Consider Selling Capstead Mortgage (CMO) Before Earnings

July 20, 2010

I have had occasion to suggest Capstead Mortgage as an attractive purchase partially based on attractive economics created by historically low interest rates, and partially based on the number of difficulties in evaluating most other investment firms that are not encountered with this one. Capstead Mortgage purchases adjustable rate mortgages on a leveraged basis and holds them in order to profit on the interest differential between the mortgages and their own cost of funds. The fact that all their mortgages are adjustable rate insulates them from most interest rate volatility, and the fact that the mortgages are all GNMA, Fannie, or Freddie securities insulates them from the possibility of default, as the government is explicitly guaranteeing them for the foreseeable future–taxpayers are understandably irate that their tax money is going to bail out these institutions but by buying companies that hold their debts they can easily recover what they lost and more. At any rate, actual impairments of value for CMO are highly improbable and the only issue is making sure that the share price is right.

In that vein, I had occasion to point out around the date of the “flash crash” that the real issue was not simply Capstead Mortgage’s book value, but instead the actual principal amount of mortgages held. It is natural to assume that a default-free and largely interest-rate-risk free security would trade at a premium to its principal value. However, when mortgages prepay, or suffer of defaults which are treated as prepayments, that premium disappears and the mortgage holder is left only with the return of principal. As a result, purchasing CMO at a price that is too high exposes the purchaser to risk of losses even if the business itself is not risky at all. The day after I expressed this view, the flash crash occurred and CMO was briefly pushed even below this principal value, creating a literal no-brainer buy situation. The equity interest in the principal value of the mortgages based on their last report was $10.04 a share, although the situation is complicated by preferred stock with a liquidation preference, so the ultimate worst case scenario price is actually $7.81 per share. And I don’t expect the premium to shrink to zero, even if I don’t think it should be relied on too much.

So what are my grounds for recommending selling before earnings, which are due on July 28th? Well, as I said, although interest rate spreads are the source of Capstead Mortgage’s profitability, book value is the source of its safety, and the current price of almost $12 a share represents a considerable premium over the principal value of the loans, which no doubt represents the premium over the principal value of the mortgage securities owned. In their first quarter earnings announcement, Capstead Mortgage pointed out that defaults were running high and that Fannie and Freddie were engaging in a buyout of seriously delinquent loans, which causes higher than normal amortization of premiums. Furthermore, in this uncertain environment the firm could not justify repurchasing all of the repaid principal, thus lowering the leverage and theoretically the profitability of the firm. This is no doubt a major influence in causing them to reduce their dividend last quarter from 50 cents a share to 36.

So, it occurs to me that there may be some confusion in the minds of the investing public about the distinction between book value and principal value. At prepayment rates prevailing in the 1st quarter, over 7% of the premium existing after last quarter’s earnings, or about 30 cents a share, will have evaporated due to prepayments alone, and perhaps more of that will have evaporated by the actions of the market now that Fannie and Freddie’s actions have made prepayments more likely. To those of us who track principal value this is of little consequence, since principal has just been turned into cash (and not always back into principal, as stated above), but if the market is focused solely on book value it may lead to a wave of selling as the apparent book value diminishes.

Of course, it may not be the case that the market will react so badly, as the situation with Capstead Mortgage may already be priced in, but I would just as soon not take the risk. And at any rate, holding stock of an investment company that represents too big of a premium over its principal value is a risky move whether or not it is earnings season. Therefore, I will be looking for an opportune selling time definitely before the 28th.

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