leverage to multiply a historically very attractive raw spread over funding, no matter what the borrower prepayment option may do to take the shine off that attractive alternative.  Until then, it looks like 12% to 14% is likely to be the yield to investors, even if the stock goes up a half buck or so.

Still, from the “safest” of the bunch, that’s not bad.

hh

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4 Responses to As Expected

  1. Patrick says:

    I rather like Annaly’s explanation for the agency MBS pricing of late:

    As we suggested in our previous month‟s commentary, just because the Federal Reserve‟s agency MBS purchase program is complete does not mean that its market impact is over. We continue to see a problem with “fails” in the system, because there is not enough collateral to fill the bid from the Federal Reserve‟s MBS purchase program in the to-be-announced (TBA) market. This will likely continue to be a driver of performance going forward. Nomura Securities recently put out a research piece that quantifies the extent of the problem. “Gross fails by primary dealers have spiked up from $100 billion in the first half of 2009 to $600 to $700 billion in the first quarter of 2010,” they write. “What is even more interesting is that gross fails by primary dealers have suddenly spiked up over the week ending on May 19th to $1.058 trillion versus $665 billion over the TBA settlement week in April. Essentially, dealers (and indirectly investors sometimes), are choosing to provide 0% financing rather than delivering mortgage pools on TBA settlement days.” Nomura further elaborates that “the volume of fails in the system is expected to be high because the MBS purchase programs of the Federal Reserve and the Treasury have caused a significant reduction in the float available in 30-year [Fannie and Freddie] passthroughs.” As a result of these “fails” from the Federal Reserve‟s mortgage-backed security purchase program, agency mortgage-backed securities are likely to remain well bid for the foreseeable future due to light daily origination activity.

    • hhill51 says:

      Being out of the daily flow hurts, I see. That certainly would have been a third reason, if not the first among the reasons I offered.
      thanks, patrick

  2. Fred says:

    Howard, have you looked at HTS, Hatteras Financial Corp?

  3. Fred says:

    p.s. I see you have already mentioned HTS at the bottom of your post. I should pay more attention, but if you have more to say about it, I would appreciate it. TIA

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