CYS Loses, Now All Mortgage REITs Must Pay

Investors were bullish on CYS Investments (NYSE: CYS  ) early on Wednesday, apparently expecting great news from the mortgage REIT's second-quarter earnings report. Later in the day, their hopes were quashed, as CYS announced a loss of $402.3 million, or $2.32 per share, compared with a $17.7 million loss, or $0.10 per share, in the previous quarter. One year ago, CYS declared net income of $101.7 million, or $0.87 per share.

Second-quarter upset
As if that news wasn't bad enough, book value took a nasty hit, too. The drop from $12.87 at the end of March to $10.20 at the end of June was huge, even considering the $0.34 dividend paid on June 10. Earlier in the day, Deutsche Bank had downgraded a handful of mREITs, including Western Asset Mortgage (NYSE: WMC  ) , based on book value declines of up to 16% during the second quarter. CYS, even factoring in its payout, suffered a drop of closer to 19%.

That was a big loss, and the stock price immediately began to tumble. Approximately two hours before markets closed on Thursday, CYS had lost 4.33%. Not only that, but it was dragging fellows Annaly (NYSE: NLY  ) , American Capital Agency (NASDAQ: AGNC  ) , Armour Residential (NYSE: ARR  ) , and hybrid Two Harbors (NYSE: TWO  ) down, as well. Interestingly, Western Asset stayed green, despite its downgrade one day earlier.

Misjudgment on hedging?
On the earnings call, CEO Kevin E. Grant noted that volatility was high in the second quarter, and that the quick rise in interest rates took its toll. The consequent decrease in the values of legacy mortgage-backed securities was a blow to book value, though Grant thinks the market is presently baking in a Federal Reserve taper of quantitative easing regarding MBS pricing.

Grant noted that CYS kept itself on track by keeping liquidity high and leverage fairly low. He wasn't kidding: More than half of the loss came from net realized loss on investments as CYS sold off legacy MBSes. The total loss came to $211.4 million -- compared to a gain of $46.7 million in Q1 of this year. In the year-ago quarter, the gain was more than $61 million.

CYS notes that it had plenty of liquidity to meet margin calls, and it's not hard to see why. The trust sold off over 14% of its agency MBSes in Q2, ending that quarter with a $17.2 billion portfolio, compared with $20.1 billion at the end of the first quarter. The drop in values during the second quarter, naturally, led to that $211.4 million loss. Leverage was kept low, at 7.5 to 1, as well -- but the price was pretty high.

While the company does point out how volatile the MBS market became each time the Federal Reserve released minutes or commented on Federal Open Market Committee meetings, Grant also admits that the trust's hedging didn't work as well as he would have liked.

What this means for other mREITs
CYS is one of the first to announce earnings, so it is understandable that its report has garnered so much attention. While there is a very good chance other mREITs also experienced dents in book value, hedging behavior may be different at other companies. Just because CYS' hedges didn't work out as planned doesn't mean the same is true for Annaly, American Capital Agency, Armour, or Two Harbors.

Over the next few weeks, more trusts will reveal how Q2 treated them, and the sting will fade. By the close of business on Thursday, in fact, investors seemed to be relenting in their harsh treatment of CYS, which closed with only a share price drop of 1.57%.

The second quarter was a tough one, and doubtless mortgage REITs learned some valuable lessons. The winding down of QE3 must be done, and how these companies deal with that is something that mREIT investors should train a sharp eye upon.

Shrinking payouts may very well be in the future for mREIT investors, if only for a little while. Meanwhile, if you're on the lookout for high-yielding stocks, The Motley Fool has compiled a special free report outlining our nine top dependable dividend-paying stocks. It's called "Secure Your Future With 9 Rock-Solid Dividend Stocks." You can access your copy today at no cost! Just click here.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 19, 2013, at 12:02 PM, jad9000 wrote:

    Extrapolating a single company across an entire industry is nonsense. You might want to wait and see a bit rather than making such sweeping statements. Unfounded sensationalist comments are irrelevant and completely useless to readers.

  • Report this Comment On July 19, 2013, at 1:10 PM, pace2001 wrote:

    I think CYS earnings call state it clearly that the hedges that most publicly traded MREITs were not as successful in Q2. This is because most hedges these MREITs put on are to lock in spread and cost of funding. Unfortunately what was happening in Q2 was long term rates were rising and spread was widening and these hedges dont do much in those circumstances.

    While you can't Extrapolate one company's results across MREITS space due to the fact that MREIT's portfolio are totally different from one to another but from CYS you can see that the holders of Long Term Fixed Rate Agency Paper with Low Coupon took it the worst in the Quarter.

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