CMO - Capstead Mortgage

[Josh4580]

>$1 billion market cap REIT listed on NYSE for 25 years

 

Current 14.40% dividend yield

 

100% of assets invested in Mortgage-Backed-Securities (single-family residential) which are 100% backed by the U.S. Government. 

 

88% of assets invested in current-reset (less than 18 months) ARM securities

 

12% of assets invested in ARM's that reset in an average of 3 years. 

 

1.10X book value

 

CEO owns 500,000 shares worth ~$7 million

Management owns 1.4 million shares worth $18 million (2% of outstanding)

 

Low leverage ratio of 7.91:1

 

5 year CAGR of 29% vs. 4.5% for Russell 2000  (includes market meltdown of 2008/2009)

 

any opinions on CMO out there?

[biaggio]

Josh,

 

I am not familiar with CMO.

 

Seems like it is too good to be true?

 

What is the catch?

 

Being guaranteed by government agencies will it be paid if say 20% of their mortgages default.

 

Certainly operating in an industry where you would expect to find some bargains i.e. contrarian

[PlanMaestro]

How are they funded (matched?, ST maturities)? Usually with all these type of REITs there is interest rate risk.

 

[Kraven]

I'm not sure that being leveraged basically 8:1 is low leverage.  A spike in interest rates or some other adverse event and they could be wiped out fairly quickly.  As they say, with debt you need to worry what people think of you every day.  You don't get a 14% dividend for nothing.  There are no free lunches.  MBS can be very volatile as well.

[onyx1]

Capstead has come a long way since the mid 90's when they blew up the firm on MBS IO strips and handed the management over to Fortress.  I haven't looked at them in years, but at first glance it appears they are now following the strategy of Annaly (NLY).  Basically, they buy GSE ARM securities and put them out on one-month repo with the street at 8:1 leverage.  They try to match as best they can the ARM securities reset dates with pay fixed swaps, but are left holding the risk of interim and lifetime coupon caps on the cash portfolio.  The caps and the always present negative convexity of the MBS prepayment option times the leverage is the risk to the equity holder.  This risk can be very problematic in volatile rate environments.

 

The good news with these types of mortgage REITs is that price discovery of the assets on the balance sheet is excellent.  The hard part is deciding how much vs. BV you are willing to pay for a strategy that virtually any money manager can replicate.  GSE ARMs are extremely liquid and there is plenty of street firms who will repo them with a 10% haircut.  Management comp is important.  I know NLY gets paid on growth in BV and they have a loyal following.  CMO may be the same, but I don’t know for sure.

 

My advice: Don't extrapolate the dividend!  It will change with market conditions/curve shape/prepayments/repo rate/short term rate volatility.  The best way to invest in these is to look at P/BV.  Keep in mind that these are liquid government bonds on street repo and should be valued at BV unless you believe management has exceptional interest rate skills. (Personally, i'm very skeptical of anyone who claims they can predict rates).  Management will look to issue shares above BV because it is very easy to accumulate new assets.  I would never consider buying unless there is a discount to BV.  This, however, rarely happens unless the market is under stress because there are lots of retail investors who buy based on dividend yield.

 

[ericd1]

Great explaination Onyx. I've not understood NLY and didn't spend any time on it because I figured the outsized yield was probolamitic. Looks like it is. Thanks

[Josh4580]

onyx thanks for the help

[HJ]

One can go into details of comparing NLY vs. CMO vs. a whole set of mortgage REITs.  The primarily differentiators are on management fee structure, leverage and which part of the mortgage curve they are currently chosing to clip the carry.  But running a mortgage carry trade well over a long period of time can do quite well.  On a total return basis (with dividend reinvested), from Annaly's inception in 1995 till today, they have actually outperformed Berkshire over the same period of time.  But paying ongoing taxes will bring Annaly's total return down to lower than Berkshire's depending on tax rate.  You are betting on the management's ability to size leverage properly against the interest rate curve and dividend pressure.  The bad scenario is as the Fed tightens, the curves flattens, the manager is under pressure to actually increase leverage to deliver the same dividend, which of course could very well be a bad decision in that environment. 

 

At the moment, for the mortgage carry strategy, all's going well.  The difficult time will come when the Feds truly tighten.  But that could be a while.  Meanwhile, you are the first beneficiary of the Fed's QE policy among all sectors of the economy.  Or if people thing QE does nothing to the economy, then you are the only beneficiary of that policy.  Where else can you basically borrow at zero, and put the money to work at 3% +?  Certainly for a tax advantaged account, the strategy has a place.

[twacowfca]

One can go into details of comparing NLY vs. CMO vs. a whole set of mortgage REITs.  The primarily differentiators are on management fee structure, leverage and which part of the mortgage curve they are currently chosing to clip the carry.  But running a mortgage carry trade well over a long period of time can do quite well.  On a total return basis (with dividend reinvested), from Annaly's inception in 1995 till today, they have actually outperformed Berkshire over the same period of time.  But paying ongoing taxes will bring Annaly's total return down to lower than Berkshire's depending on tax rate.  You are betting on the management's ability to size leverage properly against the interest rate curve and dividend pressure.  The bad scenario is as the Fed tightens, the curves flattens, the manager is under pressure to actually increase leverage to deliver the same dividend, which of course could very well be a bad decision in that environment. 

 

At the moment, for the mortgage carry strategy, all's going well.  The difficult time will come when the Feds truly tighten.  But that could be a while.  Meanwhile, you are the first beneficiary of the Fed's QE policy among all sectors of the economy.  Or if people thing QE does nothing to the economy, then you are the only beneficiary of that policy.  Where else can you basically borrow at zero, and put the money to work at 3% +?  Certainly for a tax advantaged account, the strategy has a place.

 

 

This situation cries out for some sort of sidecar for investors whereby they could get the high yield now, and have their capital returned when the spread tightens.  As it is, this could be a roach motel.

[HJ]

Sounds like the P&C insurance business, you mean?  Look, in the end of the day, these are financial companies, you live off the cost of capital, return of capital, and leverage.  You always face the "blow up" risk, and the decision of whether to stay with a management to navigate through the current environment or not.  At this moment,  it's just fine.  If one is inclined to take a stance on the macro environment, you'd say it may well be fine for the foreseeable future.  You get the benefit of a steep curve, without the regulatory driven uncertainty, and if the management is smart, you get a front row seat, and hopefully can take advantage of the whole sale restructuring of the US mortgage market.