Contrarian Mortgage Plays: IndyMac Bancorp

Jun.25.07 | About: IndyMac Bancorp, (IDMCQ)

Alex Troy, Troy CapitalNewsletter Value Investor Insight carried an interview May 30th with Troy Capital's Alex Troy, whose fund has returned an average of 23.6% annually net of fees since inception in March 2003, versus 15.8% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview in which he discusses IndyMac Bancorp (IMB), which was trading at $33.69 at the time of the interview (current price here):

IndyMac Bancorp (IMB) is another idea with its fair share of detractors.

AT: Since 1992, this company grew from almost nothing to being the largest “Alt- A” mortgage originator in the country. Alt-A loans are those with less documentation than is required by government agencies like Fannie Mae to buy the loans on the secondary market. Credit scores are typically much better than for subprime borrowers, but for whatever reason those taking out Alt-A loans may not have the income or credit history that prime borrowers do. Often it’s because they’re self-employed and may have uneven annual income.

What I find remarkable here is that after compounding earnings at 20% per year over 15 years, this company is now considered to be just another mortgage lender with potential credit problems. The stock trades at less than 10x forward earnings and 8x trailing earnings and has a nearly 6% dividend yield.

But the short interest is still off the charts. Why is that?

AT: There are probably several reasons. Until recently, being short was working and more people tend to pile in when that happens. More fundamentally, there seems to be a belief that troubles in the housing market in general and subprime mortgage loans in particular will severely impact credit quality of IndyMac’s Alt-A loans. To some extent that has been borne out: after consistently generating 20% returns on equity, ROE in the first quarter was only 10%.

There appears to be concern over the company’s reliance on the California housing market, which accounts for about 45% of its loan base. Shorts also tend to be attracted to the fastest growers in lending industries that are retrenching, assuming they cut corners on underwriting or otherwise inappropriately boosted earnings. You can find a lot of ingenuity on Internet bulletin boards focused on questioning IndyMac’s earnings quality.

How do you get comfortable that the shorts aren’t right?

AT: First, we see no evidence that the company, after 15 years of doing a lot of things right, all of the sudden lost its way and is hiding things from shareholders. The ratio of loan-loss reserves to non-performing loans is currently 46%, and while detractors may want to see that higher, the actual historical level of the company’s non-performing loans that it has had to charge off is 32%. There’s always a risk that the housing market totally falls apart and we see big negative surprises in the loan portfolio, but with a 4.4% unemployment rate, we don’t see that happening.

We also have a very simple barometer for earnings quality, which is the dividend. You can’t pay dividends with anything but real cash and we think the maintenance of the dividend will be the best answer to concerns over earnings quality.

As for exposure to California, the state’s real estate market is like a highbeta stock: it grows faster than the U.S. market in good times and does worse than the overall market in bad times. Given that, the reliance on California may not be so great in the current market environment, but it will be in the next up market. With an appropriate time horizon, this is just not something that worries me.

The company recently completed a preferred share offering, increasing its Tier 1 capital and reinforcing the fact that it doesn’t have any liquidity problems. One thing the company was very smart about was to start a more traditional thrift business in order to attract retail deposits. That’s critical, because it’s a much more stable source of funds in the event capital-markets liquidity ever does dry up. To me, that’s further evidence that you’re dealing here with a high-quality management and company.

In the end, I don’t profess to have any unique insight into real-estate prices or where exactly we are in the housing cycle. But I do know that when it’s raining today the market tends to think it will rain tomorrow, so there’s an opportunity when you believe the sun will eventually come back out – as I believe it will here.

With IndyMac shares trading around $34, how are you putting numbers on that belief?

AT: We’ve run a variety of scenarios to determine how bad things can get. As I mentioned, the company has historically compounded book value at close to 20%. If we assume ROE turns negative this year and then rebounds over the next five years to only 12%, we expect the share price to grow around 15% per year. If we assume flattish ROE this year and the company getting back to just a 15% level, we’d expect 20% annual share-price increases. With the dividend yield on top of that, that would be a very nice outcome.