CMO Smackdown

Capstead Mortgage led the parade of Q3 dividend announcements for the mREIT group, and they definitely disappointed.  Cutting their dividend to just 26 cents a share from 36 cents, the market responded by taking a healthy slice off their share price.

Merrill Ross at Wunderlich summarized as follows:

Capstead Mortgage (CMO) cut its dividend for the third consecutive quarter, declaring a 3Q10 dividend of $0.26 per share, down from $0.36 the previous quarter. GSE buyouts of seriously delinquent loans from collateral pools triggered accelerated prepayments, resulting in faster premium amortization. This put pressure on net interest income, which is the main driver of Capstead’s earnings. We believe management bears the burden of proof that dividends and earnings momentum can be reinstated once the initial agency buyouts are completed. We observe that it is difficult to achieve multiple expansion under such conditions. We reiterate our Hold rating and have cut our price target to $11.75.

Since Capstead tries to hedge out its exposure to an increase in funding costs, unexpectedly high prepayments of principal can put them in a bind.

High funding costs locked in by hedging when you own high-yielding assets become expensive locked-in liabilities if the assets are unexpectedly paid off early.  That leaves the management team with the ugly choice of

a) buying whatever they can as quickly as they can or

b) taking a substantial cost without earning positive yield to offset that cost.

They’ll reinvest, in other words, even if it locks in a lower profit spread than they were earning on their portfolio before.

Their other choice, to crank up leverage, is what I think is going on at Annaly.  You can see that Annaly is running much higher leverage than they state at the end of the quarter by looking at the size of their future purchase contracts.  That has been growing to pretty big numbers over the past couple of years, and I see no reason to expect something different this quarter.

That approach — to “get down” in time to file quarter-end and year-end reports — is one of the most common techniques Wall Street has used forever to affect the “cosmetics.”  That is, to make things like the leverage ratio look good so the investors don’t react to the actual level of risk being taken.  There were reports during the heyday of the CMO business on Wall Street (early 90’s) that leverage was as high as 50-1 or more at Kidder, Peabody and Salomon Brothers in between reports, but temporarily back down to the twenties in time for the quarterly report.

We can see this in forward purchase commitments outstanding at the end of the quarter.  While I don’t think the team at Capstead uses this as a regular quarterly bit of eyewash, I’ll be looking when the report comes out.  Of course, today’s announcement will be tiny dot in the rear view mirror by the time the 10Q comes out in early to mid November.

I should also let readers know when it’s appropriate to have large forward purchase commitments.

The obvious case is when money is being raised but has not closed yet, as in a secondary stock issue.  Less obvious, but still appropriate, is when forward commitments are replacing future paydowns.  We get the factors (new amount of principal balance) on Agency MBS pools about six weeks before the actual payment comes in, so it’s actually prudent to make forward purchase commitments as soon as you know what principal you will be getting next month.

Today we are seeing large prepayments, both from a renewed refinancing market and from Agency buyouts on serious delinquencies.  That cash can be re-deployed as soon as you know you’ll be getting it through the mechanism of forward purchases.

I haven’t changed my read on CMO as a more robustly hedged, and therefore less risky, amREIT than some of its peers.  I will continue to hold my core position (built up at single-digit cost per share some time ago), and wait for the 10Q to see whether I want to add a “trading” position.  In the mean time, the company has a trailing book value of $11.82 per share, a value that I think is unlikely to dip beneath $11 even in the face of these prepayments and the recent spread widening.

I’m slightly more optimistic about their ability to increase per-share earnings next year from the (apparently) $1 per share run rate the Q3 dividend implies.  If they bring the income to the $1.20 to $1.40 range I think is possible, then a trading position bought anywhere near $10 a share will likely make me happy to own.

As always, this is not advice. You have your own circumstances, which could make this a poor investment.  The easy times of 2009 are over for these companies, and they don’t have the pre-meltdown option of expanding leverage to double digits.

I suppose they technically do have the option, since I’m hearing that seasoned ARM MBS can be financed with 19-1 leverage these days.  But the biggest lesson from 2008 is that even government guaranteed paper can be hard to finance in a crisis, a lesson being learned by many European banks this year, just in case our American non-bank financials are tempted to forget the recent past.



7 Responses to CMO Smackdown

  1. BarryZee says:

    Good comments, Howard. Merrill’s comments on prepayments exaggerate their effect on eps in Q3. Most of the analysts missed the effects from the buyout July, but also the lag effect into August as well. however this would have been less than the damage done in Q2. Tjhis applies to all amreits and justifies their sympathetic drop with CMO.

    However what may have played a larger role in CMOs miss was their inability to reinvest the proceeds of the buyouts as quickly as expected, due to the constraints of their business model, which now has them buying currently adjusting ARMs almost exclusively.

    I suspect they are even behind their own target for reinvesting the proceeds and may not complete the program until Q1, causing further disappointment.


  2. jill says:

    What has changed and why? It seems the FDIC, the GSEs and the FHA are agressively forcing the liquidation of properties…

    IrvineRenter in an article “Government Expedites Foreclosures, Threatens Banking Cartel” writes: “The end of the banking cartel is being signaled by coordinated efforts at a variety of governmental agencies to expedite the foreclosure liquidation.”

