Thornburg Mortgage, Inc. The Wall Street Analyst Forum Call Transcript

| About: Thornburg Mortgage (THMR)

Thornburg Mortgage, Inc. (TMA) The Wall Street Analyst Forum November 17, 2008 9:50 AM ET


Clay Simmons - Chief Financial Officer


Good morning, ladies and gentlemen. In our ongoing attempt to adhere to the published schedule, I would like to introduce the next company in today's financial services program, Thornburg Mortgage who has presented with us in the past about every two to three years.

Thornburg was established in 1993. Thornburg Mortgage, Inc. is a New York Stock Exchange company, ticker symbol TMA. They are single-family residential mortgage lender that originates, acquires, and retains investments in adjustable rate mortgage assets, thereby providing capital to the single-family residential housing market.

The company's portfolio comprises of both traditional and hybrid ARM assets, it originates as well as purchased ARM assets. Purchased ARM assets are mortgage-backed securities that represent interest in pools of ARM loans, that are publicly rated and issued by third parties and may include guarantees or other third-party credit enhancements against losses from loan defaults, like traditional banking institutions.

The company's income is generated primarily from the net spread or difference between the interest income it earns on its ARM assets and the cost of its borrowings. The company's strategy is to maximize the long-term sustainable difference between the old and its ARM assets and the cost of financing these assets and maintaining that difference through interest rate and credit cycle.

So without any further introduction, I'd like to introduce Clay Simmons, Chief Financial Officer of the company.

Clay Simmons

Good morning. I apologize I've got a bit of cold today, so I hope you all can hear me. Before I get started here, here is the normal disclaimer here as the public company, obviously there could be some forward-looking statements here and so this is a typical disclaimer.

Just to get started, it's been a tough road. Obviously, Thornburg was one of the strongest companies in the mortgage origination space and in the REIT space up until June of last year. Just to give you some highlights here, $3.2 billion of market cap as of June 30, 2007, $57.5 billion of assets and Fortune 1000 company and a very strong long-term return.

Last August, everything changed for Thornburg with the first round of price declines in the mortgage market. We saw $23 million worth of assets, recorded well over $1 billion of losses as a result of those sales. And essentially probably we put ourselves in a position where with a little bit of additional capital that we raised about $1.5 billion that we would be able to see these prices through.

Obviously in late February, early March, whole other round of margin calls from our repo dealers and the latest blow in the mortgage market has put more than 275 companies out of business in the mortgage space. But what we manage to do in order to survive is, negotiated a standstill agreement with our repo lenders, which allowed us to raise over a $1 billion of new equity and basically capitalize on the credit quality of our mortgage portfolio which I'll talk about later.

Going forward, we do see a lot of opportunities for Thornburg Mortgage as a high quality mortgage originator in the period of time after describes it settled out, a very limited competition in the jumbo mortgage space based on the folks that have left the industry. We have got a proven origination franchise that is well known for quality lending and good customer service. And we have kind of an unusual ability to serve both the correspondent and the broker channels in a high quality manner, and our cost structure is very low which allows us to compete favorably with banks.

Our business strategy, as you may or may not know, has always been is a single family mortgage lender. We're focused on prime jumbo and super jumbo space. We're a portfolio lender. We don't sell our loans and historically a diverse financing and capital strategy. Unfortunately, all of the capital markets financing strategies that we have employed are pretty much gone away in this marketplace with the exception of the repo book that we have under a standstill agreement.

Our strengths historically have been risk management and remained so. Our credit risk performance has been outstanding. We typically manage our interest rate risk to a very tight tolerance. Unfortunately, interest rate risk wasn't what caused the crisis that we have in the marketplace right now. And so unfortunately, the interest rates swaps and caps that we had in place didn’t protect us from the drop in value as result of liquidity.

We have a very low cost operating model. Currently we are at 32 basis points. Historically, when we are in full operation in around 19 basis points of operating expenses, and as a REIT, we offer an organizational structure that’s very efficient from a tax perspective. As I mentioned, our operating model is efficient, 32 basis points in the most recent quarter, somewhat overstates what our ongoing operating expense structure would be.

