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Today, Hatteras Financial (NYSE:HTS) reported its performance for the third quarter. The following table demonstrates how the bottom line marginally exceeded expectations, while the top line remained 10% behind consensus mean estimates. Analysts were expecting an earnings figure of $0.82 per share, while the company reported a figure of $0.83 per share. The reported revenues for the third quarter were $79.6 billion against $88.6 billion. Given the current interest rate environment, we suggest investors to stay away from Hatteras as future spreads can get worse because of the Fed MBS buying program.

Despite an ultra low interest rate environment and the flattening of the yield spread between mortgage backed securities and short-term treasuries, the company reported a moderate 2% increase in the interest income that it generated during the third quarter. However, the results for the third quarter were adversely affected by a 14% surge in the interest expense.

Both revenues and earnings, when compared to the linked quarter, dropped. In our earlier reports on the impact of the third round of easing (QE3) on mortgage REITs, we concluded that mortgage REITs will face pressure from the flattening of the yield spread and the prolonged ultra low interest rates.

Despite a 27 basis point sequential compression in the average asset yield that the company earned during the third quarter, Hatteras' reported interest income advanced 2% to $132.3 million as compared to the linked quarter. The compression in net interest margin reflects the effect of the continuous efforts of the Fed. The margin declined from 1.49% during the prior quarter to 1.22% at the end of the third quarter. Much of the improvement in interest income was a result of a 15.6% sequential increase in the average interest earning assets from $21.1 billion to $24.4 billion.

Reported net interest income plunged 4% to $79.6 million as compared to the linked quarter. This was a result of a decline in the net interest margin from 1.49% in the second quarter to 1.22% at the end of the third quarter. The decline in net interest margin was a direct result of a 27 basis point decline in the average asset yield that the company earned during the third quarter.

The company was able to curtail its operating expenses, which moderately declined from $6.1 million during the second quarter to $6 million during the third quarter.

The effect of an increase in interest expense translated into an 8% sequential decline in the bottom line of the company, from $89.1 million at the end of the second quarter to $82 million at the end of the third quarter.

During the third quarter, the company managed to decrease its leverage ratio from 7.5 times at the end of the linked quarter to 7.3 times, while the conditional prepayment rate increased from 19.7% to 20.5% over the same time period.

Asset portfolio composition:

Around 83% of the company's entire agency portfolio is composed of adjustable rate securities, which has less prepayment risk as compared to fixed rate securities. Compared to this, at the end of the second quarter, adjustable rate securities were 93% of the entire agency security portfolio. 15-year fixed rate agency securities are around 17% of the entire agency portfolio at the end of the third quarter.

Dividends:

The stock currently offers an attractive dividend yield of 12.2% well backed by a 15% operating cash flow yield. The quarterly cash dividend coverage ratio comes out to be 1.5 times. This suggests that the company generates enough cash to support such elevated shareholder distributions. However, due to the third round of easing and previous initiatives of the Fed, the company was forced to cut its quarterly dividend from $0.9 per share to $0.8 per share. If the Fed accelerates bond buying and as a result the interest rate yield curve flattens, investors could expect further dividend cuts.

Valuations:

The stock trades at an 11% discount to its book value, while the stock of MFA Financial (NYSE:MFA) trades at a 5% premium to its book value. Invesco Mortgage Capital Inc. (NYSE:IVR) and Armour Residential (NYSE:ARR) trade at 14% premium and 3% discount to their respective book values. All stocks have similar market capitalizations.

In conclusion, the results were negatively impacted by the continuous efforts of the Fed to stimulate the sluggish U.S. economy and the resultant flattened yield curve. If the Fed accelerates its bond buying, it will hurt future interest income of agency mortgage REITs like Hatteras, which has a high CPR of 20.5%. Therefore, we recommend investors to stay away from Hatteras. Given the current interest rate environment we favor mortgage REITs that invest largely in non-agency mortgage backed securities.

Source: Hatteras Financial: Despite Tough Environment 12% Yielding mREIT Beats Earnings