    IrvineRenter relates: “One of the barriers to liquidation is the write downs required by “solvent” banks. A huge problem within the GSE portfolios is that the services of delinquent loans are intentionally delaying foreclosure when the parent bank holds the second mortgage.The GSEs are going to start charging servicers who fail to properly follow their loss mitigation procedures” as related in Al Yoon Reuters article Fannie Mae Gets Tougher On Mortgage Servicers.

    “A compensatory fee not only compensates Fannie Mae for damages but also emphasizes the importance placed on a particular aspect of a servicer’s performance,” Fannie Mae said in an announcement to servicers. “In some cases, a compensatory fee will relate to the action a servicer took, or failed to take, in handling a specific mortgage loan,” it said. Fees will be applied in various instances, including failure to provide access to records and delays on completing foreclosures and selling foreclosed properties.”

    IrvineRenter states: “These comments are aimed directly at the practice of avoiding foreclosure on properties that have second mortgages on the servicer’s books. That is the primary reason a servicer fails to foreclose and dispose in a timely manner.”

    The Reuters article continues: “More aggressive action by mortgage servicers could help ease burdens on Fannie Mae, whose losses on loans it guarantees or owns forced it into regulator’s hands in September 2008. It has required some $86 billion in taxpayer funds since then. Fannie Mae, which uses hundreds of servicers, did not specify any that might have prompted the announcement but has identified rising stress at the firms. A spokeswoman declined to comment beyond the announcement. “The growth in the number of delinquent loans on their books of business may negatively affect the ability of these counterparties to continue to meet their obligations to us in the future,” Fannie Mae said in its quarterly filing with the Securities and Exchange Commission last month.”

    IrvineRenter relates: “If the GSEs are not forced to back down from this policy due to pressure from lenders, this change in policy and incentives will signal the end of the banking cartel because this will push product on the market whether or not the market is capable of absorbing it. That will push prices down.“

    IrvineRenter also references the John Prior REOInsider article FDIC sells another $760 million in REO which describes the FDIC’s Public Private Investment Partnership with Mariner Real Estate Management, MREM, a real estate investment and management firm based in Kansas. MREM is part of Mariner Holdings, a $7 billion wealth and asset management company. The portfolio includes roughly 1,100 loans and properties from 20 banks the FDIC has taken into receivership. The properties are located across 24 states. Earlier in August, the FDIC sold a similar $1.7 billion portfolio to PMO Loan Acquisition Venture, a partnership of other investment firms.

    IrvineRenter relates: “These guys are going to keep what cash-flows and liquidate the rest.”

    • hhill51 says:

      One element of today’s high prepayment numbers is the “churning” of mortgages in 2009 and 2010 pools. Those houses got through the Agency/appraisal gauntlet, so when rates drop, the mortgage loan officer knows they can easily generate another fee by refinancing a loan they closed less than a year earlier.
      Seasoned pools continue to pay off slower than the interest rate advantage would dictate, so that sharpens the importance of what kind of MBS these amREITs buy.
      Given the average premium over book value running in the low single digits compared to the 35% premium we saw during the Greenspan easy money era, the market clearly doesn’t trust mortgage funds the way it used to. Doubly strange when you consider how the Greenspan Fed was constantly threatening higher rates, while the Bernanke Fed has just plain given up pretending they will have a tight monetary policy any time soon.

  3. Marc says:

    Bot a tiny bit at good price to sell pre divy. Ya pays ya money, ya takes ya chances.

  4. Patrick says:

    I’m out of all the “pure” amREITs (which I define as NLY, CMO, ANH, AGNC, and HTS). I just don’t see a lot of opportunity left in the sector, especially with much of the group now trading above book value.

    I’m much more bullish on the hybrid residential mREITs (CIM, IVR, TWO, RWT, and MFA), simply because think that credit risk is much less dangerous than either interest rate risk or prepayment risk.

    On a separate note, what are your thoughts on the mREITs adopting a level distribution policy that is re-evaluated annually? Would it help mute the wild swings that follow dividend cuts / increases?

    • hhill51 says:

      I like your idea of “normalized” dividends. Years gone by, RWT was the biggest player doing that, though they did it by paying what they thought was the absolute minimum their portfolio supported for three quarters, and then paying a monster in Q4. Not quite the same, but it did have a stabilizing effect on the stock price.
      I’ve still got two of the pure amREITs, with ANH the largest position. On the “hybrid”, or credit front, I’ve kept my exposure to just one (MFA) and occasional swing trades in others. Also, I’ve held onto ABR for some time now in the commercial space, and blew some serious dough on “lottery tickets” from the former AHR that will end up like most lottery tickets. Too bad on that one. I made a ton of dough way back when in CMM as they emerged from Ch. 11.
      I’m not a fan of the deferred cash re-REMIC model at CIM, though I do trade it for swings from $3.60 to $4, which seem to happen regularly. TWO has gotten some respect, and DX and WAC both have reasons to like them.
      Coming back to the amREITs, at least the recent spread widening has brought the underlying Agency MBS back into a value range that allows portfolio managers to buy and hold to some advantage… They look like a better value than investment grade corporates, for example. That was certainly an improvement after months of giving up way too much option value on these beasts.

  5. Patrick says:

    Redwood (RWT) was definitely the best at holding on to capital. I believe they would spillover everything they could and pay the 4% excise tax and even after the spillover only paid out 90% of each year’s taxable income – until they had a taxable income / GAAP reversal in 2008.

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