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Aug 28

More on Impac Mortgage

Yesterday was another big moving day for Impac Mortgage. I was nervous adding to the stock last week given that it had risen from $2.30 to over $4 in a single day but I’m feeling better about those purchases now. I’ve been looking at some of the details of the company, trying to fill in the gaps. Below are some of the answers I’ve found.

On the Business Strategy…

During the year end conference call the company focused much of the discussion on what they were doing to expand the business going forward. They are focused on expanding retail lending activities, their broker network and on purchase money loans.

I had to look up the definition of a purchase money loan:

Simply put, a purchase money loan is a loan used to buy a home. In some ways, it is easier to describe what a purchase money loan is not. It is not a loan that is taken out after you buy a home such as a home equity line of credit or a home equity loan. It is not a refinance mortgage. A purchase money loan is evidenced by the trust deed or mortgage a home buyer signs at the time the home buyer purchases the home.

Impac is developing a business model that is directed at new home loan originations, as opposed to refinancing. I think this is a good strategy going forward. The refinancing business has been a strong business but at some point, probably in the not too distant future, interest rates are going to go up. The whole thesis behind my idea to get into mortgage servicing rights has been premised on rates going up. When they go up the refinancing business is going to dry up. At the same time, the increase in rates is almost certainly going to coincide with an improvement in the resale market, since rates aren’t rising unless the economy improves and the economy isn’t going to improve until housing improves. Impac is positioning itself well for this turn.

Retail volumes were flat in the first quarter but the company guided to higher volumes in the 3rd quarter. Retail volumes have increased significantly over the past year, up from $60.5 million to $132 million in Q2.

The company also restarted their correspondent lending business in January. I’ve written about correspondent lending before, in my write-up of PHH Corporation, and as I point out in an excerpt from that piece below, I really like the prospects of the correspondent business because everybody is running away from it as quickly as they can:

Consider the following. Imagine a mortgage broker who develops significant business volume, earns the confidence of wholesale lenders who will authorize him to approve their loans, and has accumulated some capital. He can now obtain a credit line from a bank that can be drawn against to fund loans, repaying the loans when they are sold to wholesale lenders. Under the law, the broker has morphed into a “lender” – the type called a “correspondent lender”.

This has been a business the big banks have traditionally taken a large piece of. Until now. In August Bank of America reported that they were exiting the correspondent lending business. Ally Financial, who lends through GMAC, retreated from correspondent lending back in December before recently announcing that they would get back into the business on a limited basis. Met Life announced that they were winding down their origination business entirely in January.

This isn’t small potatoes. The above 3 companies were in the top 12 correspondent lenders by volume in the third quarter.

There are rumors others are leaving the business. I thought this quote from a Mortgage News Daily article was spot-on:

One can just hear large lenders talking in their boardrooms. “Do we really want to be in this business, given the regulatory, legal, financial, and public relations issues? Where the value of servicing has dropped dramatically in the market, and could drop further depending on Basel III? Where the mortgage insurance tax deductibility has gone away? Where every week brings a new lawsuit – when will we have more attorneys on staff than originators?”

Its a low margin, highly competitive business. But the opportunity is that it could become less so with some of the big players moving on.

Impac is doing exactly what a small, nimble mortgage originator should do. Get into businesses where the big boys are getting out of. We’ve already seen some of the fruits of that. Correspondent lending volumes were $81.9 million in the second quarter versus only $24.7 million in Q1.

On the preferreds…

The company issued the preferred shares in 2004. The preferred shares paid a dividend of 9.5% and were redeemable at $25 per share. The shares also held precedence in the event of a liquidation over the common shares.

And then Impac changed the rules. In the second quarter of 2009 Impac sent out a proxy to tender the preferred shares. The tender price, at $1.37 for the series B and $1.43 for the series C, was a small fraction of the redeemable.

About a month later Impac amended the proxy. The amendment rather drastically changed the rules of the preferred. It stripped them of their dividends, stripped them of rights to elect members to the board of directors, and stripped them of almost all other rights that made them senior to the common.

