Liquidity Fears and Repo Flu Infect Agency mREITs

Bloomberg is reporting that agency mortgage-backed bond spreads have reached their highest levels since 1986. Meanwhile, Reuters is reporting that Dutch-listed affiliate of private equity firm Carlyle Group said it received margin calls totaling more than $37 million from seven financing parties on Wednesday and was unable to meet the demands for extra collateral to cover its market positions for four of them. This branch of Carlyle invests in agency RMBS.

This news has spread fear and doubt to the agency mREITs today, who are all off sharply in early morning trade. All the agency mREITs have thus far been virtually unaffected by the credit crunch, as their paper is implicitly guaranteed by the GSEs and has remained liquid throughout the credit freeze. However, as buyers remain on strike and the credit crunch continues to travel up the mortgage security food chain, investors are nervous that even the agency mREITs may receive significant margin calls under the terms of their repurchase agreements. Should spreads widen to the point where margin calls go out to the agency mREITs, the effect would be devastating, since this group of mREITs typically does not utilize term-financing. Their entire portfolios are funded by repo agreements and warehouse lines.

Should the crisis deepen to the point that GSE-backed paper is subject to forced sales, even Fannie and Freddie could be seriously crippled by the downward mark-to-market spiral that would result.

Earnings Roundup - Thursday Edition

Chimera Investment Corp (CIM) reported core earnings for the period commencing November 21 and ending December 31, 2007 of $1.3 million or $0.03 per average share. The Company reported a GAAP loss for the period commencing November 21 and ending December 31, 2007 of $2.9 million or $0.08 per average share. The difference between the Company’s Core Earnings and GAAP results is related to the Company’s unrealized losses on interest rate swaps at December 31, 2007 - meaning the Company is not designating its hedges under FAS 133.

Capstead Mortgage (CMO) reported net income of $15,860,000 for the quarter ended December 31, 2007 compared to net income of $2,350,000 for the fourth quarter of 2006. After considering preferred share dividends, the Company earned $0.31 per diluted common share for the fourth quarter of 2007 compared to a loss of $0.14 per diluted common share for the fourth quarter of 2006. Not surprisingly, Capstead's results benefitted from several accretive equity raises and aggressive Fed rate cuts.

BRT Realty Trust (BRT) announced its results of operations for the first quarter of its fiscal year. For the three months ended December 31, 2007, BRT reported total revenues of $7,508,000 and net income of $3,230,000, or $.28 per share on a diluted basis. For the three months ended December 31, 2006, total revenues, net income and net income per share on a diluted basis were $12,745,000, $8,289,000 and $.95 per share, respectively. BRT's results suffered as a result of a decrease in interest and fee income on outstanding loans. The decrease in interest on loans was due to (i) a decline in the average balance of loans outstanding, (ii) the increase in non-earning loans, and (iii) a decline in the rate earned on the portfolio. During the quarter ended December 31, 2007 two loans, aggregating $18,700,000, became non-earning.

Capstead's Lawyers Logged Lots of Hours for this Q

Just finished skimming Capstead Mortgage's (CMO) third-quarter 10-Q - the first 10-Q to be filed by a mREIT this quarter. Not too much beyond what was in Capstead's earnings release except for the six pages of risk factors -- much more in the way of disclaimers and warnings than Capstead had ever put in a 10-Q. It wasn't all boilerplate, either. The most interesting piece of information (to me) was this disclosure: "As of September 30, 2007, the Company’s largest single counterparty (Cantor Fitzgerald & Company) accounted for $1.45 billion in repurchase arrangements that had an average maturity of 18 months." That means Cantor is the counterparty for 32.5% of all Capstead's repurchase agreements - a significant risk if Cantor decides to tighten up margin requirements in the future.

Fed Comment Undercuts Agency Investors

The Federal Reserve slashed its key fed funds rate by another 25 basis points Wednesday, but thoughts that the Fed may be done easing triggered a significant selloff among the agency RMBS investors.

