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Capstead Mortgage An Unlikely Survivor

Posted: Nov 28, 2008 12:10 PM by Eric Fox

Tickers in this Article: BAC, TMA, FRE, FNM, CMO

Despite the rupturing of the housing bubble and what pundits are calling the worst financial crisis since the depression, all indications are that Capstead Mortgage (NYSE:CMO) will make it through to the other side.

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Capstead Mortgage is a real estate investment trust (REIT) that owns a leveraged portfolio of adjustable rate residential mortgage pass-through securities. The company also has two issues of preferred stock outstanding Capstead Series A (NYSE:CMO-A) and Capstead Series B (NYSE:CMO-B). (To read about REITs and see if it's the investment for you, see The REIT Way.)

Simple Business Model
Capstead Mortgage is one of those companies whose business model in the current environment sounds frightening but in reality is fairly simple. The company borrows money through various counter parties in the repurchase market. The company has 17 counter parties that it can borrow from to mitigate risk, and this borrowing rate is usually somewhere between the fed funds rate and LIBOR rates, and averaged 3.26% in the third quarter of 2008.

The company then takes these funds and reinvests the proceeds in high quality agency paper, primarily adjustable rate securities issued by the government sponsored enterprises (GSE). This portfolio earned 5.0% in the third quarter, earning Capstead a financing spread of 174 basis points.

This financing spread varies through time and is one of the risks of investing in the company. The average spread over the last eight years is 148 basis points, and varied from negative 16 basis points to a high of 371 basis points.

The portfolio was split between short- and long-dated adjustable rate mortgages (ARMs) in the third quarter, with approximately 58% set to reset within five months. The average duration of its assets is 10 months, and its liabilities have duration of five months. This close match in duration protects the company from the interest rate volatility inherent in its business.

For example, if all of its funding was short term and was due within one year, but its investments were at a fixed rate with a long term maturity, then if borrowing spreads spiked higher for a sustainable period of time, above the rate it was earning on its portfolio, a negative financing spread would be the result.

The sector got a boost last week after the Federal Reserve announced that it would purchase up to $100 billion of direct obligations of the GSEs, including Fannie Mae (NYSE:FNM), and Freddie Mac (NYSE:FRE). The Federal Reserve will also purchase up to $500 billion of mortgage-backed securities (MBS) backed by these two GSEs. This will increase liquidity, as many investors are afraid to own any fixed income investment that have the word "mortgage" attached to them. (Get more information on MBS in Profit From Mortgage Debt With MBS and The Risks Of Mortgage-Backed Securities.)

Financials
The company has reduced risk during the financial crisis, and its debt to long-term capital ratio is currently at 8.4 versus a target range of 8-12. Capstead has also raised $440 million in common equity capital since the fourth quarter or 2007.

Capstead paid a 55 cent dividend in its last quarter, and $1.90 over the last 12 months, giving the company a tailing yield of 19%.

The only thing that holds me back from a company like Capstead are my memories of other financial stocks over the last year that assured investors that their business models held no risk, and that they were hedged, etc.. Some companies that pop into my head include Countrywide, which was purchased from certain death by Bank of America (NYSE:BAC) and Thornburg Mortgage (NYSE:TMA), which is teetering on the edge.

Bottom Line
While it appears that Capstead will make it through and survive the crisis we are in, investors should be aware that the financials behind mortgage stocks are notorious for being opaque, and the street is littered with the remains of similar companies that thought they had all bases covered.

By Eric Fox

Eric J. Fox, is the founder of Brittain Capital Management, LLC., which manages the Alesia Fund, LP., a Value oriented long/short investment partnership. You can read more of his views on investments at his blog - Stock Market Prognosticator.

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