Looking back on the event, it could be interpreted that the preferred holders got a raw deal. But keep in mind this was the spring of 2009, the stock market had recently hit decade lows in March, and most believed that the rally off those lows was a dead cat bounce. Many of Impac Mortgage peers were going bankrupt. The preferred holders were probably happy to getting anything and walk away. The proxy reached its required minimum tender of 66.7% and along with the shares tendered the amendment was passed.

There are now 665,592 series B preferred outstanding and 1,405,086 series C preferred outstanding. The liquidation value at $25 per share works out to about $52 million. I think you have to consider these shares in terms of the detrimental effect they would have on a takeover bid, because if you wanted to take over the company today you would have to pay something above the current market rate for the common, which would work out to greater than $30 million, plus you would have to pay out the $52 million for the preferred shares.

The weird thing about the preferred is that the only value they is in the event of liquidation.r. They have no value in a change of control (at least as far as I can tell). So the preferred’s effectively can be ignored unless you are considering a bankruptcy scenario. If you are considering a bankruptcy scenario, you also probably should not be considering the common.

So I think its fair to ignore the preferred shares in terms of stockholder equity calculations such as earnings per share and such. Because those earnings are not going to be siphoned to the preferred. It is only if you were buying IMH with the intent of benefiting from a takeover or from the liquidation that you would have to consider them.

There is a lawsuit outstanding with respect to the preferreds. I haven’t been able to dig up a lot of details on the lawsuit and how much of a risk it is. The original source of the news release of the lawsuit (not put out by Impac) is not available, but there are reproductions are a few message boards. The essence of the complaint was explained here:

Silverman says a condition of the tender offer was that at least two-thirds of the holders of the Preferred B and at least two-thirds of the holders of Preferred C shares tender, with the purpose of obtaining sufficient “exit consents” to eliminate the valuable quarterly dividends, preference rights, voting rights and other valuable rights of preferred holders refusing to tender their shares. In this way, the linked tender offer/consent solicitation was deliberately structured to coerce the preferred shareholders into tendering for reasons other than the economic merits of the transaction and into voting for amendments to the terms of the Articles Supplementary of the preferred shares they were selling. Holders of the Preferred B and C shares had to tender or face the prospect of losing virtually all of the economic value of their shares.

This is something I will have to continue to monitor and dig up information on.

A Capital Raise

I think its pretty likely that Impac is going to raise capital here at some point. During the AGM Impac’s CEO, Joe Tomkinson, said flat out that was part of the plan.

We’ve done a great job on recovery. When all the competition was declaring bankruptcy, and that quite frankly it would be have been the easiest thing in the world for us to walk away and start a whole new company. We didn’t do that. We’ve done everything we can to preserve the shareholders equity. We haven’t gone out and raised capital, although quite frankly I intend to raise capital which will dilute the shareholders. I’m told that we’ll get sued for that but my feeling is that its better to have 20% of $100 million dollars than 20% of $20 million dollars. And so to increase the overall efficiency of the company we’ve got to raise capital.

It was actually a pretty interesting comment. It was about as blunt of a response as I’ve ever heard to the question of a capital raise. No fluff about exploring our options or being proactive or some other two-bit turn of phrase to obscure the obvious. Tomkninson said yup, you bet, we need the cash.

The thing is, they do need cash. They are growing like a weed and what is beginning to hinder their growth is their warehouse line and the capital required for holding on to servicing.

A warehouse line is a short term line of credit that provides cash for Impac to extend money for the period of time between when the loan is made and the company sells the loan off to Fannie or Freddie.

Warehouse lines are short term and relatively safe so they don’t require a large capital cushion, but they do require some. The main risk is with respect to loans that are made but that can’t be subsequently sold. This could be because the loans have problems with the documentation (Called scratch and dent), or because the eventual loan purchaser decides not to buy the loan. A good description of the risks of warehouse lending can be found here. The article describes the key key evaluation metric for a warehouse lender:

Take any mortgage banker’s financial statement and see how much you need to deduct from loans held for sale to trigger insolvency. Divide that by the average loan amount for that customer. That’s the number of unsaleable loans it will take to put the customer in the tank, and it is typically not going to be a large number.