"The committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth," the FOMC statement says. "The committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth."

That statement sparked selling in Annaly Capital (NLY), MFA Mortgage (MFA), Capstead Mortgage (CMO), and Anworth Mortgage (ANH). The agency investor group is all liability-sensitive, meaning that the impact of the change in its assets is smaller than the impact of the change in its liabilities after a change in prevailing interest rates. A liability sensitive entity’s economic value of equity decreases when prevailing rates rise or increase when prevailing rates fall. If the Fed stops lowering interest rates, these mREITs will have limited success investing long and borrowing short because the net interest spread available will not be as wide as they would like for it to be.

Capstead Comes Clean

Update: Just finished listening to Capstead's conference call. My biggest takeaway was that Capstead is lengthening the duration of their portfolio to approximately four months and they are more concerned about being overhedged versus underhedged. The market cost of swaps remains high. Also, despite the attractive yield currently offered by fixed-rate passthroughs, Capstead doesn't anticipate changing its investment strategy of investing in ARMs only. Additionally, prepayment speeds continue falling on ARMs despite recent Fed cuts. Despite the large operating loss sustained in the third quarter, Capstead intends to pay out 100% of its fourth quarter operating earnings.

Capstead released third-quarter results this afternoon, posting a shocking loss of $0.43/share versus earnings of $0.04/share in the second quarter of 2007. Driving the loss was the sale of $809 million of its lower-yielding, faster prepaying agency-guaranteed securities incurring a loss on sale of $5.9 million and a loss of $2.3 million from terminating related longer-dated repurchase arrangements. Net interest spread improvement was a disappointing six basis points.

Most notably, Capstead admitted that

With asset values falling and lenders becoming more cautious, many investors in non-agency securities were forced to liquidate substantial amounts of their holdings. These distressed sales placed downward pressure on market values of all residential mortgage securities, including agency issued and guaranteed securities...

This statement leads me to believe that agency RMBS may be facing more serious mark-to-market adjustments for the third quarter than first thought. If even agency securities lost some pricing visibility and liquidity, competitors like MFA Mortgage and Annaly Capital may post results that are considerably short of expectations. While these downward valuation adjustments will not affect taxable income, they will push down book value, which is typically the metric off which passive REITs trade.

Capstead's book value fell to just $7.57/share as of September 30, which excludes the $0.60/share accretion to book value from the recent common offering.

Capstead's failure to disclose the impact of portfolio sales during the quarter via a press release or even in a separate 8-K is troubling given the timing of the common offering. The information was disclosed in the offering prospectus; however, existing Capstead shareholders may have easily missed this information.

Based on the pro-forma book value of $8.17/share (including the accretive offering), Capstead is trading at a lofty 1.4x book value.

Capstead Continues Climb

Another day, another uptick for Capstead Mortgage (CMO). As the macroeconomic news gets worse, this agency RMBS investor gets a boost from speculation that another federal funds rate cut is forthcoming. But has Capstead gotten ahead of itself?

The Company hasn't paid a double digit quarterly dividend since 2005, and even in the most recent quarter, Capstead only managed to earn net income available to common shareholders of $0.04/share, equal to its common stock dividend. Capstead doesn't release taxable income information, but agency RMBS investors tend to have fewer GAAP/tax adjustments than other mortgage REITs, so Capstead is probably paying out close to 100% of its taxable income. At June 30, 2007, book value was just $8.32/share, yet CMO was recently trading up at 4% to $11.40/share, a premium of 1.37x book value.

Capstead's dividend yield is significantly lagging its peers, and its investments are primarily floating-rate securities -- meaning that the upside from falling interest rates is effectively capped.

Capstead reports third quarter results on Friday and plans to declare the fourth quarter dividend in early December. We'll see if Capstead was able to effectively deploy its recent capital raise and improve net interest margins.