Capstead Mortgage Part Two: 3 Negatives And 1 More Positive

| About: Capstead Mortgage (CMO)
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This is part two of my analysis of Capstead Mortgage (NYSE:CMO). In my previous article I articulated many positive attributes of CMO. Here let me first deal with the three negative attributes.

1. Market Failure: In the near term, when interest rates are under pressure, the mREIT sector is strongly affected. CMO gets swept into this current, but usually reverts to its fundamentals when volatility subsides. The vast majority of the mREIT universe is composed of companies (Annaly (NYSE:NLY), American Capital (NASDAQ:AGNC)) that hold long-term fixed rate mortgages using high leverage tied to short-term interest borrowing. When long-term rates go up, they are locked into lower yields on their mortgage portfolio, and when short-term rates inevitably follow, their rising costs of borrowing squeeze or totally eliminate the spread on rates they receive. This is a well-proven recipe for failure. Additionally, prepayments on their mortgage portfolios fall with rising rates as individuals are hesitant to move for fear of paying higher rates on new mortgages, so called negative convexity. Their term and risk increases with rising long-term rates, mortgage values in their portfolio fall, and their book value per share gets crushed. Their earnings get killed next when short-term rates finally rise toward long-term rates. The market knows this story, and punishes the stock prices of these mREITs in a rising interest rate environment as we are now experiencing. Hedging can mitigate some damage, but as the last quarter book value performance showed, certainly not most.

CMO is different than like mREITs in that it borrows short term and lends short term, a proven model for success when there is no credit default exposure and low overhead When long-term rates rise, people have less incentive to refinance their short-term variable rate mortgages to lock in cheap long-term fixed rates. Thus the recent near doubling of 10yr Treasury rates is very positive for the future of CMO. When short-term rates finally rise, CMO's mortgage holdings will see rates adjust right along with CMO's borrowing costs.

However, the market usually does not recognize this and punishes CMO's stock along with the other mREITs when interest rates rise. As CMO is a relatively small-cap stock and one of the smallest mREITs, investors can suffer near heart attacks as the stock unjustly falls. It always rights itself, as it should given no underlying fundamental issues with book value, earnings, or dividends: but it is cardiac city in between. Also many investors buy CMO on margin to further enhance yield, and the resulting margin calls exacerbate the downward price pressure. The mREIT ETFs, (like the Market Vectors Mortgage REIT (NYSEARCA:MORT) or the Leveraged mREIT ETF (NYSEARCA:MORL) for example) have also heightened the problem. However, this problem also gives investors an opportunity to buy a portfolio of essentially variable rate treasury securities at a meaningful discount to book value. You are literally buying $10 bills for $9 or less.

2. Yield Creep: CMO has begun to be tempted to drift from its core strength and mission in the search for more yield. CMO now has over 40% of its portfolio in mortgages with an average of a 40-month duration to interest reset, versus 6 months to reset on its core one-year adjustable rate mortgage portfolio. This is not dangerous by industry standards, but it is much more risk sensitive to rising interest rates than the one-year adjustable. Hatteras Financial (NYSE:HTS) lengthened over 60% of its adjustable rate portfolio from five to seven years average time to reset in Q2 and got destroyed. CMO was either lucky or good with its hedging of this portion of its portfolio last quarter, but risk is higher nonetheless. Note To Capstead management: It may be preferable to let yield fall for a limited time period rather than chase yield. Also CMO could certainly increase its leverage on one year adjustable agency mortgages as they have virtually no interest rate risk and no default risk. If the company wants to maintain a floor dividend of about ten percent, it would be less risky to increase leverage rather than increase maturity.

