Hatteras Financial Corp. (HTS) is a mortgage REIT. It is externally managed by Atlantic Capital Advisors LLC, which also manages ACM Financial Trust. Hatteras has a strong senior management team and extensive industry experience. However, that did not prevent them from recording a huge book value loss for Q2 2013 of $6.00 per common share. The book value on March 31, 2013, was $28.18/share. The events of Q2 2013 saw it fall to $22.18 by June 30, 2013. Ouch!
Much of the above loss was not of the company's doing. During the latter half of Q2 2013, mortgage rates and U.S. Treasury bond yields spiked dramatically. Both mortgage rates and the U.S. Treasury 10-year bond yields went up roughly 100 bps in just a few weeks. This caused decreases in the value of the Agency ARMs and Hybrid ARMs, which is most of what HTS owns. The tables below describe HTS's portfolio holdings as of June 30, 2013.
The ARM holdings:
Click to enlarge images.
The fixed-rate holdings:
The Treasury bond yields and mortgage rate rises were so dramatic that they eventually resulted in a "market sell-off" of Agency RMBS -- both fixed rate and ARMs -- in the latter half of June. This last battered Agency ARM prices further.
One might normally expect that the value of Agency fixed rate RMBS and even Agency ARM RMBS would go down as rates rise. To some extent hedging acts to counteract these types of losses. However, in Q2 2013 a special type of loss was felt acutely in the ARM portfolio. The basis for the ARMs rose by 30 to 35 bps for the 5/1 ARMs and by about 50 bps for 7/1 ARMs. The following chart shows the disorderly Hybrid ARMs sell off at the end of Q2 2013.
The chart and table below show the hybrid ARMs' mortgage basis widening since the end of Q1 2013.
As you can see, the spread between the index interest rate and the fully indexed interest rate (index rate plus a margin) went up dramatically during Q2 2013. This margin is on top of the increase in the index interest rate. For instance, the index interest rate might be figured based on a 12-month Libor rate. The margin is then an effective safety factor for the lender. It is added to the index interest rate to obtain the fully indexed interest rate. Lenders obviously felt that a much larger safety factor was needed.
Since we seem to be at the beginning of an uptrend in mortgage rates, the degree of uncertainty about the future will continue to be a problem. It is unlikely that these expanded spreads will narrow considerably in the near future, although they may fall back slightly over the next several months. Still all of this margin increase translated directly into book value losses for Agency ARMs and Hybrid ARMs. I note that non-Agency ARMs are a different animal since they generally trade at a huge discount to face value currently. Do not draw non-Agency parallels as they may not be appropriate. HTS owns Agency ARMs and Hybrid ARMs.
Another problem that HTS had in Q2 2013 was higher-than-normal average CPRs (constant prepayment rates). One might normally think that higher mortgage rates would mean borrowers would prepay less often. However, in the case of Hybrid ARMs and ARMs, the expectation of higher mortgage rates in the future apparently made many decide that they should immediately refinance into a fixed rate mortgage (or sell). For all of Q2 2013, the average CPR was 20.8; but for June 2013, the average portfolio CPR was 22.9. This led to noticeable losses. The average CPR for HTS's portfolio by mid July was back to a more reasonable 20.6.
For Q2 2013 HTS's net interest income was also negatively affected. HTS reported $63.4 million, which was down from $71.4 million in Q1 2013. The good news is that HTS's average earnings assets increased to $24.8B for Q2 2013 vs. $24.1B for Q1 2013. Many other mortgage REITs had to sell off assets in order to maintain a reasonable margin of safety. HTS's net interest margin decreased to 0.93% vs. 1.11% in Q1 2013. The good news is that ARM rates will eventually reset to higher levels by definition. HTS believes this is a significant advantage over other types of mortgage REITs. It sees the margin increase to the basis for ARMs and Hybrid ARMs as at a high (or at least at a level where further margin increases to the basis will be much less if they occur at all). It has already seen the CPRs fall in July 2013.
HTS did mention that it will likely trend toward a lower amount of leverage. This will probably mean slightly lower net interest income. However, ARMs and Hybrid ARMs appear to be a much more certain bet in the current highly uncertain environment. HTS is likely a buy or at least a strong hold going forward. It has not tried to hide its losses; and it is likely correct about having a more certain future.
The two-year chart of HTS below provides some technical direction:
Both the relative strength sub chart and the slow stochastic sub chart show that HTS is oversold. The main chart shows that HTS is in a down trend. The stock price has recently spiked lower on earnings information to $20.27 per share. This price is a discount to the $22.18 book value as of June 30, 2013. In addition, the mortgage rates have fallen a bit since the end of June. The average portfolio CPR has fallen from its June highs. The Fed and others are trying to restore market confidence. This may mean that the margin expansion part of the mortgage rates basis increases may fall a bit in the near term.
HTS looks desirable at a 13.80% annual dividend. The dividend may fall a bit in the future; but mortgages will eventually reset. It will regain net interest income. It still has huge assets. HTS carries a 2.8 average analysts' recommendation (a high hold). It has a four star CAPS rating (a buy). It deserves investor interest. It is a possible buy for those willing to take a little risk. Even if the dividend does go down, the dividend will still be substantial. If there are further book value losses, they are likely to be much smaller. Plus, the ARM rates will eventually adjust upward for greater income (and greater book value).
Note: Some of the fundamental financial information above is from Yahoo Finance.