Obviously, we've been going through a lot of legal expenses, a lot of audit expenses associated with our operations, and also our loan originations have been very low during the course of this year. So, very little of the cost of maintaining our loan origination capabilities are deferrable. So, the operating expenses are somewhat elevated, but as you can see against other competitors that we have in our marketplace is very low operating expense structure.

Over time, the company started out slow. We are originally purchaser of mortgage-backed securities, when the company started back in 1993. Since that time in 1997, we started buying bulk loans and securitizing them ourselves. And subsequent to that, starting in 1999, we began originating loans through the correspondent then the retail and then the wholesale channel.

Every loan that we originate gets securitized and in the context of the securitization we sell the AAA piece, which essentially is provides the financing for the structure and we maintain the loan servicing. The remainder of the loans is either financed with reverse repurchase agreement or with equity, and that's basically how we fund ourselves.

During the third quarter, we reported income of $140 million. I think we Thornburg Mortgage is certainly the poster child for FAS 157 and FAS 159, we essentially wrote down our mortgage-backed securities by $654 million as a result of price changes in the market place.

And but offsetting that was a fair value decrease in two liability components, one being the senior subordinated debt, which was written down about little over $500 million and that the principal participation agreement and additional warrant liability, which is again associated with the capital that we raise in April was written down as well and that resulted again, when you write down a liability. So, all told we had a gain there.

The good news is that from a core income standpoint, our net interest income was $80 million for the quarter, our net spread 116 basis points, and the average portfolio yield increased by 22 basis points during the course of the quarter. The balance sheet continues to decline in size as we pay down our repo balances and our mortgage-backed securities portfolio pay downs.

Current total assets are at $26.3 billion. I think the best news is on the credit side. Our seriously delinquent loans and those that are defined 60 plus through foreclosure, only 96 basis points, and that compares very favorably to the prime space nationally. We are reporting the 96 basis points as of the end of the third quarter. The NBA's most recent statistics are as of the end of the second quarter and seriously delinquent loans there 8.25%. So, clearly the Thornburg portfolio is performing better than the rest.

What's important to note is our originations are performing considerably better than that. Our originations have 68 basis points. The bulk portfolio, which we purchased that we exclude the option ARMs are performing at a similar level around 80 basis points of seriously delinquent loans.

We do have approximately $1 billion of option ARMs, which we purchased in the market place largely from a very large lender on the West Cost, who is no longer in business. And that portfolio although it represents only about 4% of our total loan portfolio is responsible for a significant amount of our delinquent loans, those option ARMs are have a seriously delinquent percentage of 5.83%. So, that’s what pushes up our total seriously delinquent loans. We haven't bought any option ARMs since very early in 2007. So, that problem is working itself out.

I think it’s also important to note that we have been very successful in going back against this lender in getting loans repurchased. We essentially during the quarter had over $10 million repurchased out of that pool and so essentially the recoveries there were $10 million versus about $3 million losses on that portfolio, so a very good performance there.

Clearly we’ve been restructuring our debt. If you go back to 2007, we had almost $10 billion of commercial paper, collateralized commercial paper and a very substantial repo book. We have basically paid off the commercial paper and reduced what was $20 billion repo book down to what’s now about $4.6 billion. So, you can see the progression here away from short-term capital markets financing and to the collateralized mortgage debt financing, which is a permanent financing structure.

The quality of our credit portfolio remains very strong even though there have been substantial downgrades in the marketplace, which I'll show how that plays out in our portfolio. We still, based on the lowest credit rating on any of the bonds that we own; we still are 93.8% AAA or AA after the recent downgrades.

The rating agencies as you probably know have downgraded and this primarily Fitch and S&P, but have downgraded $2.6 billion in current phase of our portfolio between during the course of this year. The lion share that $2.6 billion has happened between June and September or June and November 3rd. All of our mortgage-backed securities are over collateralized and so subordination is what provides the credit enhancements. We don’t have any insured bonds and so none of those risks exist.

This next slide gives you a sense of what our borrower profile is and why our portfolio has performed from a delinquency perspective so well. If you look at first the Thornburg originations in the most right-hand column, you can see that, the average LTV at 67%, FICO scores in the mid-700s, good debt ratios, very high annual income and our borrowers are not neophytes, that we are not dealing with first time home buyers. Our borrowers tend to be have considerable experience in home ownership and in general a very high percentage of fully documented loans. We believe very strongly that whole documentation is the key to good portfolio performance.

