<

Hatteras Financial reduces leverage

Hatteras LeverageEnlarge GraphHatteras Financial is a mortgage REIT that focuses on agency adjustable rate mortgages

Hatteras Financial (HTS) is a real estate investment trust that focuses on adjustable rate mortgages that are guaranteed by the US government. Adjustable Rate Mortgages (ARM) generally have much lower interest rate risk than 30 year fixed rate mortgages. A typical adjustable rate mortgage is a 5/1 ARM which means that the initial interest rate is fixed for 5 years, and after that the rate resets every year at some specified spread to a short-term interest rate, usually LIBOR.

Because adjustable rate mortgages reset every year after the initial time period, they have much lower interest rate risk. Unlike a 30 year fixed rate mortgage, where the lender takes all of the interest rate risk, in an adjustable rate mortgage, the borrower bears most (not all) of the interest rate risk. The borrower is compensated for taking that risk in that they get an initial interest rate that is much lower than the rate one could get on a fixed rate mortgage.

For a agency REIT, interest rate risk is by far the biggest risk they face. Agency mortgage backed securities (MBS) do not have credit risk because the principal and interest payments are guaranteed by the government. However they do have interest rate risk, both with respect to prepayment risks and duration / convexity risk. Hedging these risks eats into returns, so a REIT that invests in ARMs may have lower gross returns on investment, but they also have lower hedging costs. This also allows them to have more of a margin for error when using leverage.

Quantitative easing has been driving the difference between MBS with fixed-rate mortgages and MBS based on ARMS

While adjustable rate To-Be Announced (TBA) securities technically exist, they are very illiquid. So when the Fed is conducting quantitative easing (QE), they are directly influencing the rate of the 30-year fixed rate mortgage, and they are indirectly influencing the 5/1 ARM mortgage rate. Historically, the spread between the 30-year and the 5/1 ARM was close to 80 basis points. In other words, the Fed is purchasing 30 year fixed rate mortgage backed securities and not ARMs. So at the margin, the Fed is squeezing rates for fixed rate mortgages and not ARMs. This means a higher relative return for REITs that invest in ARMs.

As the market began to anticipate the end of QE towards the end of last year, the 30-year/ARM spread widened over 100 basis points. Since then, we have had some disappointing economic data: Federal Open Market Committee (FOMC) minutes that seemed to indicate that quantitative easing would last at least through this year, and the Bank of Japan has started its own quantitative easing program. As a result, the spread has tightened to just under 80 basis points.

Highlights from Q1

Hatteras reported net income of $.62 a share and declared a $.70 dividend. This works out to a 11.4% dividend yield. The net interest margin increased to 1.11% from 1.08% in the prior quarter. Their cost of funds was basically flat. The balance sheet shrunk slightly to $24.1 billion from $25.8 billion in the fourth quarter. The annualized yield on average assets increased two basis points to 2.06%. Leverage dropped slightly to 8.1 after peaking at 8.5 in Q312. Lower interest rates have decreased the portfolio yield from 2.61% a year ago to 2.06%. Cost of funds have not dropped as much. The dividend has dropped to 70 cents from 90 cents a year ago. Prepays have been relatively flat at 26%.

Implications for the other mortage REITs

Hatteras’s earnings per share of $.62 was below the Street expectation of $.67 a share. Other agency ARM REITs like Capstead (CMO) and MFA Financial (MFA) may end up reporting similar type results. For the other mortgage REITs like Annaly (NLY) or American General (AGNC), there probably isn’t that much of a read-across.