Hatteras Financial Corp. (HTS), Capstead Mortgage Corporation (CMO): How Bad Was It?

The second quarter saw a sharp spike in interest rates, which caused havoc in the mortgage REIT sector. As inevitable book value losses became the norm, it became a question of which mREIT could get away with the least damage.

Hatteras Financial Corp. (NYSE:HTS) was one of the worst performers during the period despite following a relatively conservative strategy of investing mostly in adjustable-rate mortgage (ARM) mortgage-backed securities, as opposed to fixed-rate 30-year MBSes that can often carry a larger interest rate risk.

How bad was it?
Hatteras Financial Corp. (NYSE:HTS) reported EPS of $0.66 for the quarter, a rise of $0.04 per share over the previous quarter. The company’s net interest spread dropped by 18 basis points from Q1 to 0.93% as its Constant Prepayment Rate (CPR) jumped to 20.8% — the highest in almost two years. However, the real shock came in the form of a steep drop in book value, which fell to $22.18 from $28.18 in Q1 — a drop of 21%.

This is bad by any standard, but what makes it even worse is that Hatteras Financial Corp. (NYSE:HTS) is known to have a relatively defensive portfolio when compared to its fixed-rate focused peers; at the end of the second quarter, ARMs comprised almost 89% of Hatteras Financial Corp. (NYSE:HTS)’s MBS portfolio. Capstead Mortgage Corporation (NYSE:CMO), a mortgage REIT that follows a similar strategy of investing in ARMs, reported that its book value per share declined by just 3.8% because of market price movements.

In terms of book value loss, Hatteras Financial Corp. (NYSE:HTS)’s performance can be compared to that of ARMOUR Residential REIT, Inc. (NYSE:ARR), whose book value per share declined by 19% from the previous quarter. However, ARMOUR Residential REIT, Inc. (NYSE:ARR) follows a strategy of investing primarily in long-duration fixed-rate MBSes, which can carry much larger interest rate risk.

What went so wrong?
To understand why Hatteras Financial Corp. (NYSE:HTS) underperformed its peers in terms of book value losses, you have to understand the concept of basis risk.

Simply put, basis risk is the risk that the hedges may not move in an equal and opposite direction to the underlying asset. In this case, this translates to a risk that mortgage rates rise more sharply than the benchmark interest rate. Since the value of the hedges is usually tied to a benchmark index such as the 10-year Treasury note, a widening spread between mortgage rates and Treasury yields is generally negative for mortgage REIT book values.