Tomkinson said that if they raised capital, they could increase their warehouse lines by $70 million for every $700K they had. Right now warehouse capacity is about $140 million (top of my head) and so you could raise $1.5 million and double that. $1.5 million at $5 per share would be less than 5% dilution. Even if they doubled that amount, the dilution would not be significant and the money raised would allow the business to continue to grow.

The company has also been growing its servicing portfolio. I have talked extensively about how I feel the servicing business is a great business to be in, including this article I published on SeekingAlpha. As I wrote in that article:

Mortgage servicing rights are one of the most attractive opportunities in the market right now. There is the potential for returns as much as 30-40% IRR for the companies involved.

I believe the opportunity is being ignored by a market for three reasons:

The market lumps mortgage servicing rights in as just another housing play, and housing is still 2-3 years away from recovering
Mortgage servicing rights are complicated and most market participants don’t want to take the time to understand them
Mortgage servicing rights have traditionally been a crappy business and over the past 5 years they have been a really crappy business

If the company uses capital to grow its servicing business at 30% returns, I would be ok with that. This is a case where a little dilution may not be such a bad thing.

Limitations on acquisition and change in control ownership limit

The last item that I have been researching but have not had much success in understanding is whether there are obstacles to a potential take over. With the 10-K risk factors was the following statement:

Our Charter and bylaws, and Maryland corporate law contain a number of provisions that could delay, defer, or prevent a transaction or a change of control of us that might involve a premium price for holders of our capital stock or otherwise be in their best interests by increasing the associated costs and timeframe necessary to make an acquisition, making the process for acquiring a sufficient number of shares of our capital stock to effectuate or accomplish such a change of control longer and more costly. In addition, investors may refrain from attempting to cause a change in control because of the difficulty associated with such a venture because of the limitations.

Unfortunately I have searched and cannot find any clarification on this.

Aug 23

Reviewing MGIC’s Complaint against Freddie Mac

I was fortunate enough to find a link to the original court document of MGIC’s Complaint for Declaratory Relief against Freddie Mac. It was posted on MGIC’s yahoo board.

The document describes the pool insurance dispute between the two companies. This is the same dispute that I wrote about here, and that has caused much turmoil to the MGIC stock price and left many proclaiming an imminent bankruptcy for the company.

Having read through it over my lunch hour yesterday, and then again when I got up this morning, my takeaway is that MGIC has a decent case against Freddie Mac, and that the primary impediment to their success is simply the leverage (read: bullying) that Freddie Mac can inflict upon them.

What’s at issue

The disagreement revolves around 11 pool insurance policies. Each of these policies contain a number of pools of loans that MGIC has agreed to insure for Freddie Mac. The insurance is designed to be in force up to a limit defined by a percentage of the principle balance of each pool.

To get an idea of how these policies work, I’m going to go through a simple example. Let’s assume we have one policy and it contains two pools of loans. Each pool contains loans worth $1 million dollars. Let’s also assume that the policy is structured such that MGIC has agreed to insure a maximum of 1% of the principle balance of the pools within it. MGIC therefore has an aggregate loss limit (meaning the maximum amount that they could potentially be on the hook to pay if a lot of the loans in the pool started to go sour) with respect to the policy of $20,000.

The disagreement between Freddie and MGIC stems from what happens once insurance on one of the pools expires. Going back to our example, let’s assume one pool was added to the policy in 2000, and the other was added in 2007. Both of the pools have insured agreements for 10 years. Time passes and 2010 rolls around and insurance on the first pool reaches its expiration. According to Freddie’s interpretation MGIC is still responsible for $20,000 of losses (less what had been incurred up to 2010) because Freddie believes that the aggregate loss limit of the policy is based on the total principle balance of all loans ever included under the policy. Under MGIC’s interpretation, the aggregate loss limit is determined by the total principle balance of loans insured under the policy, so when the first loan pool runs off, it is no longer included in the calculation. Under MGIC’s interpretation, the aggregate loss limit would drop to $10,000.

In this example, the difference between the two interpretations is $10,000 of insurance that MGIC may have to pay on defaults in the remaining pool. In the actual contract between MGIC and Freddie the difference between the two interpretations is $550 million. And $550 million could be the difference between life and death for MGIC.

