The Thornburg Meltdown: Resolution Trust Corp. Redux?

Shares of Thornburg Mortgage (TMA) are down more than 40% to 2.01 in the after hours after the company said that it was unable to meet a $28 million margin call from JP Morgan Chase (JPM), one of its lenders. JP Morgan has decided to exercise its right to liquidate the collateral under a $320 million financing arrangement Thornburg defaulted on. This notice of default from JP Morgan triggered cross-defaults with other lenders who can now demand their money back. Unless a white knight emerges, this might be the end of Thornburg Mortgage as we know it.

The contrast with other companies failing due to the sub-prime mortgage mess could not be more ironic. Thornburg is a well respected mortgage lender with high lending standards and one of the lowest default rates in the business. It primarily lends to high income individuals who take out Jumbo mortgages on their homes and rarely suffers a loss on its portfolio. Company insiders have been on a buying spree since last fall and have purchased more than 1.26 million shares in the open market.

The mortgages Thornburg originates are not bought by the GSEs (Fannie Mae (FNM), Freddie Mac (FRE)) since they are above the confirming loan limits. Thornburg securitizes them or holds them in its own portfolio. To finance the mortgages, Thornburg borrows money from other lenders and pledges its loans and securities based on its loans as collateral. In the past, Thornburg was able to borrow without much difficulty since the collateral was of very high quality. Its business model uses a large amount of leverage, and is dependent on its ability to borrow on a regular basis.

Over the past year, the fall in home prices, and the subsequent rise in the default on loans made to sub-prime borrowers has significantly weakened the secondary market for mortgage loans, and mortgage backed securities. Securities which are not backed by the GSEs are dropping in value since investors fear that the home owners will default and not pay back the principal. This drop has not only affected the guilty sub-prime segment, but also the prime-Jumbo and the Alt-A (no-doc loans for individuals with a high credit score). This is reflected in the higher rates being paid for Jumbo mortgages at the retail level, where the spread between Jumbo and confirming loans is at one of the highest levels ever. Recognizing this, Congress recently raised the limit for confirming loans which can be purchased by the GSEs to a number determined by the median price of homes in different areas.

However, this has not helped Thornburg since the market price of the collateral it has posted to its lenders is falling. This price has little to do with the underlying value of the cash-flow (principal and interest payments) represented by the loans and the securities. It just reflects the pessimism and the lack of liquidity in the secondary market. Investors are not willing to risk their capital to buy these assets since they are afraid that the price will fall further and mark-to-market rules will force them to book a loss on the value of their holdings. The markets, as they say, are frozen.

If a responsible lender like Thornburg goes under, what is next? If the lenders start liquidating the collateral provided by Thornburg, the price of these securities will fall further. Mark to market rules will force other investors who own the same or similar securities to write-down their assets. This might lead to new margin calls and another round of forced selling.

Course of Action

Mohamed El-Erian of PIMCO was recently asked this question in an interview on CNBC and his response was that it is time for the Federal Institutions to step in. Market forces have been unable to resolve the problem and the big banks do not have the cash on their balance sheet to step in to be the buyer of last resort. In order to restore the stability of the financial system, the government must act soon.

One of the proposals being considered is for Federal Institutions to purchase mortgage backed securities and provide a bid. This will prevent the slide in the price of these securities and help stabilize the market. A similar bail-out was arranged after the S&L crisis and the Resolution Trust Corporation turned out to be a good investment by the Federal government (and the tax-payers). A similar effort is needed now to prevent further melt-down in the US credit markets.

Comments

[Celticpole]

I agree with everything you say but would go one step further to encorporate the Chinese model. Find the top 50 people responsible for this abortion and execute them. Then, you can save the asses of the rest with my tax dollars.

[SeekingClarity]

Thornburg management isn't completely innocent in this debacle. The majority of the most recent margin calls were against their ~$2 billion position in Alt-A loans. These are securities that they purchased - not the high-quality loans that they originated. One has to wonder why they did not liquidate these positions during their fire sale last summer as it became clear that the market was beginning to shun anything that even sounded like it had credit risk.

[Efrain Rojas]

Financial institutions have gamed federal legislation to suit their shell game financing schemes, now they want federal intervention? Hell NO. I am an honest taxpayer and I am not going to pay for irresponsible business practices. The market will sort out this problem in the long run. Housing prices will settle back down to affordable levels and the richest 1% will give back ill gotten gains.

[Wez]

Lol, Efrain, you sound like you have no skin in this game. There is plenty of little people like me who own a few stocks and mutual funds right now that would love to see the bleeding stop. What the author is proposing is not really a bailout. He thinks our government should step in a make a market where there currently isn't one. If they don't, who knows how bad things will get.

[User 161168]

The execs running these levered up the a** shell games need to decide whether they want it the communist way - face execution and gov't intervention, or the american way - you agreed to the terms now you pay up sucka. Congrats to JPM for seizing the collateral - now thats responsibility. To even ASK for tax dollar intervention is obscene. This isn't the 1930s. Not looking too smart now for leveraging like some p*** poor latin american country. Haha. Thornburg - your company name sounds like it would make good kindling for a fire.

[helplessobserver]

I guess they don't teach the hazards of leverage in business schools these days.

[Sticks]

Yes, its time for an RTC type action (or literally revive the old RTC) and waiting until this summer will not be a smart move. The Bush Administration has its best success when it goes all in; rather than a sorry history of "limited force".