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Western Asset Mortgage Capital Corp (NYSE: WMC) is one of those stocks that might sound too good to be true. The company pays a dividend of more than 20%, a level thats rarely sustainable over any long period of time. And, shares trade for less than the value of the companys assets, so not only do you get an excellent dividend, but you can buy it at a discount.
If this sounds too good to be true, why are company insiders loading up on shares? Maybe, just maybe, theres real value here.
What is Western Asset Mortgage Capital?
The company is a real estate investment trust, or REIT, which invests in mortgages in order to profit from the difference between its cost of borrowing and the interest paid by the mortgages it owns. Most of Western Assets portfolio consists of agency mortgage-backed securities, or MBS, which consist of mortgages backed by Fannie Mae, Freddie Mac, and Ginnie Mae. As a percentage of the companys total asset value, 67% of assets fall into this category.
The rest of the portfolio consists of non-agency MBS, as well as both agency and non-agency commercial mortgage-backed securities, or CMBS, as well as some other derivative securities. These types of securities pay more, but carry more inherent risk than the agency MBS in the portfolio.
During the past year, there have been 12 insider buying transactions, and absolutely no insider selling. In all, 69,424 shares were acquired by company insiders, and almost 48,000 of these were purchased on the open market. In other words, these were purchased simply because the directors believe theres value in the shares, and not because they had any other incentive to buy, such as exercising stock options.
Of the shares that were bought on the open market, the majority were purchased by Gavin James, CEO of Western Asset, who now holds more than 55,000 shares worth about $780,000 as of the latest insider filing. Additionally, COO Travis Carr and CIO Anupam Agarwal each made substantial insider buys. In fact, Steven Sherwyn, the only one of the companys executive officers who didnt buy shares on the open market, was the recipient of most of the other non-open market shares acquired by insiders.
In other words, all four of the companys executive officers have substantial, growing positions in the company, which shows a lot of faith that the stock will produce nice returns. But how can that dividend be realistic and sustainable?
How can the company pay so much?
The short answer to that question is leverage. If a company simply bought mortgages that paid 4% interest, income seekers really wouldnt be inclined to invest. Instead, mortgage REITs borrow money on a short-term basis at relatively low rates, and use the money to buy mortgages that pay out substantially more than it costs to borrow.
For example, Western Assets agency MBS investments pay an average of 3.36%, and it only costs the company 1.05% to borrow the money. So, the company pockets the spread of 2.31%. And at the current leverage ratio of six-and-a-half to one, we could expect a total yield of about 15%. However, the company uses some other strategies to increase its income.
The first is the non-agency and CMBS investments, which carry more risk, but higher spreads. When factoring these in, Western Assets average interest rate spread rises to 2.69%. The second reason in that the effective leverage ratio is actually 7.5-to-one, thanks to the companys investment in so-called TBA securities, which are pass-through securities issued by Fannie, Freddie, and Ginnie that are each backed by a yet-undesignated MBS.
When taking this into account, the actual calculated (theoretical) yield is closer to 20%. And, the companys results back this up. During the most recent quarter, Western Asset produced core earnings of $0.75 per share, well above the dividend of $0.67 it paid out. And, since REITs are required to pay out 90% of their income, the earnings and dividend numbers are right where they should be.
High risk, but maybe the reward is worth it
While mortgage REITs are inherently sensitive to interest rates due to the nature of their borrowing to finance MBS purchases, Western Asset is actually well-hedged. So, while an interest rate spike would likely have some impact, it shouldnt be too devastating to the companys income. In fact, Western Asset recently announced a dividend increase to $0.70 per share for the current quarter, which tells me that everything is going according to plan for the company.
Western Asset is a heavily leveraged company that isnt without risk; but maybe the companys 20% dividend yield -- which it actually has the money to pay -- is worth taking a chance on. It certainly seems that the companys officers feel that way.
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For the past five years, investors have gotten drunk off the Federal Reserves easy-money punch bowl.
The Feds stimulus program, known as quantitative easing or QE, left investors with beer goggles on. Stocks and bonds that normally would look unattractive suddenly looked pretty good.
Now that Janet Yellen is getting ready to remove the punch bowl, investors are being forced to take a more critical look at their portfolios.
Everything looks good under the drug of QE, but once QE goes away those goggles start to clear up. Those warts and blemishes start to matter. Risk appetites change, explains Peter Boockvar, the Lindsey Group market analyst who came up with the beer goggles analogy back in January.
Even some members of the Fed admit the analogy works. Richard Fisher, the head of the Dallas Fed who has been critical of QE, used it in a speech earlier this year.
Investors have been dumping stocks found in the previously red hot Russell 2000, sending that basket of smaller-sized stocks into correction mode last week. Thats Wall Street code for a 10% decline from a previous high.
Smaller stocks are riskier than their larger cousins because their shares change hands less frequently, making it more difficult to buy and sell them. Theyre also more vulnerable to swings in the economy and credit markets than big stocks like Apple or Google.
The same sobering up process has hit so-called momentum stocks. High-flyers like Tesla, El Pollo Loco and Netflix are all hovering well below their 52-week highs. Even red hot GoPro started responding to the laws of gravity last week.
That doesnt necessarily mean these are lousy stocks; just that investors realize they may take a breather as less of the Feds easy money is sloshing around the financial system.
Even the credit markets are seeing the beer goggles impact. Junk bonds have taken a hit in recent weeks as Wall Street bets on which companies will be healthy enough to roll over their debt once interest rates begin to climb.
Reshaped risk and reward: The Feds emergency actions transformed the risk and reward of virtually all asset classes. Thats because with interest rates at zero, cash in the bank earns virtually nothing. It actually loses value due to inflation.
To avoid losing money, investors are forced to put more of their money in riskier assets like stocks and bonds. That helps explain one of the driving forces for the bull market in stocks and why the US government can borrow money for 30 years at just 3%.
But now the Fed is hitting the brakes on QE and is poised to lift interest rates off the floor next year.
So what should investors do in this changing environment?
Boockvar believes the bulls party days may soon be over.
People should brace for a correction. You could easily have a bear market if the Fed starts to lose control, he said.
Boockvar argues that the Feds easy-money policies only pulled forward a lot of asset price gains.
They want you to buy a car today instead of tomorrow. They want you to buy a stock today instead of tomorrow. When that drug goes away, you need to give back some of those gains that were artificially gotten, he said.
Others believe the party could still go on, just at more hushed tones and only for some parts of the stock market.
David Lebovitz, a global market strategist at JPMorgan Asset Management, expects large-cap stocks to fare better than small caps because they have better access to credit.
He especially likes stocks with exposure to the IT, energy and financial sectors.
The point is, blindly throwing money into the stock market might not be the best play once QE ends.
Were at a point in the cycle where differentiation is much more important. Its going to be much more about security selection, Lebovitz said.
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The Oakland School board will vote on a request by district administrators to borrow up to $50 million from Alameda County at its Sept. 23 meeting to pay bills while it is waiting for state money to come in.
The school district ended its fiscal year in July with a $14 million surplus.
State education law allows districts to borrow money from counties while they are waiting for money to come in. In the case of Oakland, the district last borrowed $50 million in 2012 and $20 million in 2005, according to a spokesman for the Alameda County Treasurer.
The money must be paid back to the county by April 30, the spokesman said.
A spokesman for the California Department of Education said it is not uncommon for school districts to borrow money, because state payments from local property taxes are only made twice a year, and that is what usually causes a shortfall.