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JimVanMeerten (61.08)

Am I nuts to invest in adjustable rate mortgages?

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December 03, 2009 – Comments (1)

I needed a new stock for my Financial Tides/BarChart VMNHI portfolio that I have on Marketocracy. I screened for stocks hitting new highs trading over 100K shares a day and went through my filtering process and came up with Hatteras Financial Corp - HTS.

HTS is an externally-managed mortgage real estate investment trust formed in 2007 to invest in adjustable-rate and hybrid adjustable-rate single-family residential mortgage pass-through securities issued or guaranteed by U.S. Government agencies or U.S. Government-sponsored entities, such as Fannie Mae, Freddie Mac or Ginnie Mae. Hatteras Financial Corp. is managed and advised by Atlantic Capital Advisors LLC.

You might think I'm totally nut to invest is these risky assets but they are all guaranteed by governmental agencies.

The stock has hit 15 new highs in the last 20 sessions and 5 new highs in the last 5 sessions. There has been a 15.84% price appreciation in the last 65 days. BarChart's technical indicators signal 11 buys and 2 holds for an 88% overall buy rating.

Right now none of the major brokerage firms are turning out research reports but their not trashing it either. The stock has had increasing revenue, EPS and dividend increases since it was formed and with the governmental agency backing why would that change?

Over on Motley Fool CAPS the members vote that it will out perform the market 114 to 19 with the All Stars voting 36 to 7. The Wall Street columnists following the stock have positive recommendations6 to 1. The lone dissenter is Jim Cramer and the stock has appreciated 11.16% since he gave a sell signal.

1 - The stock passes my screening process:
2 - HTS is hitting new highs better than 50% of the time No major brokerages are trashing the stock 3 - Other rating sites confirm my analysis

Recommendation: You may think I'm crazy for adding an adjustable rate mortgage holding company to my portfolio but I'll go with the gov't agency backing. Adding to VMNHI around 30.90 with a tight stop loss at no lower than 29.

Jim Van Meerten is an investor who writes on financial matters here and on Financial Tides. Please leave a comment below or email FinancialTides@gmail.com

Disclosure: No position in HTS at time of publication

1 Comments – Post Your Own

#1) On December 18, 2009 at 3:35 AM, pakdog (< 20) wrote:

This REIT represents banking stripped to bare essentials, borrowing money at one rate to lend it at a higher rate, while taking care not to lose money. You would think that adjustable rate mortgage-backed securities would have been beaten down pretty hard but it isn't the case. Mortgage backed securities didn't see the wide spreads of corporate bonds in the last year, and haven't seen the same dramatic price appreciation either.

Check here for the most recent data from Barron's:

http://online.barrons.com/mdc/public/page/9_3022-bondbnchmrk.html?mod=bol_topnav_9_3000

Here's an interesting quote from Fannie Mae's website that sheds light on why: “Fannie Mae MBS carries a guarantee of timely payment of principal and interest to the investor, whether or not there is sufficient cash flow from the underlying group of mortgages.” We also know that the taxpayers have backstopped the mortgage agencies to allow them to keep making these payments in the face of massive delinquencies and defaults.

http://www.fanniemae.com/mbs/mbsbasics/market/structure.jhtml?p=Mortgage-Backed+Securities&s=Basics+of+Fannie+Mae+MBS&t=Basics+of+MBS+Market+%26+Pools&q=MBS+Structure

Hatteras buys the mbs' from the agencies with short-term debt, mostly repos. This will cause their internal spreads to narrow quickly when interest rates rise because their borrowing rate is more sensitive than their lending rate. We know that interest rates aren't going any lower from here, so that is a factor to consider. Gradually they'll replace the older securities with newer ones at higher rates but their need for short-term financing moves at a faster pace. Since the primary source of net income is the difference between these two rates, rising rates will have an effect. They also use various strategies to hedge their risks, but the net will probably be a little uneven as rates trend upward.

Another issue they deal with is mortgage prepayments which have rebounded lately as credit has loosened a little. That's an ongoing variable of mortgage-backed securites. Practically speaking, it's a call option without an expiration date which will reset the interest you will earn on that money reninvested at the current interest rate. We're in a strange environment in regards to refi's right now – especially with all of the government intervention. This should continue to normalize as the economy and credit markets improve. Overall not a huge issue but it can marginally affect net income as rates change.

Their Sep-09 10-Q filing shows (in thousands):

3rd Q Net Interest Income        49,016

Interest Earning Assets       6,908,876

Annualized Yield                          2.8%

Operating expenses are skinny, skinny. Just 7% of net interest income. ROE is a a pleasantly plump 18.1% (I extrapolated annual net income from the nine month figure to get this ROE percentage, so it may be a little conservative going forward given the events of the last year.) A share of this stock buys a lot of leverage that is used to create a fairly steady income stream and dividend (hopefully rising upward).

It's a great scheme, very simple and well executed during the company's brief history. I found an article on the cycle REIT's tend to follow that is instructive. What it suggests is that now is a time to buy – assuming we are in the beginning of a new cycle rather than in the drawn out end of the last one. Make your own conclusion about that. It also suggests that an exit strategy is essential. A discussion on that topic would be interesting. Here's the link.

http://www.fool.com/investing/value/2009/08/12/how-george-soros-predicted-the-mortgage-crash.aspx?source=isesitlnk0000001&mrr=1.00

Hatteras has raised equity three more times since their IPO in 2007. It will continue to raise equity to enable it to finance ever larger purchases of mbs' with government backing. Assuming continued efficient management and prudent borrowing, this should mean rising levels of income and dividends payments for some time to come.

 It seems that the market is undervaluing this security right now, perhaps for the same reason why you asked if you're nuts to even consider investing in ARM's. All of the bad news could be keeping people from looking closer. Your technical indicators and Cramer contra-signal may be telling you something after all. I'd be interested in hearing the arguments against.

 I'm new to the Fool (as an active member) and to REIT's but enjoy analyzing investments. Just not holding myself out as an expert.

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