Non-Agency Mortgage REITs; Part 6 - The Residential Sector

Includes: CIM, PMT, RWT
by: Philip Mause

This series of articles deals with those mortgage REITs which invest in mortgages and assets other than agency guaranteed mortgages and mortgage securities. The companies described in this series are often confused with agency mortgage REITs and are lumped into the single category of "mortgage REITs" with them. This can be very misleading; non-agency mortgage REITs ("NMREITs") are quite different from agency mortgage REITS because the assets NMREITs invest in involve default risk. As a result, NMREITs generally use less leverage and are exposed to a very different set of risk factors. This series of articles is intended to provide the reader with a full listing of stocks in this often ignored sector as well as some analytical tools useful in evaluating them. I have included some investment recommendations because I believe that the sector is misunderstood and some of the stocks are undervalued.

The first article dealt with "newbies", companies formed since the Crash of 2008. The second article addressed some "winners" which have successfully emerged since the Crash. The third article dealt with companies in transition to a different business strategy or asset mix. The fourth article dealt with companies still struggling to achieve steady profitability. The fifth article dealt with very small NMREITs and the problems of limited size. This article will deal with NMREITS that focus on mortgages of owner occupied residences.

The categorization of NMREITs the into different Parts of this series is a bit arbitrary. Many of them own some mix of real estate equity, commercial mortgages, residential mortgages, agency mortgage securities, and other mortgage backed securities and it has been difficult to pin point which company should go into which Part. This Part focuses on companies which are not hybrid (predominantly agency mortgage security) but are dominantly committed to residential mortgages. By "residential" I mean "owner occupied" as opposed to rental. Apartment mortgages could be defined as "residential" because people live in apartments but I really think that they are more like office building mortgages than owner occupied home mortgages. Let me explain.

The owner occupied home mortgage market is unique in a number of ways. It is heavily impacted by regulation premised on the need to protect individual home owners; there is no similar need to protect owners of office buildings and apartment buildings. The owner occupied home market (the "residential market") is also impacted by the presence of the federal agencies which have tended to establish norms for mortgage terms. Mortgages tend to be long term - at least 15 years and usually 30 years. There is almost never a prepayment penalty so the interest rate risk on a long term fixed rate mortgage is a "one way street" - exposing the lender to risk if rates go up, but permitting the borrower to refinance if rates go down. Again, this is often not the case with commercial mortgages which, in any event, tend to have shorter terms which mitigate interest rate risk.

Mortgages on owner occupied properties also tend to be much smaller than commercial mortgages. A complex industry made up of originators, servicers, "correspondent" lenders, packagers, and securitizers has grown up and can be confusing to the investor. There is much less of a pattern of a single entity originating, servicing and continuing to own a loan than there is in the commercial real estate lending or the BDC markets. Recent events have put the residential mortgage market through the ringer and have led to structural changes.

For a long time, there was an assumption that homeowners would do virtually anything rather than default on their mortgages and that therefore residential mortgages had a very low risk of default. Now, that we have had defaults, we have become aware of the various legal challenges that homeowners can assert making the process of foreclosure difficult and uncertain for lenders.

The Panic of 2008 taught us all that there can be serious default risk with residential mortgages and the market quickly distinguished "agency" guaranteed from non-agency mortgages. Non-agency RMBS securities were devastated and could be bought at significant discounts; this created opportunities which some REITs have taken advantage of. Chimera Investment (NYSE:CIM), PennyMac Mortgage Investment (NYSE:PMT), and Redwood Trust (NYSE:RWT) are three very different companies. The table below provides Monday's closing price, the Pre- Crash high, the Post-Crash low, the current yield and an estimate of economic book value for each of these companies. The financial data is based on SEC filings; the stock price information is based on Yahoo Financial.

  Price High Low Yield Value
CIM $2.73 $19.00 $2.50 12.9% $2.87
PMT $27.64 ------ $15.14 8.2% $13.37
RWT $18.83 $63.56 $10.18 5.3% $12.08+

CIM has failed to file financials for a number of quarters but did file a release in December updating its economic and GAAP book values. Based on its most recent financial release (filed for the period ending September 30, 2011), it held roughly equal amount of agency and non-agency RMBS securities. It is possible that the September 2011 release may have to be restated. All of this makes CIM hard to evaluate and subject to considerable risk which probably explains the very high yield. I suspect that the type securities CIM holds (largely through SPEs) have tended to and will continue to appreciate somewhat in value and I have held on to CIM, collected the dividend, and waited it out. CIM is managed by the same folks who run Annaly Capital (NYSE:NLY) and so I doubt that there is anything horribly sinister behind the delayed financial filings, but this is somewhat of a "blind pool" until financials come out.

PMT has three lines of business - 1. acquisition and monetization of troubled mortgages, 2. correspondent lending, and 3. mortgage servicing. PMT is unusual in that it specializes in troubled mortgages - buying them from lenders and then working hard to avert foreclosure and, when necessary, using its expertise to manage the foreclosure process. It was not publicly traded until 2009 and so there are really no "Pre-Crash" stock prices to compare with the others. PMT has had a good track record of working out problems on troubled mortgages and seems to have developed expertise at maximizing lender recovery in these situations. Its servicing and correspondent lending businesses are very profitable. These two businesses are really not well reflected in the company's book value so that the book value is probably not a very useful metric for evaluating PMT. PMT has moved up nicely recently and may be a bit richly valued at this price level. PMT generally issues a user friendly presentation in connection with its quarterly financials and its website has useful information on its businesses and future business strategy. I think it is well positioned to benefit from the trends that the market seems to be going through.

RWT buys and securitizes residential and mezzanine commercial mortgages. It tends to focus on prime "jumbo" residential mortgages, defined as over the size limit applicable to agency mortgages. It has had a very high success rate with these mortgages as it appears that no mortgages it has recently held are in default. It retains interests in pools of securitized mortgages which are organized into SPEs. The Value in the table above is based solely on RWT's non-SPE assets and does not include any value associated with its SPE interests; this certainly understates true value as it is clear that RWT's SPE interests have considerable positive value. RWT is taking steps to involve itself in the packaging and securitization of agency residential mortgages and may enter this line of business soon. RWT puts out the very useful "Redwood Review" on a quarterly basis and the report provides a very useful picture of the company's activities and financial results as well as some very helpful insights on the direction of the housing finance market.

CIM is somewhat of a gamble given the absence of recent financial reports. PMT has done well lately; I would definitely be inclined to buy on any significant pull back. RWT is a solid dividend performer which merits a place in a well diversified dividend oriented portfolio.

Disclosure: I am long NLY, CIM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.