3. Management's missed opportunities. Management has tried to implement a policy of using redemption and prepays to buy additional mortgages rather than to repurchase company shares even when the stock traded as much as 16% discount to book value. It did begin a share buyback program, but it should have been much larger and far more lucrative to shareholders. Let me break this down for you by making the following assumptions:

a. book value is $10 per share, but the stock trades at a 10% discount to book value, or $9 per share.

b. thus each share would represent the ownership of $10 worth of mortgages, one mortgage financed with equity, and 9 mortgages financed with borrowing, but they are being priced at $9

c. the company has just received full prepayment of $10 on some of its existing mortgages (representing one share of stock) as these customers refinanced or sold their homes.

d. Management faces a choice. It can go into the marketplace and purchase replacement mortgages with that money, or it could repurchase one share of stock in the market for $9, and sell $10 worth of mortgages associated with that share of stock and then it would pay back the $90 of borrowing associated with 9 of those mortgages, and after paying the $9 for the share bought back, it would have an additional $1 left which would represent profit to the remaining shareholders.

This missed opportunity amounts to large amounts of wasted funds when prepayment rates are high and the stock trades at a discount. Yes, the overall market cap of the company decreases, but the book value and earnings per share of individual shareholders increases. The only logical reason for not doing this would seem to be ego that is management wanting to grow market cap at the sacrifice of shareholder value.

An even greater missed opportunity is a derivation of this concept. CMO is unique, in that its total book value is represented by highly liquid securities. Thus CMO can easily go back and forth between its assets, mortgages, and cash. This means the company could establish a policy and announce the policy of buying every share offered when the shares trade below a certain percentage of book value, say 10%, and to offer more shares when the stock traded above, say, 110%. It needs no further borrowing or outside resources to do this. It can sell mortgages on its books to repurchase shares. These repurchases will increase the book value and future earnings of remaining shareholders as described above, but more importantly, will dramatically decrease the risk of holding CMO shares. When CMO sells shares for more than book value, existing shareholders also benefit with increased book value. This is the same process that index ETFs use to maintain their stock price at virtually book value. CMO's holdings are as liquid or more liquid than most ETF holdings. This policy would make CMO extremely attractive, and the company and individual shareholder value would expand over time. We at NH Holdings have unsuccessfully pressed management to institute this shareholder friendly policy change. I would encourage all that would hope for such a policy to contact company management and urge the same.

Outstanding Positive: Comparison to Bank loan funds: One of the hottest investment products today are so called bank loan funds. These funds are both open and closed end mutual funds and ETFs. These funds buy and hold loans made by banks to corporations. The attraction of these funds is that the loans are all variable rate, usually tied to short-term rates, usually LIBOR. The loans adjust rates on a periodic basis with typical interest rate duration of the portfolio of three to six months. Thus when short-term rates finally rise, the rates on these loans rise together. Many of these funds have some leverage, which is fine. They borrow based upon short-term interest rates, and they lend on short-term interest rates. That's why they are so popular. These funds have substantial default risk. The companies receiving the loans are all non-investment grade, or so called "junk." The thought is that since these loans are almost always senior in the debt structure of the company, that in the event of a default, that recovery rates will be sixty to eighty percent, rather than the typical forty percent in standard junk bond defaults.

Based upon the attributes of variable interest rates and higher recovery in default, these funds typically currently yield only about four percent. Also, the closed end bank loan funds trade at a meaningful premium to book.

The outstanding positive analysis is that CMO has attributes of the bank loan runs, but has one more favorable attributes, CMO gets all its money from the U.S. Treasury if a borrower defaults. There is no delay waiting for a corporate bankruptcy with slow liquidation and large fees prior to any creditor distribution. Bank loan funds are better than junk bonds in default, but CMO has zero default risk. CMO has the virtually identical variable rate structure on the mortgage loans it owns. But most importantly, from a value perspective, CMO yields over twice the rate of bank loan funds, and trades at a substantial discount to book value rather than a substantial premium. So if you own CMO, pat yourself on the back. If you have purchased all the attributes of the most popular investment vehicles, you have discovered a security that is even better in the positive attributes that make bank loan funds so popular, and you have purchased at a substantial discount to book value, rather than a substantial premium.

You, investor, have truly found Alpha!

Disclosure: I am long CMO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.