05/09/2012 | by
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Capstead Mortgage Corporation's (NYSE: CMO) focus on adjustable-rate mortgage (ARM) securities has positioned the company well for the next phase in the economic recovery.

The Dallas-based REIT's portfolio consists almost exclusively of ARM securities that are issued and guaranteed by government-sponsored enterprises, such as Fannie Mae, Freddie Mac or Ginnie Mae. Company executives say their lack of credit risk helped to shield Capstead from volatility during the recent recession.

Founded in 1985, Capstead has more than 25 years of experience under its belt in the mortgage REIT sector and over the last five years has seen the numbers of competitors in the mortgage REIT industry grow substantially.

Andrew Jacobs, president and CEO of Capstead and head of the NAREIT Mortgage REIT Council, has been with the company since 1988. He says Capstead's focus on ARM securities is the biggest differentiator between Capstead and its peers.

"We focus on ARM securities because the adjustable-rate features of these investments results in smaller fluctuations in portfolio values due to changes in market interest rates," he says. "It's not your typical mortgage investment, where your rate is fixed. The coupon interest rate we receive continues to adjust, and because it can go higher when interest rates rise, our portfolio will retain its value better than a fixed-rate mortgage loan portfolio."

Growth in the Mortgage Market

A flood of new mortgage REITs have entered the market since the financial crisis hit in 2007.

"Our industry sector has seen a tremendous amount of growth from both the legacy mortgage REITs, like Capstead, and the newly formed companies. Now the sector has a market capitalization of around $50 billion," Jacobs says. "I guess we should be flattered that people want to get into this business."

Jacobs says Capstead is also appealing because Fannie Mae, Freddie Mac and Ginnie Mae securities are considered to have little, if any, credit risk associated with the underlying mortgage loans. "We're not concerned with the credit risk side of the business, our job is to manage the interest rate risk," he says. "We have about $13 billion in agency-backed residential securities, of which 67 percent are ARM securities that will reset in rate in less than 18 months, with the remainder of the portfolio invested in ARM securities that will reset in rate within five years."

Matt Howlett, analyst with Macquarie USA LLC, has an outperform rating on Capstead. He says he likes the composition of the portfolio, given that short ARMs provide the least risk.

"It's our top pick in the agency REIT space," he says. "It has the lowest risk return in the space, and that's mainly the result of Capstead holding a 100 percent ARM portfolio."

Howlett adds that in a rising rate environment there are extension risk fears for investors in fixed-rate mortgage securities, meaning the risk that a security's expected maturity lengthens due to the deceleration of prepayments. However, he says Capstead's securities have the most protection from extension risk.

External Factors

Multiple external factors can impact the mortgage REIT sector in the near term. Jacobs notes that "Housing reform, including what role Fannie Mae and Freddie Mac will play in the housing market, will have the greatest impact on the mortgage REIT sector over the long term."

"Fannie Mae's and Freddie Mac's share of the mortgage lending market is coming off a peak of somewhere close to $6 trillion. Whatever reforms are made, the amount of securities to be issued by the two agencies in the future will likely decline," he says.

"New regulations that reduce mortgage securities' market liquidity will be problematic," according to Jacobs. In that regard, he says, "the challenge for all mortgage REITs is to make sure that legislators understand the effects of any housing reforms before they are passed."

The upcoming presidential election and further disruptions in the global financial markets also have the potential to affect the mortgage REIT sector, Jacobs's points out. "We're not immune to all of the disruptions that we've seen around the world, but the quality of our assets allowed us to navigate through, and prosper in, one of the most difficult times in the last 80 years," he says. "I think a lot of the election talking points are more of a headline risk than a reality that could have an impact on our business."

Management Transparency

In addition to its unique investment strategy, Jacobs looks at the way the company is managed as an important factor in its success.

"We are internally managed and that's important for a number of reasons," he says. Jacobs points out that all of the company's investment activities are performed by Capstead employees, as opposed to an external management company. As such, "this structure avoids concerns of conflicts of interest and it provides a higher degree of transparency regarding how the financial interests of our executives are aligned with our shareholders," he says.

Jacobs notes in 2011 that more than 70 percent of Capstead's compensation was performance based. A significant portion of that amount took the form of shares of Capstead's common stock. "We believe we are a very transparent, efficient and stockholder friendly company."

No Sleep Lost Over Interest Rates

Mortgage REITs that invest in agency mortgage-backed securities have outperformed the overall REIT market over the last five years. Jacobs says sector fundamentals continue to be positive and he expects the sector to do well in 2012, adding that investors are confident in the sector because of its low credit risk.

He adds that banks across the world have continued to provide capital to the mortgage REIT sector throughout the financial crisis. "We currently borrow from 25 banks and financial institutions across the world, and because of the quality of our assets, they don't question the credit quality, and we expect that they will continue to provide financing to us," he says.

Capstead reported net income of $45.2 million, or 44 cents per diluted common share, in the first quarter of 2012. It marked an increase of nearly 8 percent from the prior quarter's reported net income of approximately $42 million, or 43 cents per diluted common share.

For 2011, Capstead reported net income of $160 million, or $1.75 per diluted common share, compared with $127 million or $1.52 per diluted common share in 2010.

Looking ahead, the Federal Reserve has announced that it expects to keep short-term interest rates low through the latter half of 2014. If that holds true, Jacobs says it will be a good market for those investing in agency mortgage-backed securities.

"That's a positive factor for us. But then again, our portfolio is more defensive than others, so I'm not losing any sleep if the Federal Reserve starts increasing interest rates sooner than that," he says.