Western Asset Mortgage Stock's Big Insider Buying

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Western Asset Mortgage Capital Corp is one of those stocks that might sound too good to be true. The company pays a dividend of more than 20%, a level that's rarely sustainable over any long period of time. And, shares trade for less than the value of the company's assets, so not only do you get an excellent dividend, but you can buy it at a discount.

WMC Dividend Yield (TTM) Chart

If this sounds too good to be true, why are company insiders loading up on shares? Maybe, just maybe, there's 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 Asset's 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 company's 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.

Who's buying?
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 there's 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 company's executive officers who didn't 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 company's 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 wouldn't 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 Asset's 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 Asset's 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 company's 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 company's 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 shouldn't be too devastating to the company's 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 isn't without risk; but maybe the company's 20% dividend yield -- which it actually has the money to pay -- is worth taking a chance on. It certainly seems that the company's officers feel that way.

These high-yielding stocks might be a safer investment than Western Asset Mortgage
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The article Western Asset Mortgage Stock's Big Insider Buying originally appeared on Fool.com.

Matthew Frankel 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.

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