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.