Anworth Mortgage (ANH)

Next in order of capitalization is Anworth mortgage, my largest holding in the residential mortgage REIT peer group.

I don’t hold more of it because I think Lloyd and his team are the best traders or hedgers, but because their stock is cheapest when compared to its capital and earnings risk.  Having said that, THIS IS NOT FINANCIAL ADVICE.  I can virtually guarantee that my financial situation is substantially different from yours, and that what is worth doing for me is potentially much too risky for you.

For that reason, I’ll share how I decided to do what I’m doing, but it’s up to you to decide how you need to invest for yourself in your situation.

With Agency mortgage securities setting yet another record for high prices (and low yields) today, I have no doubt that Anworth’s book value will be higher at the end of the current quarter than it was at the end of the last quarter.  Last quarter it was $7.46 per share.

My friend and former colleague Scott Simon describes today’s MBS prices as “insane,” but he still owns them.  As Andy Harding, another former Wall Streeter who now works on the buy side explains, as steamy as the MBS market has become, there’s still reason to own them.

Unfortunately for Anworth shareholders, the company seems to be a kind of Rodney Dangerfield of the group, never getting any respect.  In the 2006 review I mentioned in another company-specific post in this series, Anworth was grouped with four other RMBS investors.  All the others were trading at least at book value, with Annaly sporting a healthy premium of 36% over book.  Poor Anworth was trading at 86% of book value.

At the time I wasn’t investing in Agency REITs, so it would take a little research and forensics to explain why, but I’ll hazard a guess.  My guess is that Anworth had taken in too many premium MBS and been burned by the crazy refinancing binge that was going on in America at the time.  That would explain the paltry 8 cent quarterly dividend from Q2, 2006.

This is actually a good example of why I like to understand the management and how they react to the market more than I care to dissect the snapshots of specific portfolio elements at any given time.  For me, the portfolio mix and the hedges (especially) help me know the philosophy of the managers.

With Anworth, it’s clear.  They are very straight-forward, and they hedge every risk they can afford to hedge, even if it cuts into earnings.  That’s why they had the highest effective financing rate in the group right through 2008 and most of 2009, because they bought new-issue 5/1 ARMs in 2004 and 2005 after the Fed tightened and immediately hedged all five years of the fixed rate exposure.  It’s also why they get no respect as they “underperform” the peer group that takes on more risk and pays out more dividends per dollar of capital.

Recall that MFA only hedges the first 2.5 years, and Annaly used to go without hedging its hybrid ARMS at all.  Even today, Annaly only hedges some (less than half) of its fixed-rate MBS, and seems to be leaving the ARMs and floating rate CMOs to fend for themselves.  That makes for higher earnings and higher investor yields, so today NLY has 12 times the market cap that Anworth sports, even though they were only four times Anworth’s size in September of 2006.

So why would I put more of my personal money into the less adventurous management team that hedges so much that they pay a lower dividend?  Because I know that this environment is nearly perfect for all spread traders who avoid credit risk, and I think that Anworth will be paying excellent dividends and increasing book value for a while longer.

The Fed confirmed again today that it won’t be tightening at the short end of the curve any time soon, and the main reason is the continued weakness of the housing market.  Since Ben and Boyz haven’t joined Jimmy Carter in Habitat for Humanity yet, they can only try to help the housing market by facilitating housing finance.  That means they will be the repo lender even if the banks lose their shirts in European CDS or some other foolishness like that.

I’ll lighten up on Anworth when it trades to 105% of book value or higher.  Right now, that would be a number in the $8 region, I would guess.  Even if MBS spreads widen out to more normal levels, Anworth won’t be taking an enormous hit on its capital base because of their hedging, so I can comfortably wait it out.

I don’t expect Anworth to change who they are, and I am comfortable with the idea that they may continue to trade at a cheaper ratio to book value than the others.  I also don’t expect them to miss out on this amazing Fed-driven recapitalization of the banks through the carry trade, and some of that capital will flow out of savers’ pockets (getting their lousy 1.5% CD yields, or 0.25% money market yields) into amREIT investor’s pockets (getting their 15% yields).

I bet the management of these companies are sorry they have to pay out all the earnings right now, because they could gather an amazing amount of capital to grow their companies if they didn’t have to distribute it to us.

Some will make up for that by issuing secondaries, especially if they are “externally” managed.

hh

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9 Responses to Anworth Mortgage (ANH)

  1. Gary Anderson says:

    ANH is my largest AMREIT, CMO second. The stock price has occasionally been frustrating as many of the peers have been outperforming ANH.

