When Ronn Lyttle, chairman of Capstead Mortgage, brought Christopher T. Gilson on board a little over a year ago, he had big plans for his new brand-name executive.

With Mr. Gilson, previously the head of Nationsbanc Mortgage, at the helm of Capstead Inc., a new subsidiary, the company had its eye on creating a big-league mortgage originations franchise. All possibilities were open: wholesale, retail, even buying an existing mortgage bank.

"But then we started to see the trap door open up. We are talking about 1994," said Mr. Gilson.

The worst year for mortgage lenders on record forced many a company to radically change its business strategy.

With the Federal Reserve Bank dealing out interest rate hikes, Capstead was caught in a high-stakes game and forced to make a big bet. It chose to lay its money down on servicing rights.

Abandoning the idea of building a production network, early last year Capstead began snapping up bulk packages of mortgage servicing rights.

With more than $200 million in capital to deploy, Capstead was able to achieve stunning growth in its portfolio. Starting the year with just $2.4 billion in servicing, Capstead expanded its portfolio to $14.4 billion by year's end, an increase of about 500%.

The company made a decision to pay a premium for servicing with low interest rates, says Mr. Lyttle.

The idea was to build a portfolio with less prepayment risk. The result is that Capstead's portfolio now has a weighted average coupon of about 7.2%.

"I'm a little leery of buying rights at 9.5%," said Mr. Lyttle. But if attractive opportunities arise, Capstead may choose to leverage its servicing portfolio with lines of credit from Wall Street as a means to grow.

"I don't know how big big is," said Mr. Gilson. "I can see $25 billion, I can see $50 billion. We talked $100 billion. Its not insurmountable."

At the same time, the operating environment was worsening for the Dallas-based real estate investment trust.

Capstead had its origins in Lomas Financial. Originally organized as a unit of Lomas, Capstead was spun off in 1985.

As a real estate investment trust, Capstead invests in mortgage-backed securities and collateralized mortgage obligations as well as operating a conduit that gathers closed jumbo mortgage loans and packages them into securities.

Capstead funds these activities out of capital but also through short- term borrowings. So when the Fed began tightening, margins were squeezed and volume at the conduit dropped. Also, income from securities investment was impinged.

Some sort of a hedge against rising rates was needed.

"To make an acceptable return in this business, you have to take risks," said Mr. Lyttle. "There are a couple of risks in mortgage banking that I decided I didn't want to take. One was operations risk. You hire people and then have to cut back when the crunch comes. The second was asset quality risk - as a REIT we could take that, but decided not to."

"The risk we choose to take was interest rate risk," said Mr. Lyttle. We decided not to take two out of three, but we did take interest rate risk. The jury is out on whether that was the right approach."

The structure of Capstead is a twist on the sort of macro hedge that mortgage banks attempt to employ. Mortgage banks that originate and service loans hope for the cushion of servicing income when rates rise and originations drop.

That hedge worked imperfectly under the extreme conditions of last year and early this year because of the extremely heavy drain on servicing portfolios due to prepayments. But it did work in some degree for most of the major players.

Capstead now has a sizable servicing portfolio to hedge its securities investments, which, like originations, also drop in value when rates rise.

"Clearly it's an interest rate bet," says Gary Gordon, an analyst with PaineWebber Inc. who covers the company. "And it's not a perfect hedge. But you have got to feel comfortable with the low-rate aspect of the servicing."

The servicing will start to throw off a strong flow of income in 1995, about $22 million, according to Mr. Gilson. It was put into place too late to rescue earnings for 1994, which were $2.36 in the first nine months, down from $2.64 in the 1993 period.

As a result, Capstead's stock has hit heavy weather, declining from a high of $42.125 to its recent level of about $17.625.

Going forward, the challenge will be to expand the portfolio while managing prepayment risk.

There is a finite supply of loans with coupons in the 7.5% neighborhood, Mr. Gilson points out, and as time passes, Capstead will have to decide if it wants to follow the current coupons north.

While the conduit may generate sizable amounts of servicing if the market picks up, for now Capstead Mortgage seems to be taking a defensive stance.

"It's a pretty bloody competitive market," said Mr. Gilson. He points out that at least seven conduits are competing for jumbo loans, about a fifth of the overall market.

"And a lot of those loans have gone to portfolio lenders this year. It's kind of like having 20 or 21 Fannie Mae and Freddie Macs," said Mr. Gilson.

"We can stand on the sidelines if that's necessary," said Mr. Lyttle. That willingness is illustrated by a dramatic slowdown in loans purchased.

Whereas Capstead bought just over $1 billion in jumbo loans in the first quarter, when volume was still heavy, it took in only about $100 million in the fourth quarter.

While Capstead has no plans to close its conduit, "some of us are going to get out of the business eventually," said Mr. Lyttle.

For now, Capstead Inc. will focus on wringing efficiencies from its newly burgeoning servicing business.

Unlike servicers with longer histories, Capstead has had the advantage of starting with a clean slate.

Since its loan portfolio is all conforming or jumbo, and since runoff is at a slow 6% rate, Capstead is able to process 1,200 loans per employee, more than 50% above industry averages. "We think we can get to 2,000," said Mr. Gilson.

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