Monday, April 7, 2008

And if you DONT KNOW what the Earning is ...

like the case of Capstead Mortgage (CMO).

Or Agency mortgage bond investors in general, I can cite NLY and ANH to be in the same vein with slightly different leverage and securities preference.

Earnings projection is impossible to make given the uncertainty of credit market in terms of final performance and borrowing cost through the life of the investment.


Look at the Book Value and then ask yourself, is this FULLY INVESTED company? ( Unlike Berkshire which hoards $50B+ cash? )

The reason you should ask is: if the company is fully invested, then how could it CLAIM to take advantage of LOWER mortgage bond prices during a shake-out?

CMO is fully invested.

Book Value tells you how much the CMO thinks their equity is worth given the price they paid for their investments.

At what price? Well, suffice to say that they invest 90%+ in Agency (FRE/FNM) ARM securities, mostly backed by 5/1 Prime borrowers. In the past 12 months, the bonds widened by 80 basis points (0.8%) in spread relative to Swap. Generally speaking, ARM 5/1 has an average duration of 3-4 years. It has gotten longer lately given it's SOOO HARD to refinance or get any new loan.

Therefore just say the duration of the bond is 3 years.

What has CMO lost over one year, in terms of Equity? How many percent of their stake is lost from this analysis?

Just use the basic bond analysis and leverage (about 14x as of Dec 2007) :

Leverage x Rate Change x Leverage = % Equity Book Value Change.

3 x 0.80% x 14 = 34% DOWN from Mar 07 to Mar 08.

Therefore, absent further cash availability to take advantage of higher spread, they should trade DISCOUNT of 34% from book value. They committed capital at the wrong time and earned less than they could have given the cost of equity (money).

But where is CMO traded right now?

38% PREMIUM to Book Value.

Lesson to take home: You need to be LESS than FULLY Invested to take advantage of lower priced bonds. Otherwise, you are going to return less than the book value because your eventual cost of funding is higher than you predicted when you bought your securities.

The fact that there is Fed's TAF to get emergency borrowing from is irrelevant. CMO has poorly timed the market and will earn sub-par results relative to people buying with cash at right now. Thus, their market value should trade at DISCOUNT to book value.

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