Capstead Mortgage (CMO)

This is a company that has had several lives, even as a REIT.

It traces its roots to a real estate company that used to reside in an old Victorian house on Chapel Street in New Haven, Connecticut and rent its top floor to three brilliant and gorgeous Yale co-eds in the mid-1970’s.

While I was investing back then, I wasn’t investing in Lomas and Nettleton, which wasn’t even a public company.  Lomas moved to Texas in the 1980’s, and it became the largest originator and servicer of residential mortgages.

In one of the several “ends of the mortgage markets” the capital markets served up in the 1980’s, Lomas effectively went under, done in by the fact that mortgage servicing is essentially an interest only strip of payments, and at risk if rates drop and the borrowers refinance before the company can recoup the expense associated with creating the servicing asset.  Its failure as a REIT happened in 1992, at which point it was looking far too much like a thrift, loading up its balance sheet with construction and real estate development loans.

The late 80’s was more than a Thrift Crisis, though most of the focus of trouble in the mortgage market was concentrated in the S&L’s.  Lomas was an example of a company like Countrywide (but far larger at the time) that was outside the banking system and making mortgage loans.

The husk of Lomas and Nettleton was purchased and it became what morphed into Capstead.  You’ll note that the symbol, CMO, was the sine qua non of structured mortgage investment in the late 80’s, so the choice of the new name and stock symbol was something of an inside joke to us in the business.

As Capstead, CMO survived the thrift crisis and the LTCM crisis, becoming an amREIT in the new millenium.  That’s the company you buy today when you buy CMO.

As an amREIT, CMO is the “safest” of the lot due to very robust hedging.  In the post on MFA, we saw a group that limited itself to ARMs and hybrid ARMs, but chose to hedge only the first 30 months of funding rate exposure.  Owning paper that resets on a longer time frame leaves that company exposed.  We call that exposure the “duration gap.”

CMO has the shortest duration gap among the amREITs, at less than three months.

Put in non-technical terms, that means they have less than the risk of 3-month T-bills exposure to their capital if the rates market goes against them.  For back of the envelope figuring, that means a 1% change in the value of their holdings would require a 400 basis point move in rates.  Even after taking the leverage into account, that’s still a relatively small risk compared to peers that average a year or longer.

Others in the group have as much as 12 times the exposure.

As a general suggestion, if you are ever moved to call in to a conference call from one of these REITs, my favorite questions to ask are the number of years of duration of the portfolio, and the duration gap after taking hedges and existing financing into account.  A good follow-up is the average length and rate of current financing.

Anyway, one of my favorite indicators on this stock used to be one of their outside directors.  Howie Rubin of Merrill Lynch Trust 13 fame (and also Bear  Stearns after Merrill and also Salomon in the book Liar’s Poker).  Howie stepped in and bought lots of CMO stock a couple years back when it was trading with an $8 per share “handle.”  His timing was exquisite, and he’s gotten more than half his investment back in dividends, and hasn’t sold, as far as I know.

hh

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4 Responses to Capstead Mortgage (CMO)

  1. Gary Anderson says:

    Howard,

    I agree with you that CMO can be viewed as lower risk due to the duration of their borrowings. I bought with an $8 handle, then with a $9 and a $10. Happily holding on.

    Cheers,

    Gary

  2. The best option these days to unlock the value of your home involves taking out a lifetime mortgage plan, equity release schemes will let you borrow money against the value of your home with the debt being repaid from its sale only after your death, seem an attractive solution to many cash-poor, asset-rich retirees.

    • hhill51 says:

      What does this have to do with amREITs? Reverse mortgages are interesting, and have been around for roughly 20 years. None of the companies I discuss invest in them.

  3. I come back often to re-read your article to remind me why i hold onto my CMO shares, even when there is bad news like last week’s dividend cut! In this environment, three month treasuries is a good risk matrix to embrace!

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