Points raised by the declaration

As I said, there were a number of points raised in the declaration that made me think that MGIC has a fairly strong case. The key points that were raised in the document were:

The premium paid by Freddie for the policy insurance was consistent with the interpretation of the agreement by MGIC. Freddie paid premiums that were consistent with the 10-20 year periods that each pool was to be insured. Freddie did not pay anything extra that could be construed to reflect the extra insurance coverage that Freddie’s interpretation results in.
It was only in 2008 that Freddie began to reinterpret the agreement. Prior to that time Freddie acted as though they agreed with the MGIC interpretation. Specifically, Freddie created additional policies with MGIC after 2007. These policies were used to insure new pools. This coincided with when the existing policies began to wind down. If Freddie had believed at the time that the insurance in force was not dependent on whether the existing policies were winding down, they would have just added new pools to the existing policies.
Before 2000 the 11 policies existed separate from one another. In 2000 Freddie and MGIC changed the agreement so that the 11 separate policies were combined into a “mega” policy whereby the losses to all policies would be aggregated and a single loss limit would be applied to the “mega” pool. When this change was made, the language of the change specifically referred to the loss limit being determined by “loans insured” and “loans that become insured”. MGIC’s position is that the language is clear that once a loan is no longer covered by the insurance, it should be removed from the aggregated volume. I would say this sounds in line with the language.
With respect to the mega-pool Freddie Mac’s reading of the contract would have resulted in an increase in the regulatory capital requirements of MGIC when the agreement to combine policies into a mega pool was made. This is in conflict with one of the objectives of both Freddie and MGIC for creating the mega pool. The mega pool idea was conceived to reduce capital requirements for MGIC so they could write more pool insurance for Freddie in the future. MGIC argues that it makes no sense to accept Freddie’s interpretation, which would have menat that Freddie was constructing an agreement that would accomplish the opposite of that.
There is an element of incompetence assumed on the part of MGIC implicit in the Freddie interpretation. There are these policies outstanding. MGIC is allowing Freddie to continue to add pools of loans to these policies. These pools of loans, because they are new, are extending out the life of the policy and increasing the total UPB that has been added to the policy. So with Freddie’s interpretation that the limit of the insurance is independent of whether older pools have expired, those newer pools are effectively having higher and higher loss limits. This would be a ridiculous business decision on the part of MGIC.
In 2007 the individual pools within the mega pool began to wind down. Under MGIC’s interpretation this would have meant a corresponding reduction in aggregate coverage of the pool. Under Freddie’s interpretation, the coverage would have remained the same. Yet Freddie, beginning in 2007, created new policies with MGIC that were not part of the mega pool. Naturally the inference is that they did so because they would receive better coverage from a new policy than from the existing policies that were winding down, which means that at that time they understood the nature of the agreement as being consistent with the MGIC interpretation.
During 2008 there was an email communication between MGIC and Freddie where the two parties discussed how MGIC could reduce exposure on the some of the policies. In that exchange, Freddie noted that most of the risk in these policies would be unwinding due to their natural expiration dates during the remainder of 2008 and throughout 2009.” With the interpretation of the agreement Freddie has, this would not have been the case and the risk would be continuing for a number of years hence.

What I’m doing

With MGIC back to $1.20, it is at a level that no longer prices in imminent bankruptcy. I have been debating taking some of my position off at this level, and reducing the size back down to around one half of what I own in Radian. I still may do that, but, given that MGIC does have a decent case against Freddie Mac, I would not want to eliminate my position completely. I want to keep some skin in the game because a reasonable settlement to the court case with Freddie would likely result in a move in the stock price back to $2.

Aug 20

2 Comments

Week 59 Optimism

Portfolio Performance

Portfolio Composition

(note that US stock prices are converted to equivalent Canadian dollar prices)

Click here for the last two weeks of trades.

Portfolio Summary

If we lived in a world where we could have perfect understanding, there would be no such thing as an optimist or a pessimist. In such a world we would be able to comprehend the extent of all current conditions and evaluate the events to come by extrapolating those conditions into the future.

Instead, however, we live in a world that is too complex to understand with much certainty at all, and therefore our predictions are at best educated guesses.

