Impac Mortgage: A Growth And Value Story

I wrote the following article on the weekend for SeekingAlpha publication.  Hopefully it will be published on SeekingAlpha in the next few days.

Impac Mortgage Holdings (IMH) is a very simple thesis and so I am going to get straight to the point. Impac is a mortgage originator and real estate services provider that has been growing their origination business at an impressive rate. In addition to its two operating segments, the company has discontinued operations in run-off associated with its pre-2008 activities in mortgage lending and as the manager and residual holder of non-recourse trusts.

Impac earned $1.50 per share from mortgage originations and real estate services in the third quarter. The mortgage origination business pulled in earnings per share of $1.04, while real estate services business earned $0.46. Below are earnings for these two segments over the first three quarters of 2012.

In addition to these strong numbers, growth is expected to continue to be strong going forward. The company noted on the third quarter conference call that origination volumes in October were another 22% higher than the average monthly volume in Q3.

As the earnings from the Mortgage Lending segment attest, Impac Mortgage has seen tremendous growth in its mortgage origination business over the past few quarters. The company has grown its market share at an extraordinary rate. The chart below shows just how substantially Impact has grown its origination volumes since the beginning of 2011.

The vast majority of loans originated are sold to Fannie Mae or packaged into Ginnie Mae securities on a servicing retained basis. This strategy has allowed Impac to amass an impressive portfolio of agency mortgage servicing rights. Currently the portfolio of servicing rights has an unpaid principle balance of $1.7 billion. This is up substantially from Q2, as the chart below illustrates:

I have already written an article about the opportunity in mortgage servicing here. To recap that thesis as it applies here, Impac is growing their book of servicing on Agency backed loans at a time of record low interest rates and strict lending standards. Thus the company is amassing a portfolio of high quality servicing that should pay out for years to come.

The growth story at Impac Mortgage is one of growing origination volumes from its retail, wholesale and correspondent channels, an expanding portfolio of mortgage servicing rights, and future growth opportunities in commercial mortgages in 2013. The value story at Impac Mortgage is because the current share price of $12 only prices in 2x third quarter earnings.

GAAP Earnings are Misleading

With the basic thesis out of the way, lets get into the details. The difficulty in analyzing Impac Mortgage is because the company’s GAAP earnings are obscured by a couple of factors. These factors are similar to the ones that are obscuring the results of many financials, originators and mortgage servicers these days.

In particular, Impac reported the following GAAP adjustments last quarter that are not related to the earnings of the two operating segments:

1. Mark to market and real estate owned adjustments of non-recourse trusts
2. legal fees and repurchase requests from their discontinued legacy business

The adjustments and one time charges led to significant negative GAAP earnings from these discontinued and non-recourse operations. Earnings of the non-recourse trusts and the discontinued legacy business are tabled below.

Let’s talk about each adjustment item in turn to get a clear picture of why they do not represent recurring earnings from operations.

Mark to Market adjustments on non-recourse entities

GAAP earnings at Impac are misleading because they include the mark to market and REO adjustments of trusts that the company manages and holds residuals in but of which the assets and liabilities are non-recourse to the company (the company defines these trusts as its Long-term Portfolio segment). Because these trusts are non-recourse, the mark to market adjustments have no economic impact on the company.

The company originated mortgages prior to 2008 and sold some of these mortgages into trusts that bought them with funding they received from investors they sold securities to. This was just the sort of securitization process that was common prior to the 2008 meltdown.

The problem for financials that had originated these sorts of securitizations is that so long as they continued to hold a residual interest in them (which Impac does) and held a management capacity within them (which Impac does) they had to hold them on their balance sheet and mark the assets and liabilities to market every quarter. I’ve seen the same effect for Newcastle Financial and Gramercy Capital and it makes a cursory look at the balance sheet and income statement of such companies confusing.

While the intent of having such entities on the balance sheet was to increase transparency, in some ways it does the opposite because every mark to market adjustment has to feed through onto the income statement, even though the change in value of the assets is of no importance to the company’s operations. Given that the assets and liabilities in these trusts are currently marked at a fair value of over $5 billion, it does not take much of a mark to market adjustment to throw off GAAP earnings substantially.

Yet what matters is that these trusts are non-recourse to the company. Apart from the residual interest that Impac holds in the trusts (which I will get to in a second) the company has no liability to them. Thus any true look at company earnings should ignore the market to market and asset valuation adjustments that they cause.

The Residual in the Trusts Spin-off Cash

The only true economic impact that these trusts have on Impac Mortgage is with respect to the cash residual they pay.

Even though many of the trusts have been adversely affected by the housing collapse (in fact Moodys downgraded a small amount of these trusts just recently), some of the trusts still have enough performing assets to pay a decent residual. When the interest paid on the assets owned by the trusts exceeds the interest required to be paid by its liabilities, and so long as all the collateralization requirements are met, Impac receives the excess cash as a residual payment.

