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Green Thumbing Leveraged Mortgage Backed Securities??? - Hatteras Financial (HTS)

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November 28, 2008 – Comments (4)

The 17 November 2008 issue of Barron’s reprinted their Daily Stock Alert titled “When Mortgages Are Loveable” by Fleming Meeks.  Mr. Meeks gives Hatteras Financial (HTS) a favorable write-up and I decided to do a little research.  I wasn’t able to find the article online; apparently it was only in Barron’s print edition.

HTS is a mortgage REIT.  HTS has been operating since September, 2007 and went public on April 30, 2008.  The HTS website describes the REIT, “Hatteras Financial is an externally-managed mortgage REIT 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 (FNMA), Freddie Mac (FHLMC), or Ginnie Mae (GNMA).”  HTS leverages up by borrowing via repurchase agreements.  All of the assets are Level II under FASB 157, meaning they’re based on market data, but not on data for identical securities.  From the 10-Q, “The estimated fair values of MBS are generally determined by management by obtaining valuations for its MBS from three separate and independent sources and averaging these valuations.”  Seems like a fair approach.

The 10-Q for the quarter ended 30 September shows assets of $5.1 billion.  Nearly all of the assets are mortgage backed securities (MBS).  There are $4.6 billion of liabilities, nearly all repurchase agreements.

Over the quarter ended 30 Sep, the average cost of funds was 2.9%.  The vast majority of the repurchase agreements have a term of less than 30-days and at end of quarter the average rate was a little over 3%.  To limit the risk of financing longer term, ARM backed securities at short term rates, the company purchases interest rate swap agreements.  They only buy interest rate swaps to cover a portion of the repurchase agreement financing.  On 30 Sep, HTS had swaps covering $1.4 billion, so nearly one-third of their borrowing was covered.  The manager has the flexibility to determine what level of interest rate hedging is prudent.

The primary reason for owning a REIT is dividend income and HTS really shines here.  The company has only been public long enough to pay two dividends.  Annualizing those two payouts gives a 14% yield based on the 28 Nov close.  Annualizing just the last quarterly dividend gives a yield of over 16%.

As most Fool’s know, yields this high don’t come without some risk. 

The income producing assets are all US Government backed securities, so default risk is near zero.  There is a pre-payment risk; as the underlying mortgages get paid off either by refinancing or selling the home, the principal associated with the mortgage gets returned to the security holder.  I’m not sure what happens in the event of foreclosure, I assume principal is returned with the government guarantee covering any shortfall from selling the property.  Other than that, about the only asset risk would be if the government was to change its policy on backing Fannie and Freddie securities.

On the liability side, the risk is much clearer.  Since HTS borrows using short-term repurchase agreements and buys longer term assets, a rapid rise in short term rates would hurt earnings.  That risk is partially mitigated by the use of interest rate swaps and by the fact that the MBS are adjustable rate.  But, the liabilities are only partly covered by swaps and the MBS rate adjustments have much longer terms than the repurchase agreements the company uses.

Another similar risk would be if the market narrowed the spreads between the MBS and short-term repo agreements.  If this business model is solid, it’s reasonable to expect more players to compete in the market which would narrow the spreads.

As long as the government continues to back Fannie and Freddie paper and the Fed continues to keep short term rates low, HTS should continue to deliver high dividend income.  The company looks attractive, but HTS has rallied over 15% over the past week. If I was going to buy it, I’d wait to see if it pulls back a few bucks before hitting the order button.

Disclosure:  At time of posting, I have no position in HTS.

4 Comments – Post Your Own

#1) On November 28, 2008 at 9:31 PM, ikkyu2 (99.38) wrote:

Counterparty risk on the swaps?  You've omitted its mention; I'm not sure that's wise.

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#2) On November 28, 2008 at 9:51 PM, rd80 (98.66) wrote:

Good catch.  They list the counter parties in the 10-Q and the conference call discussed a small loss that may result from a swap with Lehman.

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#3) On November 29, 2008 at 12:02 AM, starbucks4ever (98.98) wrote:

The yield curve will flatten in the next couple of weeks. I wonder if we can get a better entry point then...

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#4) On December 01, 2008 at 10:29 AM, ikkyu2 (99.38) wrote:

I have to say that counterparty risk for derivatives in this market chills me to the bone.  HTS may only have a small swap with Lehman, but how many of the other companies, that it engages in swaps with, have transactions that eventually fall apart because they lead back to AIG or Lehman?

I keep thinking back to Buffett's 2002 shareholder letter where he compared Byzantine, interlocking webs of derivatives to WMDs for this reason.  If he can't sort this kind of thing out with the analysis resources that he can access, how are you or I supposed to do it?

I kind of feel like the skeleton at the feast, typing this.  Perhaps those troubles are behind us - Buffett is trading swaps himself, now, or so I am given to understand.  

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