Of course there are times when pessimism is warranted. Times such as the fall of 2008, where, if you understood the intricacies of the mortgage market and the speculative excesses that it had come to embody, you could have drawn a number of pessimistic conclusions with sufficient certainty, and having that pessimism would have been profitable.

And, to be sure, there are many times when the best course of action is to shrug your shoulders and walk away. I’ve done just that on more than one occasion over the course of my investing life and over the life of this blog. There is little tolerance for a hero in this game.

But you can’t walk away from everything, and rarely can conclusions be clearly drawn. If a choice is to be made, the eventual direction often comes down to whether you look upon the current set of conditions optimistically or pessimistically. And I think in the end the choice is as much determined by the view of the world you wish to embody than your evaluation of the cold, hard facts.

As a general rule, while I allow myself to be swayed from optimism to pessimism with the market, I prefer to be on the optimistic side and I tie my rope securely to that dock for the long run.

The reality is that focusing on the negatives is a tough way to make money. How many great ideas are conceived within the depths of despondency? I think it’s a rare soul that has the constitution of someone like Jim Chanos; to devote themselves to the discovery of the flaws created by others and use that to their own advantage.

I think that when I am too pessimistic I have a lot of difficulty seeing the potential of what something might become. And because of that I will err on the side of caution and miss out on opportunity. While caution is often prudent, caution alone will not beat the market. Caution will doom you to a life of mediocre returns.

It simply does not pay to be too pessimistic. For every 2008, where the bears rule the day and laugh at the collapsing bulls, there are years upon years of bull markets, in this sector or that, usually born out of the depths of a pessimistic bottom. I realize that we can focus today on the outsized debts and unfixed Europe, and we do indeed need to keep a ready eye on both. But are we really so sure the dire ends we are told these debts forebode is so inevitable? I think we often forget just how much healing a good dose of growth can do, how little we understand what truly underpins growth and how often our expectations of growth turn out to be wrong. In particular, the United States is now 7 years into a massive and probably once in a life time housing correction. What if it ends?

We rarely ever identify the turn ahead of time. It is only looking back that we can point to signs that in retrospect appear unmistakable. But at the time those signs appeared as a one-off fluke to the upside or a dead-cat bounce. It is only after a stock breaks out that it becomes inevitable that it would do so.

Yesterday I posted about Impac Mortgage, which I bought last week. Two weeks ago I talked extensively (and hopefully realistically) about the problems that MGIC and Radian have and why I was willing to optimistically bet that they will find a way out of what still remains quite messy. I am finishing up a piece on PremierWest Bancorp, which looks to me to be turning around after a miserable performance over the past year. In all cases I am carefully weighing my conclusions, never getting to zealous in my conviction, but, above all, I am trying to look optimistically at what might happen if things start to go a bit right.

It is a strategy that has worked better for than a pillow.

Aug 19

5 Comments

Impac Mortgage: Out of Nowhere

Sometimes you have to act before you know the whole story.

I’ve been on holidays all week and have had pretty limited access to the internet. I’ve checked my emails maybe once a day at most. On Tuesday night I checked and I noticed the following google alert (by the way I would highly recommend using google alerts for all key words and company names. Its an invaluable tool).

I had never heard of the company but I’ve been looking for other ways of playing the origination and servicing industry, especially through smaller companies. So I read the earnings release.

50 cents per share earnings in the second quarter. Most of the earnings appear to be coming from plain vanilla mortgage origination (same business as PHH). The company almost doubled origination revenue year over year. They also hold on to their servicing rights and appear to be growing their servicing portfolio.

Then I check the stock price on yahoo. The stock had a $2.30 close before the earnings release.

Wait a minute. This company just earned 50 cents in the quarter and its trading at $2.30 per share?

Well before I went to bed I thought about what I needed to clarify before the market opened the next day if I were going to buy the stock. I needed to make sure that the share structure was what it appeared. I needed to make sure that the earnings were legitimate (that they were coming from mortgage origination and not from a one time mark to market valuation change). And I needed to make sure that there wasn’t some sort of debt or financing issue (for example some sort of GSE putback overhang) that would put the company close or perhaps over the precipice.

