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US Agency Mortgage REITs Marketweight
Analyst(s): Matthew Howlett mhowlett@foxpitt.com 212-857-6163
Initiating Coverage on Agency Mortgage REITs
• Launching Coverage on Three Agency Mortgage REITs: Anworth Mortgage, MFA Mortgage, and Capstead
Mortgage. The group is principally focused on investing in agency MBS, or essentially credit riskless assets.
The group appears undervalued on a P/B and forward dividend yield basis, given our outlook for margin driven
earnings growth and book value appreciation.
• Operating Model Should Thrive in 2008: After years of operating pain, in our view it’s a good time to be an
Agency REIT. Gone are the days of rising funding costs, high MBS bond prices, elevated prepayments and
inverted yield curves. We see today’s environment as being particularly attractive for the agency MBS carry
trade, which will likely produce ROE generation at the high end of their historical range (low 20% range).
• Margin Expansion Could Reach Record Territory: Federal funds futures are currently pricing in a 2.25%
Federal Funds rate by mid-year. At the same time, rates on current coupon MBS have been declining at a
slower pace, reflective of secondary market swap and credit spread premiums. If we assume a Federal Funds
below 2.50% by year end, net interest spreads could exceed 200 bps by 4Q08.
• Convexity Concerns Less of An Issue: Improving operating fundamentals do not just stop at declining shortterm
interest rates. Convexity risk is less of an issue for the group in this cycle, as premiums embedded in
portfolios are low. A significantly smaller origination market next year should lower amortization costs. Legacy
hybrid ARMs should also bolster returns on portfolio, as post reset tails perform better in a declining HPA
environment. In addition, higher guaranty fees (G-fees) along with wider MBS OAS spread should keep current
coupon MBS yield at elevated levels, increasing the steepness between MBS yields and their funding costs.
• Delevered Operating Structures: Amid the worst performance in Agency MBS in recent memory, REITs
scaled back their acquisitions in late 2007 and delevered their operating structures. As a result, leverage ratios
are near the low end of historical ranges, which gives us greater comfort with MBS trading levels and
subsequently the ability to roll over repurchase agreements. The delevered operating model also give the
group some “dry powder” to increase leverage (and therefore by more assets) when market conditions improve
(we are modeling an improvement in 2009).
• Stock Ratings: While we are buyers of the group, we find ANH and CMO most compelling, given the potential
for accelerated REO improvement. We are In Line on shares of MFA, as we expect portfolio margin expansion
to lag the peer group and the operating structure is less efficient than CMO and ANH.
TABLE OF CONTENTS
Initiating Coverage On the Agency Passive REITs ......................................................4
Executive Summary..................................................................................................5
Other Key Investment Positives:...............................................................................7
Investment Risks..........................................................................................................8
Valuation ......................................................................................................................9
Mortgage Industry Overview ......................................................................................10
A Brief Operational Overview .................................................................................10
Leverage ................................................................................................................13
Growth .......................................................................................................................15
Management Structures.............................................................................................16
Assets (Agency MBS) ................................................................................................17
Anworth Mortgage......................................................................................................21
Earnings Forecast ..................................................................................................22
Company Overview & Strategy...............................................................................22
Management Fee Structure....................................................................................22
Balance Sheet ........................................................................................................22
Capstead Mortgage....................................................................................................26
Earnings Forecast ..................................................................................................26
Company Overview & Strategy...............................................................................27
Fee Structure..........................................................................................................27
Balance Sheet ........................................................................................................27
MFA Mortgage Investments .......................................................................................31
Earnings Outlook ....................................................................................................31
Company Overview & Strategy...............................................................................32
Fee Structure..........................................................................................................32
Balance Sheet ........................................................................................................32
Disclosure information ............................................................................................35
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