    I’ll be interested in your take on some of the higher risk, high flyers in the sector such as AGNC (I got in it cheap, got out too early, and have been out of it for some time).

    Cheers,

    G

  2. Jesse Livermore says:

    Really appreciate this series. You mentioned that CMO has a 3-month duration gap. What about ANH? If MBS return to more historically normal prices, how vulnerable is ANH’s book value?

    • hhill51 says:

      I haven’t seen any place that they calculate it. My guess, from my impression of how they manage their book, is that they stay inside 6 months, and closer to 2 or 3 months. I would bet they would prefer to have duration gap of zero, if they could.
      That would be consistent with the high rate swaps they have from ’05 and ’06 that are keeping their effective funding rate above 2% through the first quarter of 2010. They do have some expensive swaps rolling off this year, so their cost of repo should drop fairly dramatically over the course of the next six quarters.
      Do bear in mind that a disciplined hedging strategy leads them to enter swaps for all the new investments, which today would be above 2% for the tiny slice of 5-year swaps they’d need, and around 1% to 1.5% for the 2 and 3 year swaps (the bulk of the principal needing hedging).

  3. HL Starr says:

    With latest quarterly earnings (.19 per share), are the earnings apt stabilize anytime soon and what are the prospects for the stock price?

    • hhill51 says:

      Sorry, but I don’t ever try to predict stock prices.
      \\
      I can say that I think they are the most dedicated among all the management teams in the sector to hedging their financing cost, but maybe a paragraph or two describing how that’s done will give you an idea why the last two quarters of Fannie/Freddie buyouts of delinquent mortgages could mess that up, leaving them “overhedged.”
      \\
      Hedging financing consists of getting swaps, caps or forward Eurodollar futures that match the declining balance of each piece of the portfolio. Anworth has been focused almost exclusively on the easiest-to-hedge (most predictable) slice of the MBS market — hybrid ARMS, which are fixed for 3,5, or 7 years, and then float over an index with annual, semi-annual or monthly resets. “Current resetting” ARMs are those hybrids after the initial period. If they are resetting each year on their anniversary, then the holder only has to hedge to the next reset date. Still, once you have the hedges on, if the mortgages pay down faster or slower than you expected, you’ll be over-hedged (when prepays are fast) or underhedged (when prepays are slow).
      \\
      The move by Fannie and Freddie to stop the bleeding of paying principal and interest on delinquent loans accelerated the principal payoff to investors by not paying off the loan balance only after the house is foreclosed and sold. That was good for us as taxpayers, but bad for mortgage investors that hedged or who paid a premium for the MBS. ANH paid the market price for their MBS, which probably averaged around 102.5% of the balance. If an extra $100 million pays off one quarter (out of their much larger portfolio), that’s a loss of an extra $2.5 million of premium over and above the amortization of premium that they had projected.
      \\
      In addition, they were more fully hedged than the competition, and that means they are stuck paying out fixed rates on swaps for up to $100 million in face amount and receiving LIBOR, or they have to pay a counterparty the present value of that differential in rates to buy out part of the contract.
      \\
      From this point forward, I expect we’ll see a slowdown in their prepayment rate to a level actually slower than the original projections, which will probably make the earnings look larger.
      \\
      I’ll wait to hear the conference call before doing anything with my position, unless the stock tumbles to $6.50 or so per share. If that were to happen, I’m quite comfortable predicting that they had nowhere near the hit to capital that Annaly took, so I’d be adding to my position.

  4. Marc says:

    Howard, as to ANH being totally unable to deliver in over a year, do you see a point where they will ask us to return divy money? Or just give up on them and buy bubble gum?

  5. Jim D says:

    ANH has around 1 billion hedges running off in the next year which will be replaced at much lower cost. This should help. I think the last quarter was a kind of minor perfect storm in what you wouldn’t want to happen. There is a lag in reinvestment of the prepays.

    • hhill51 says:

      Good points, and not clear in my previous comment. AGNC only hedges half their exposure. NLY a third. These guys try to stay fully hedged. When prepayments bump up as they did with the buyouts, the hedges are still there, but the mortgages aren’t. Still, the hedges are scheduled to roll off constantly. With their size of portfolio, the expected principal payoff is over $100 million a month. Adjusting the portfolio and the hedges is usually a matter of deciding each month how much to add to each. I’m comfortable thinking it can be rebalanced over a three or four month period, but I’ll be listening to the conference call and hoping one of the analysts asks the question.

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