I read through the 10-Q, which was released with earnings, and I read through the 10-K risk factors. I didn’t see any red flags. So I took the optimistic attitude that maybe this stock was simply mispriced. Maybe it was like all the other mortgage related stocks and the mortgage industry itself and it was just hated to the point where it no longer reflected reality.

First thing in the morning before everyone woke up and I had to get off the computer (it was a vacation after all) I bought some stock. I took a 1% position in each of my portfolios, including the one followed here:

By the end of the day, the stock was trading over $4.

I give this history in part because I hate to write up a stock after its had a run like Impac has. I’m sure its going to sound to some like a pump and dump or an unlikely piece of luck. Yet this blog is about the stocks I’ve bought so that’s what I have to write about and that’s what I’m doing.

As well, specifically regarding the outlook of Impac Mortgage, even though the stock has run up a rather ridiculous 100+ percent in the last 4 days, I think it may go a lot higher. If I’m reading it right and not missing anything (which keep in mind I very well could be), the stock has room to run. After all this was a $250 stock in 2005 and even after the run up, the market capitalization is a miniscule $30 some million dollars (though there are additionally some preferred’s outstanding). I’m not just talking the talk. I doubled my position on Friday at $4.26.

So with a word of warning that any stock that has risen 100% in less than a week should be carefully considered before buying, let’s take a look at what the company does.

On to the company…

The story here is a simple one. Impac is a mortgage originator that has been growing it origination volumes substantially for the past year, and that growth has finally reached the inflection point where it has become profitable.

The company originates mortgages through retail, wholesale and correspondent channels. A breakdown of origination volume by channel for the second quarter is illustrated below:

The company has developed a significant retail platform. Retail lending is when the company deals directly with the borrower, as opposed to wholesale and correspondent lending where they are acting through independent brokers and correspondents who are originating the actual loans which are then sold to them.

The retail business is more often the higher profit business (because there is no middle man taking a cut) but it also requires more up front capital and fixed costs as you have to develop the infrastructure, the marketing, the people and the relationships required to interact with the borrower directly. These higher start-up costs were at least partially responsible for the losses incurred in previous quarters. The company made the following statement with respect to this in the year end 10-K:

In 2011, the mortgage lending operations has been successful in increasing its monthly lending origination volumes to be in excess of $100 million. However, although the mortgage lending revenues increased in 2011, expenses associated with the mortgage lending activities significantly increased also. The increase in expenses was primarily due to start-up and expansion costs with opening new offices, hiring staff, purchasing equipment, investing in technology and the supplemental default management team as discussed above. Specifically, as the Company attempts to build a purchase money centric platform with a significant amount of retail originated loans; the related start-up costs for this type of origination platform will be higher than a wholesale refinance focused mortgage operation. In addition, the Company has made small investments in proprietary technologies that will further support our expansion of retail originated purchase money mortgages along with more competitive recruitment of realtor direct loan officers. The Company believes this is the right strategy in the long term as interest rates on mortgage loans are expected to rise in the future, which will greatly reduce the percentage of refinance transactions to more historical percentages. In order for the mortgage operations to achieve profitability, we will need to (i) increase overall origination volumes, (ii) improve lending revenues by originating a higher percentage of retail loans and products with wider margins and greater loan fees and (iii) reduce lending operating costs through increased operational efficiencies, or some combination of them.

While in the second quarter most of the growth was from the wholesale channel, future growth is expected to be driven from retail.

Second quarter volumes in the wholesale and correspondent lending channels led to significant volume increases over the first quarter; however, retail expansion during the second quarter is expected to lead to a corresponding increase in retail production during the 3rd quarter. Retail production is also expected to increase from the opening of the previously announced Reverse Mortgage operations.

Moving on to margins, Impac’s margins on mortgage lending look comparable to other companies I follow. The company booked mortgage lending gains and fees of $15.1 million on $531.9 million of loans originated. That is a total gain of 283 basis points. To compare, PHH recorded a total gain on loans of 308 basis points in the second quarter. Nationstar meanwhile recorded gain on sale of 306 basis points.

