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:

1. The market lumps mortgage servicing rights in as just another housing play, and housing is still 2-3 years away from recovering
2. Mortgage servicing rights are complicated and most market participants don’t want to take the time to understand them
3. 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.