On the bulk side very similar, particularly on the objective criteria, 68% LTV, mid 700 FICO, little bit higher debt ratio, but still well within the range, slightly higher average loan balance in our bulk portfolio and less full documentation. We try to make up for that by underwriting a very significant portion of the bulk purchases and accordingly, we have gotten a good performance out of that portfolio as well.

The proof is in the pudding here, this graph basically lays out how the different mortgage spaces have been performing from a delinquency percentage. The pink line is the sub-prime ARMs; the green line is the sub-prime fixed rate and as you can see very high delinquency in those categories. But even in the prime ARMs space, which is the next line down there at 8.25% seriously delinquent through June 30th, clearly that's picking up below that line the kind of tan colored triangle is the prime fixed space and even there, we are seeing mid-3% delinquency and the Thornburg portfolio again down at the very bottom with our purchased and our self-originated loans below 1% seriously delinquent.

I think the key to our survival has been the standstill agreement that we are able to negotiate with our repo lenders largely due to the credit quality of our portfolio. And by its original terms, we were able to suspend margin calls on $5.8 billion of repo financing back in March. It was debt standstill that allowed us to raise $1.2 billion worth of debt.

And at the end of the March, which has sustained us through this period, we basically have 5 repo counterparties, currently was Bear Stearns, now JPMorgan, Citi, Credit Suisse, RBS Greenwich and UBS. The financing rate is LIBOR plus 35 which is very favorable. And I think the benefits to us is that we are able to avoid $90 million of margin calls that occurred in March and basically a suspension of the rights to the repo lenders through the end of this March. Clearly that time is running out though and we are looking to replace this financing by March of next year.

As you can see, currently we've paid down the repo balance by over a $1 billion so far this year in 7.5 months, that we have been operating borrowing rate about 3.25%. The weighted average maturity here is incorrect; it's about 4.5 months now. We currently have $7.3 billion of current face of mortgage-backed securities on repo, along with $213 million worth of AAA IOs in market value and against $4.6 billion, $4.7 billion of repo borrowings.

On our mortgage portfolio, as you will see, as we hit the next couple of slides, are very well credit in hand still. As you know, the rating agencies have been taking a lot of action on mortgage-backed securities and their structures across the mortgage space. Fitch kind of led the way starting back in June-July time frame, S&P has followed along and Moody's says it's cracking up their efforts as so we're told. As of the end of September 30th, 2 billion in current face of our MBS have been downgraded and since the end of September another $510 million were downgraded.

As you'll see this slide here, what we try to do is break out our Prime MBS and our Alt-A MBS portfolios just to give you a sense of what the credit quality is even on a post-downgraded basis. This reflects these pools on a post-downgraded perspective, and so on the Prime side, current face of $4.4 billion. This excludes the IOs by the way and also excludes the agencies.

As you can see, the fair value of this portfolio has been written down by a $1.5 billion, but the seriously delinquent performance of the loans that underlie these securities is still very good, less than half of what is going on in the marketplace. And the LTV on the securities debt that we have on that underlying collateral very good as well, 68.2%.

The credit enhancement remains very strong on these pools, and with the exception of the non-rated classes, if you were to assume that a 100% of the seriously delinquent loans go to foreclosure and that we were to lose 50% of the original appraisal on each one on those loans, only the non-rated class would not be at least fully collateralized by the underlying credit enhancements.

As you drop down to the Alt-As pretty much the same story there, a little bit higher LTV, a little bit higher delinquency but still less than the delinquency on the Prime ARM space on average. The credit enhancement on the Alt-A portfolio is stronger as you might expect, and basically the same situation there where we are exposed on the non-rated classes, if a 100% of the seriously delinquent loans go to foreclosure and we lose 50%, but the other class is still had at least one time or better credit enhancement.

This kind of brings the whole thing to a total. As you can see the average LTV is 70% and the credit enhancement of 10% on average is still remains very strong. Just to give you sense of the balance sheet, where we stand today and after that I will take some questions.

You can see still considerable shrinkage in the balance sheet since the beginning of the year, with our assets dropping of essentially $10 billion. Our equity has dropped from $1.7 to now down to a deficit of $300 million.