The company also earns money from mortgage servicing, and they have been growing their servicing portfolio every quarter. I appreciated the company’s comments that they saw opportunity in holding on to the service rights of the mortgages they are originating given the ultra-low rates and high quality loans that are being written.

Excel expects to continue building its mortgage servicing portfolio as management believes a servicing portfolio of agency loans during a period of low interest rates and high credit quality focus is a good investment for the Company.

It’s the same line I’ve been saying for months now.

The company hasn’t been reporting the total balance of loans serviced for very long, but below the increase over the last 3 quarters is illustrated:

The company hires a subservicer to perform the servicing activities. Assuming 25 basis points for the servicing fee and 7 basis points going to the subservicer, the company stands to pull in around $2 million in servicing revenues per year.

All of the loans originated and serviced are conforming, meaning they are being sold to Fannie Mae, Freddie Mac, or Ginnie Mae.

Things to be concerned about…

With this all said, the company does have some hair.

For one, they do not do a very good job of explaining their mortgage lending revenues. While PHH and Nationstar both provide enough information to determine what they are valuing the capitalized servicing rights at, I can find no way of doing that with what Impac provides.

Second, the company appears to mark to market just about everything, including their long term debt. As noted in the 10-Q:

…long-term debt had an unpaid principal balance of $70.5 million compared to an estimated fair value of $12.0 million

Huh? I don’t know if I am misunderstanding this or what because I have never seen a company mark to market their own debt and I didn’t even know you could do that. Nevertheless, it seems to be what they do and its something worth contemplating the implications of.

Potential upside from The Long Term Mortgage Portfolio

An interesting sort of call option that Impac has embedded into its value comes from their residual interest in a number of securitization trusts. Before 2007 the company originated and packaged mostly sub-prime loans and sold them off to investors through non-recourse trusts. The company kept a residual interest (the equity) in these trusts. The residual interest was the lowest rung on the ladder, being the first to not receive payment in the event of defaults within the trust.

These trusts are basically securizations of mostly Alt-A loans (meaning loans where the borrower does not have full documentation of income or net worth or some other metric that Fannie Mae and Freddie Mac requires).

Probably the most important thing about these trusts is that they are non-recourse to the Company, so the economic risk is limited to the residual interest only.

A break-down of the current fair value estimate of residual interest in the trust by year (taken from the 10-Q) is shown below:

These trusts are carried at fair value and the debt associated with them is also carried at fair value. The difference between the expected fair value of the trusts (which is $5.469 billion) versus the debt (which is $5.446 billion) is $23 million.

While Impac seems to point to this number in its 10-Q I don’t think its terribly relevant. For one, the future value of the trust assets (the mortgages within each trust) are based on a lot of assumptions, including future default rates, prepayment rates, interest rates, and so on.

Probably more importantly, at maturity the debt associated with each trust has to be paid in full, not at fair value. While the overall fair value of the trust assets is a little less than $5.5 billion, the outstanding principle balance of the debt is $9.1 billion. So clearly the debt outstanding outweighs the trust assets. Nevertheless, the trusts are clearly not all a worthless asset. In the second quarter the company collected $4.4 million in cash from the trusts, representing residual interest payments from those trusts that are presumably in a strong enough position to meet the collateral requirements that must be met before cash is paid to the residual interest holder. Value is being realized and the potential for more value to be realized exists.

What I think is worth highlighting is that the future cash flow potential of these residual interests is basically a pure play on the US housing market. Less defaults, stronger cash flow performance from the underlying mortgages, and Impac stands to take in a decent amount of cash from these trusts. If housing goes down for a triple dip, well then you can probably write them off to something pretty close to zero.

Conclusions…

The stock is a bit of a flier, no question about it. The market capitalization is miniscule, the analyst and brokerage following is non-existent, and the disclosure is not as complete as I would like it.

Nevertheless, the industry is right and, if my thesis about the housing market bottoming and potentially surprising to the upside pans out, the timing is right. The company, if you ask me, is doing exactly the right thing at the right time by building its origination business and retaining as much servicing as cash flow will allow. I’ve taken a position and added to it once. If it continues to play out as it appears to me it could, I will continue to add on the way up.