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.
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.
Fool contributor Amanda Alix has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.