2007 Memorabilia

Mortgage-backed securities
January 12, 2017

How to win markets and influence people

What is hidden from Uncle Sam’s balance sheet is the implicit control in the largest bond market in the world, also known as the U.S. mortgage-backed securities (MBS). Established by the U.S. congress as a mechanism to make mortgages available to low-income families, government agencies such Fannie Mae and Freddie Mac market share is greater than two thirds of the total outstanding mortgage-related debt. And these government-sponsored entities have the peculiar responsibility to make loans affordable to the public on one hand, and to be shareholder-minded on the other. 

Such a dichotomy would confuse anyone. And regulatory changes over the past two decades were muddling up the cards as well. Take subprime loan origination, notoriously known to have played a major role in the 2007 recession, as an illustration. The Alternative Mortgage Transaction Parity Act permitted variable-rate mortgages and balloon payments. The Tax Reform Act of 1986 prohibited the deduction of interest on consumer debt. And the combined effect made mortgages appealing to consumers.   

The interest rate environment and financial engineering techniques such as securitization had pivotal roles as well. As interest rates rose prime originations fell and mortgage companies moved to subprime markets to maintain volume. And securitization started to gain popularity at about the same time alongside the advent of adjustable-rate mortgages (ARMs) that made borrowing easy. How the story unfolded is known but few companies took the time to study its lessons.

Capital markets seem to brush off that Capstead Mortgage (NYSE: CMO) had done its homework. As of the third quarter of 2016, a share in the company traded at 4.50 times its earnings per share, at 0.70 times its book value and with a dividend yield of 15%. Its board of directors and senior management own 10% of its outstanding shares and its balance sheet is poised to benefit should interest rates increase in next few years. 

While Capstead invests in floating-rate securities backed by the full faith and credit of the U.S. government, it should startle you that it finances its operations by using repurchase agreements as these tend to dry up at times when financing is needed most. Repurchase agreements involve the sale of a simultaneous agreement to repurchase the transferred assets at a future date. But as opposed to a conventional loan, the risk that the counterparty will not return the collateral is higher. 

The word “recession” lost its popularity in recent years. But its key lessons need not be lost. First, liquidity, the ability to sell an asset, is crucial. Second, risk management - how to avoid or minimize financial risk - will allow you to navigate the vicissitudes of the market. And third, self-reliance on portfolio valuation (i.e., being skeptical of third part valuation services such as Moody’s) would be a good start to avoid repeating past mistakes.■