Thornburg's a Huge Bargain After Monday's Crash

| About: Thornburg Mortgage (THMR)

Thornburg Mortgage (TMA) is a major single-family residential mortgage lender (and mortgage REIT) focused principally on prime and super-prime (i.e., high-credit-score) borrowers seeking jumbo and super-jumbo mortgages. Even though TMA has never held a subprime loan (that I know of) in its life, it got taken to the woodshed along with every other lender as a result of the subprime implosion of the last few months. During that time, TMA's stock price cratered from about $30 to about $10.

Things looked up in early Feb, 2008, when TMA reported a profit of 33 cents a share (Wow! A residential lender that's profitable?!) and in reading between the lines, one got the idea that subsequent quarters would be even better. But given the volatility in this space, this good news was not to last.

On Feb. 28, Thornburg said it was facing margin calls because the value of some of its mortgages had fallen amid "a sudden adverse change in mortgage market conditions" that began on Feb. 14. As of Feb. 28, TMA had met margin calls totaling $300 million, which reduced liquidity it might need to meet future margin calls, if any. Thornburg also said, however, that its securities faced a relatively low risk of further downgrades due to their quality.

That sanguine assessment turned out to be incorrect. Monday morning, before market open, TMA announced another $270 million in margin calls—and also stated it did not have the cash to meet the calls. As a result, Standard & Poor's cut its rating on Thornburg to 'SD' - one of the lowest grades possible - from 'B-.' The new rating indicated that Thornburg was in "selective default" because of a default notice it had already received.

Thornburg said the margin calls are "strictly a result of the continued deterioration of prices of mortgage-backed securities precipitated by difficult market conditions." The calls are not reflective of the actual performance of the securities, the company added. Regardless of the reason for the calls, TMA advised that yesterday's margin call could "have a material adverse effect on the company's ability to continue its business in the current manner."

Not surprisingly, shares crashed about 60% yesterday, hitting an intraday low of $3.53 after having closed at $8.90 on Friday, which itself was a big drop from $14 earlier in February. It was while TMA was trading under $4 around mid-day yesterday that I bought 20,000 shares at $3.81/share. These were my reasons for doing so:

1) TMA's business has nothing to do with subprime loans, which have default rates of 10%+. TMA's default rate is less than 0.5%.

2) A couple of months ago, Mr. Thornburg himself bought 1 million shares of TMA at about $10/share. Other insiders own a lot of TMA as well. It is my belief that when insiders own that much stock—much of it acquired at a price more than double the $3.81 I paid—they are going to work very hard to make sure the company does not go belly-up.

3) The underlying business allowed TMA to earn 33 cents per share in the most recent quarter, reported about one month ago. TMA's profit margins have actually substantially expanded in the past few months, suggesting greater profit potential once things settle down. Even if TMA did not grow its profit at all, at 33 cents per quarter, it would make $1.32. At $3.81/share, that's a PE of less than 3.

As long as TMA is not entirely incapacitated by the margin calls (and that is certainly a possibility), there is no reason to believe its earnings going forward should be much less than $1.30, but even if they decrease by 50%, that's only a PE of a bit over 5.

4) To put it a different way, iF TMA keeps making 33 cents per quarter and gets valued at a PE of 10 as market conditions improve and margin calls are done with, its stock value would be about $13. Thus, at $3.81, a very good risk-reward ratio exists. Also, it is worth noting that TMA was valued at $14/share less than one month ago, and unlike many other lenders, TMA's underlying business hasn't imploded.

5) TMA faced billions in margin calls in August 2007 and handled that emergency just fine and even lived to tell the tale.

6) I also figured that such a good business with such good underlying collateral (a default rate of less than one-half of one percent, especially in today's environment, is nothing short of spectacular) would be able to attract capital to meet Monday's margin call. I was hoping that the capital would be in the form of debt (in effect, a refinancing) rather than a bottom-feeder taking significant equity, but either would have been OK. It just seemed to me that a bailout of one kind or another was extremely likely given the good quality of TMA's mortgages.

Well, at 3:23 PM, while TMA was trading at about $3.60 (a bit under my entry price of $3.81 - oops!), TMA made this announcement:

Thornburg Mortgage, Inc., today announced the completion of a collateralized mortgage debt transaction collateralized by $992 million of the company's prime hybrid adjustable-rate mortgage loans in the publicly registered Thornburg Mortgage Securities Trust 2008-1. This transaction was accounted for as a financing and not as a sale and the proceeds were used to reduce the company's borrowings under its ARM loan warehouse financing lines by approximately $920 million.

Going forward, Thornburg Mortgage anticipates an increased use of collateralized mortgage debt financing and reduced reliance on reverse repurchase financing. At December 31, 2007, 64% of Thornburg Mortgage's mortgage assets were permanently financed by collateralized mortgage debt transactions as compared to 37% at June 30, 2007.

In summary, this transaction enhances Thornburg Mortgage's liquidity position and provides long term financing for the company's originated mortgage loans.

The stock immediately ran up from $3.60 and traded between $4.30 and almost $5.00, closing at $4.32. Although we don't know how much TMA paid (in transaction costs and interest rate) to attract this capital (undoubtedly, TMA paid a premium), I'm glad they got the cash via debt rather than equity.

Because I think we'll hear about further liquidity enhancements going forward, and for the reasons I noted above, I ended up buying another 10,000 shares near the end of the day (at $4.51/share). Assuming a press release describing additional liquidity enhancement and/or upgrades, I expect to see TMA go over $5, and probably closer to $6. If earnings in the 20-30 cent range are reaffirmed in the near future despite the margin calls, I expect to see $7. And if things settle down in the mortgage business—as they will in the next year or so, especially for a company holding only prime and super-prime debt—I see TMA at $15.

Of course, if additional margin calls materialize and are unmet, I see TMA going back to $3/share. Given the billion dollars TMA picked up today, and the excellence of its underlying mortgages, I consider the latter possibility rather small. Therefore, I think that at $4+ (or even $5+), TMA presents a very good risk-reward opportunity, albeit for investors who can tolerate risk.

Disclosure: Long TMA