How Mr. Market Is Wrong To Discount Capstead Mortgage's Book Value
February 14, 2017

Let us estimate $0.60 of dividends per share over the next three years and a share price of $13.80 in 2019. And with a discount rate of 10%, Capstead Mortgage (NYSE:CMO) is trading at 90% its estimated present value.

Not bad for a mortgage REIT that invests in securities backed by the full faith and credit of the U.S. government.

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). Government agencies', such Fannie Mae and Freddie Mac, market share in MBS is greater than two-thirds of the total mortgage-related debt. Established by the U.S. congress in 1938 as a mechanism to make mortgages available to low-income families, 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 whether the regulatory environment clarified matters is questionable. The subprime sector, notoriously known to have played a major role in the 2007 recession, was catalyzed by regulatory changes. For example, in 1982, 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. The combined effect increased mortgages' affordability and appeal to consumers.

The interest rate environment, securitization and floating-rate mortgages had malefic roles as well. Because interest rates rose and prime originations fell, mortgage companies and brokers 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, a tulip mania was in the making. How the story unfolded is known, but few companies took the time to study its lessons.

Capital markets seem to ignore that Capstead Mortgage had done its homework. With earnings per share of $0.91 as of the third quarter of 2016, the company is trading at 12 times its earnings per share, at 0.80 times its equity book value and with a trailing-12 month dividend yield of over 10%. Also, its balance sheet is poised to benefit, should rates increase in the next few years (because refinancing will be lessened). Lastly, let us not forget that Capstead invests in floating-rate securities backed by the full faith and credit of the U.S. government.

Yet, risk is looming. Because Capstead Mortgage continues to finance its operating activities by repurchase agreements, and because historically repurchase agreement financing tends to dry up at times when it is needed the most, you should be startled. 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 its collateral is higher. Because in early 2016, the Federal Home Loan Bank (OTCPK:FHLB) of Cincinnati halted mortgage REITs' access to borrow from the FHLB, the reliance on repurchase agreements is unlikely to change.

Executive Summary

Management: Headed by newly appointed chief executive officer, management reduced salaries and general administration expenses as earnings per share declined in the past five years. The former CEO was with the company for 28 years. And if the future resembles the past, Capstead shareholders should look forward to celebrate a silver anniversary with the company.

Assets: Capstead invests in securities backed by the full faith and credit of the U.S. government. The company increased its loan portfolio to $147 notes per share from $127 notes per share five years prior. But an increase in loan portfolio size did not translate to higher-yielding assets. In 2011, loan yield was 3.33% compared to a recent loan yield of 3.17%, a pittance yield compared to corporate securities (which carry credit risk, though).

Liabilities: Capstead finances its residential mortgage investments by borrowing under repurchase agreements with financial institutions. Repurchase agreements involve the sale of a simultaneous agreement to repurchase the transferred assets at a future date. And a parallel upward movement in interest rates will have a net benefit to the company, because its liabilities are less sensitive to interest rates.

Income: Revenue per share decreased to $2.25 from $3.04 five years ago. Earnings per share decreased as well to $2.11 from $2.83. This was because homeowners, expecting interest rates to rise, rushed to refinance the mortgages on their homes. Interest rate expense increased due to the increase in the 1-year LIBOR index.

Cash flow: Financing activities generated $57 a share and operating activities generated $14 a share over the past five years. And investing activities - the purchase of residential ARMs securities - were $74 during this time period. Financial spreads decreased to 0.81% from 1.56%. If interest rates increase, cash flow will likely be higher, because the premium amortization expense will be lessened.

Risk: Capstead is a highly levered mortgage REIT. While its peer group average debt-to-asset ratio was 70%, the company is leveraging its portfolio by 90%. At that level of leverage, management is left with little margin of safety to error. In addition, future earnings will be squeezed, should homeowners rush to refinance loans. Lastly, the Federal Home Loan Bank of Cincinnati halted mortgage REITs' access to borrow from the FHLB in early 2016. As a result, Capstead migrated almost $3 trillion of FHLB advances to repurchase agreements.

Capstead's market price is reasonable in terms of price-to-equity. The company is trading at a multiple of 12 times its earnings, while its peer group trades at a multiple of 16 times. And Capstead's dollar of equity traded at 80 cents on the dollar, while in 2011, it traded slightly above par.

To measure how the company is sensitive to the interest rate environment is more art than science. Yet, with that disclaimer in mind, an upward shift in the yield curve should be a boon to the mortgage sector, and in particular, to mortgage REITs such as Capstead.

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