I think the plans for us as we look forward is to continue to restructure our debt as you may know, we have tender offer on our preferred stock outstanding in the market place and looking to close that down this week. And taking other actions in order to strengthen our equity position and position ourselves for the recovery to come.

And that note I'll open it up to questions.

Question-and-Answer Session

Clay Simmons

Yes, sir.

Unidentified Audience Member

What are you seeing your lost severity on delinquent mortgages or do you have some sort of assumptions that that you've put in for loss severity?

Clay Simmons

And the question is, what kind of loss severity assumptions do we use on our losses? To-date we've really seen very, very modest losses. We have about $45 billion worth of REO properties. We have reserved approximately $15 million on those REOs. And so, I think you can imply from that what our conservative take would be. As we work those loans through REOs as I mentioned that this quarter we essentially recovered $10 million against realized losses of $3 million.

So, we have been very successful though our workout folks in either recapturing, having the originators repurchase loans or basically work it out through either short sales or whatever and have been fairly successful along those lines. I think as I mentioned, when we look at our credit enhancement levels, 50% recovery on original appraisal is kind of what we are assuming as a worst case, and that's how we are basing our assessment of credit enhancement that sort of thing, although, we haven't seen that kind of behavior in the loans that we've taken through a foreclosure and then ultimate sale. Yes sir.

Unidentified Audience Member

(Question Inaudible)

Clay Simmons

Well, the question was what happens if the tender offer fails? Well, as you know the tender offer was changed from part cash by dollar cash and one share stock to three shares post split stock. The reason we did this was there are tax within Maryland, which is the home state of Thornburg Mortgage from a corporate perspective that requires you to pass certain solvency test.

We, the Board was uncomfortable with our ability to pass the Maryland solvency test with the overwrite lenders retaining most of the cash that would be due to the company and so as a result, we converted in to a half stock. There is really no bar for us to close this tender offer. The consequence is, if we were not to would be, we would be paying 18% interest on the senior subordinated notes as opposed to 12% if we have a successful lender. So, I think those of the consequences we expect the tender offer to be successful at this point.

Unidentified Audience Member

So, did you go forward to March that time (inaudible)?

Clay Simmons

Question is, what try to fast forward to March of ‘09 and what the likely scenarios would be for the repo financing arrangement? I think the repo lenders have shown consistent willingness to work with them. We're working with them very closely now to basically deal with essentially how downgrades were treated in the original agreement. Nobody expected the downgrades of mortgage-backed securities to occur like they have and the overwrite agreement was not particularly crisp on how those get dealt with and so we're kind of working through that for the remainder of the agreement.

When we get to March, obviously we are looking at a number of different solutions for the repo book. We have a very strong investor group that is very well capitalized and we've been pursuing options that are obvious conversion to a bank or thrift. We're looking at various alternatives that have been offered by the TARP Program and we're also talking to other potential lenders both onshore and offshore to essentially finance the portfolio post March.

In terms of handicapping, I think the performance of the portfolio is really going to guide that. As it stands right now, although in a mark-to-market context based on the few trades that are available in the market place, we've basically written our portfolio down by $2.7 billion. There is no way in my mind that we're going to see $2.7 billion of realized losses on that portfolio that I just kind of walked through.

$100 million may be, $150 million but certainly nothing in the realm of the $2.7 billion that we've written a portfolio down. So unlike most of the banks where most of the impairments and market value write downs have hung up in OCI, if they are anywhere on the balance sheet, I mean our [right end] retained earnings.

And as a result of that as those securities pay down and as the loans pay down, that value is coming back in the form of interest margin and so I think it's apparent to our repo lenders and other folks that we've talked to that, that the value is going to come back to us in time and it's just a matter of being patient enough to let that $2.7 billion come back. Anything else?

Unidentified Audience Member

(Question Inaudible)

Clay Simmons

Question is what's the size and structure of the option ARM portfolio? It's about, it's actually $780 million of loans that we’ve securitized in our securities and then there is about $250 million of purchase securitized loans, essentially we bought a pool of loans in securitized form from this lender and that has been the worst performing group. So essentially, the $10 million that were bought back by this lender came out of the $250 million purchase securitized loans group. Anybody else, don’t be shy.

Okay, well thank you very much. I'll be available afterwards to answer any questions. Thanks.

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