Anworth: Good Earnings, Preferreds Still Risky

| About: Anworth Mortgage (ANH)

Summary

Core EPS matched the dividend.

The earnings release appeared to have a little typo on the value of EDFs.

Book value performance was very solid.

The technique of issuing more preferred shares presents a challenge for preferred holders because it decreases their relative protection.

Anworth Mortgage Asset Corporation (NYSE:ANH) declared their earnings and book value for the fourth quarter after the market closed on Friday, February 12th. The returns look pretty solid with Core EPS of $0.15 covering the dividend of $0.15. While investors would love a margin of safety, the mREIT sector has had little safety over the last year.

The figures on Core EPS beat analyst estimates by $0.02, which is interesting because analysts should have predicted higher than $0.13 for Core EPS. Anworth has shifted to incorporate a material amount of Eurodollar Futures contracts into their hedging technique. I believe their earnings release had a typo, because this value seems exceptionally unlikely:

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According to the press release, they were short EDFs (Eurodollar Futures) with a notional balance of $4.55 trillion. The mREIT's interest rate swaps had a notional balance of $3.866 billion, and I suspect billions is what they meant to convey regarding the EDFs.

For comparison, at the end of the third quarter the notional value on EDFs the mREIT was shorting was $5.35 billion. The impact of using Eurodollar Futures to hedge the short part of the curve is an immediate decrease in the net interest expense paid on swaps because the EDFs replace the swaps. This is one quick way to strengthen earnings.

Between the use of EDFs and the benefit of interest rates moving higher during the fourth quarter (before crashing in January), the expected impact would be lower expectations for prepayments.

Anworth's Book Value

This is where Anworth had their best performance. The mREIT lost only a penny in book value for the quarter despite paying out the $0.15 dividend. That was a great performance and I expect most of the mREITs to report substantially weaker performance. I wouldn't be surprised if NLY rallies on the positive reports of both book value and Core EPS.

One of the techniques Anworth was using to boost book value per share was the buyback of common stock. The mREIT was issuing preferred shares and buying back the common shares, which were trading at a huge discount to book value. The accretive impact of the buybacks was around $0.04 per share. Since shares began the quarter at $6.26 in book value and ended at $6.25, the buyback was worth almost 0.66% of the book value. When the mREITs are competing on book value for the quarter, 0.66% is enough to materially alter the comparable performance during most quarters.

The Preferred Share Challenge

There is one major challenge I see in this equity strategy. The company has been acquiring single-family houses in Florida to use as rental properties. The expected capitalization rate on single-family homes will not look exceptionally favorable compared to preferred equity shares that are likely to trade at an 8% to 9.5% yield. The expected yield on those shares may further move higher as the company is demonstrating a preference for using more preferred shares in the financing model. As the weight of preferred shares increases in the company's operating structure, the odds of recovering par value in the event of a collapse would become weaker. Further, the coverage multiple of Core earnings to the preferred dividend would decrease from a larger number of preferred shares requiring dividends.

The preferred share strategy is a positive sign for common shareholders in the sense that book value is driven higher, but it also means more effective leverage. The uses of rental houses in Florida still strikes me as a way to discourage activists from getting involved since the properties would be more difficult to liquidate than simple agency MBS. My expectation is that the beat on earnings is positive for common stock, but investors should be more cautious with the preferred shares. If those prices move up, investors should head for the doors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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