Definitely time to be in Capstead Mortgage (CMO)

May 5, 2010

I have gone over the details of Capstead Mortgage previously: that their exclusive concentration on adjustable rate mortgages insulates them almost completely from interest rate movements, and the blank check that Fannie and Freddie got from the government makes their loans absolutely safe, so the only thing to worry about is what premium to book value the current share price represents.

Apparently, no one has been listening to me, because lately the stock’s price has been dropping precipitously, perhaps owing to the lowering interest rate spreads or the anticipation of rising interest rates, or the fact that the company announced recently that Fannie and Freddie are buying out seriously delinquent loans and as a result the firm is receiving a great deal of cash back which, under the current market uncertainties, they are unable to prudently toss back into the market, causing the firm’s leverage ratio to decline. The issue with delinquencies is that, like prepayments, they result in the return of principal to the bondholder, which means that if the bondholder paid higher than face value for the mortgages, as would happen when dealing with guaranteed securities in a time of meltdown of the mortgage market, that premium evaporates.

As a result of this tendency, the market cap of Capstead Mortgage as of today’s close was $760 million at a price of $10.83, set against a book value of $1.008 billion according to their latest 10-Q. Capstead marks their mortgages to market, but fortunately for its investors, also discloses its principal value. The principal value of Capstead’s holdings is $7.287 billion, which are carried at a price of $7.560 billion. The difference is $273 million, which is only $33 million dollars more than the present discount to book value.

This means that right now there is a fairly small premium to principal value of their mortgages, and another 50 cent drop in the share price will eliminate it entirely. It’s not that simple; sadly; there is also preferred stock that has a $183 million liquidation preference, but it is nonetheless the case that the shares of Capstead Mortgage are less risky now than they ever have been, as the premium over book value is the only real risk that an investor takes, and that is nearly dealt with. So, despite the high prepayment rate, the diminished leverage, and the possibility of a sudden rise in interest rates, I see a bright future for taking a (larger) position in Capstead Mortgage right now.

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