A Safe Way to Dabble in Mortgages

These aren't exactly salad days for the mortgage-lending industry. Home sales are cooling rapidly, and a rising tide of bad loans has already swamped the subprime sector (which caters to borrowers with poor credit ratings) and could extend further up the food chain. What's more, stubbornly low long-term interest rates are wreaking havoc with lenders' bread-and-butter strategy of borrowing at low short-term rates, issuing mortgages at higher long-term rates and profiting from the difference.

But investors willing to nibble carefully will find a tasty reward in Thornburg Mortgage, a real estate investment trust that yields 10%. The Santa Fe, N.M.-based REIT has avoided many of the industry's worst problems. It writes adjustable-rate mortgages exclusively for the wealthy and has no direct exposure to subprime woes. Its underwriting standards are conservative -- its loan portfolio hasn't experienced a default in five years. In fact, one sure consequence of the subprime mess -- tighter underwriting standards for everyone -- should make Thornburg's terms more attractive by comparison. And higher lending rates, the result of increased risk in the mortgage market, should boost its profits.

The biggest risk is whether Thornburg can maintain its $2.72-per-share annual dividend. Analysts on average expect profits of only $2.26 per share this year, well short of the dividend. (As a REIT, Thornburg pays out almost all its profits as dividends, which are usually taxed at regular rates.) But in April, president Larry Goldstone assured analysts that this year's profits would exceed $2.40 per share and that next year's would cover the dividend.

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More convincing, Goldstone and chief executive Garrett Thornburg have put their own dollars on the line. Goldstone bought 10,000 shares, and Thornburg, head of a financial empire that bears his name, purchased 210,000 shares at $23.76 in March, when the stock (symbol TMA) was 14% off its February peak. At $27 in mid May, it's made the two collectively almost $1 million richer. Goldstone insists that Thornburg's shares are still undervalued, and he makes a solid case. First, profits should get a nice boost over the next two years as $6.7 billion in adjustable-rate mortgages reset to an average interest rate of more than 6%, from 4.6% currently.

More important, Thornburg has been able to increase its mortgage-origination business significantly by aggressively courting third-party firms willing to underwrite loans according to its specifications. These originations, which could total nearly $7 billion this year, are more profitable than loans Thornburg buys in bulk from other lenders, and they often lead to repeat business from the well-heeled borrowers. The firm, which has a portfolio of $54 billion in loans, expects originations to rise 20% this year. Meanwhile, industrywide originations are expected to fall by 9%, says the Mortgage Bankers Association. Longer term, Thornburg should also benefit from legions of affluent retirees, who are buying second homes and refinancing the mortgages on their primary homes to free up cash.

Given these factors, Goldstone's goal of generating annualized total returns of 12% to 15% seems within reach.