Thornburg: Another Subprime Victim?

There's an old Wall Street maxim that says the best time to buy is when there's blood on the streets. If that is so, the bloodhounds were out in force on August 15, snapping up the battered shares of Thornburg Mortgage Advisors, a stock that has been swept away, perhaps unfairly, in the tidal wave of selling of anything having to do with the housing industry.

Shares of Thornburg, one of the mortgage industry's premier players, soared 39%, to $10.56, after being up as much as 60% early in the day. The surge came a day after Thornburg shares (symbol TMA) lost 45% of their value, culminating a sickening two-plus-week slide that had begun with the stock trading above $27.

The drubbing of a lender that has almost no direct exposure to the imploding subprime loan market illustrates how panicky the entire mortgage sector has become lately. Thornburg, a real estate investment trust based in Santa Fe, N.M., specializes in making high-dollar, adjustable-rate mortgages to ultra-wealthy borrowers with superb credit.

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Thornburg's August 14 closing price of $7.65 was a seven-year low. At that price and with an indicated annual dividend of $2.72, the stock yielded an incredible 36%. Indeed, the yield was too good to be true. After the market closed on the 14th, Thornburg Chief Executive Larry Goldstone announced that the company would delay the scheduled August 15 payment of its 68-cent quarterly dividend to September 17 because of "significant disruptions" in the market.

He also revealed that the company's book value (the value of its assets minus its debts) had fallen to $14.28 as of August 13, from $19.38 on June 30, because of the decline in market prices for the mortgage securities that Thornburg holds in its portfolio. On August 15, Goldstone went on CNBC to say that the company has begun to "turn the corner" in dealing with problems obtaining financing. "I think by next week we're going to be on the other side of this," Goldstone said.

Like most lenders, Thornburg makes its money by borrowing at low short-term rates and then writing mortgages at higher long-term rates. But the mortgage business has become so radioactive that purchasers of mortgage securities won't touch anything except for loans that conform to certain underwriting standards that apply mostly to lower-priced housing. Thornburg specializes in writing loans for high-end housing. So even though its underwriting standards are conservative and the default rates of its customers are low, the value of Thornburg's highly-rated mortgage securities used as collateral for its loans has fallen significantly. That has prompted Thornburg's lenders to require additional collateral.

Because Thornburg is a REIT and must pay out almost all of its profits as dividends, it doesn't have the cash reserves to weather a liquidity crisis like this. Thus, it is being forced to sell securities at fire sale prices from its mortgage portfolio, which was worth as much as $57 billion as of June 30. Those losses will crimp near-term earnings, and the reduction in Thornburg's asset base will have a negative impact on its longer-term earnings power.

Key initiatives Thornburg had been taking to increase its profitability, such as stepping up its own underwriting and buying more loans from affiliated underwriters, may have to be put on hold for a while. "We believe the deterioration of mortgage environment will likely persist over the next 12 to 18 months," says A.G. Edwards analyst Greg Mason, who downgraded the shares on August 14 to hold from buy.

Credit Suisse analyst Moshe Orenbuch, who on the same day downgraded the shares to underperform from neutral, forecast that Thornburg's 68-cent quarterly dividend will fall to 30 cents this quarter and to 25 cents next quarter. He thinks the full-year 2008 dividend will drop to $1. If the dividend does fall to $1 per year, the stock would yield 9.5% based on the August 15 closing price. That’s slightly below the shares' ten-year average yield of 9.7%.

A.G. Edwards' Mason says the shares should "hold up better versus others in the mortgage REIT sector" because of the "super-prime quality of Thornburg’s loans." He thinks the shares should trade at 80% to 100% of their book value, now $14.28. That indicates they could be worth $11 to $14.

However, it's possible that book value could fall further if the market continues to regard mortgage securities, even the high-quality ones, as poison. Book value also could fall if the firm is forced to sell assets to meet margin calls on its loans.

It is also worth noting that Thornburg Chairman Garrett Thornburg has been buying shares by the truckload since their value began to wobble last month. Between July 25 and August 6, Thornburg has bought $12.7 million worth of shares at prices ranging from $23.42 to $26.72. That's on top of more than $5 million worth of shares he purchased in March (one of the reasons cited in an article in the July 2007 issue of Kiplinger’s Personal Finance that made the case for the stock). That represents a strong—though, at the moment, costly—statement of confidence in the firm he founded 13 years ago.

It's hard to imagine the mortgage market environment could deteriorate to the point that justifies Thornburg's current decimated share price. However, with the market in such a tizzy and more bad news surely to come, investors should tread carefully. Says Mason: "We think the risk profile of the entire mortgage sector has shifted and as a result, we believe that only speculative investors should be investing in the mortgage REIT sector at this time." In other words, only those willing to buy when there’s blood on the streets.