These amounts are not inconsequential. In the third quarter Impac received $2 million in residuals from the trusts, and in the first 9 months they received a total of $7.9 million. That works out to $0.25 of cash in the third quarter and over $1.00 per share of cash flow from the residuals over the first 9 months. And none of that cash is included in the $1.50 per share Q3 operating earnings that I quoted at the beginning of the article.

Further, while perhaps it is not necessarily a likely scenario, there is a chance that Impac will realize further upside from the trusts. Since Impac owns the right to residual cash flows, if the trusts begin to perform better, perhaps because of an improving housing market, Impac will capture that upside. Admittedly it is difficult to quantify exactly how much upside that may be, so it remains only a wildcard that investors should keep an eye on. Nevertheless, according to the third quarter 10-Q, in the first 9 months of 2012 the fair value of trust assets increased almost $700 million, which is not inconsequential.

Legal Fees and Repurchase Requests

In the third quarter the company resolved two separate legal disputes for a settlement cost of $6.1 million. While these legal settlements were substantial, they removed two potential litigations and left the company with no major outstanding lawsuits.

These legal costs were considered part of discontinued operations because they were made against the company’s pre-2008 business of originating Alt-A loans. Nevertheless, the GAAP number was affected by the settlements and they were a heavy contributor to the negative GAAP earnings in the third quarter.

One of the points I have heard made to stir up fear about Impac is the threat of other looming litigation. But the fact is that Impac addressed this directly on its third quarter conference call. Management first pointed to the rather obvious fact that any company that originated mortgages in the period before 2008 will be subject to at least some pending litigation these days. But management then went on to state that “we don’t have any large lawsuits currently”. They also suggested that what pending potential litigation there was “out there hanging around” and that they may or may not amount to anything. To get comfortable with what remains of existing possible litigation, I would invite a read through of the latest 10-Q and 10-K notes: Legal Proceedings. I have read through both and see nothing out of the ordinary or worrisome in the disclosure.

Apart from court cases, Impac continues to resolve repurchase requests made by Fannie Mae. This should come as no surprise to anyone, as any investor who has followed PHH Corp, Bank of America, or any other originator of pre-2008 mortgages is well aware of the repurchase requests of Fannie Mae. Much like PHH, the repurchase requests are on the decline at Impac. Reserves for repurchase requests fell from $2.3 million in Q2 to $1.8 million in Q3. Impac noted in the third quarter 10-Q that “although the number of repurchase requests are decreasing, the Company still continues to receive new repurchase requests while successfully disputing and resolving others.” If PHH guidance can be a guide, these requests should continue to fall, but remain elevated from historical levels until the end of 2013.

Growth Going Forward

In 2011 Impac got back into the mortgage origination business primarily as a wholesale lender with a smaller retail business. Early in 2012 they expanded into correspondent lending. In the third quarter they focused on expanding their retail channel. The success the company has had in each segment is evident in their growth over the last 9 months:

The company is focused on increasing its purchase money business (loans made on homes being purchased). While refinancing of course makes up a majority of the origination business right now (74% in Q3 versus 26% purchase money business), the company has made specific mention on both the Q2 and Q3 conference calls, as well as in the excerpt below from the third quarter 10-Q, that their focus is on developing relationships with realtors and brokers and focusing growth on the purchase money business, in order to take advantage of the nascent housing recovery:

The Company continues to expand its purchase money channel capabilities by leveraging proprietary technology to increase its realtor relationships. As of September 30, 2012, the Company has over 1,000 realtors using our technology. Our goal is to use our technology to facilitate relationships between our retail loan officers and realtors to drive more purchase money lending volume.

While some might question the sustainability of the refinancing business over the long run, what I think is happening at Impac is better seen as a market share story. The company is taking market share from competitors at an extremely fast rate, expanding into new states and new origination channels. Keep in mind that the last 5 years have been terribly hard for individual mortgage brokers and smaller correspondent lenders, who have been hit with changing and increasing regulation that have squeezed operating margins. With the regulatory environment unlikely to improve, things are only going to get tougher for smaller operators. Meanwhile some of the larger banks have stepped back from aspects of the mortgage business, particularly the correspondent side. Impac is positioned to take advantage of this dearth of competition and so far it has done just that, scooping up market share at an impressive rate.

In addition to growth in its traditional channels, Impac has began to offer reverse mortgages, jumbo mortgages and 203K mortgages (which are FHA guaranteed loans used to rehabilitate damaged properties).

A final growth initiative was mentioned for the first time on the third quarter conference call. In response to a question, management confirmed that they have began to refocus attention on commercial mortgage originations. The commercial real estate business used to be a large segment for Impac before 2008. The company said that they are originating loans right now, and that they are currently “in the process of creating programs for 2013 will lead to the reemergence” o the segment. One has to wonder how closely the company can duplicate the success it has had in the residential business.

Net Operating Losses

Lastly, one advantage of having survived the collapse of the housing market is that the company has extremely large net operating losses that it can apply against future earnings. On the third quarter conference call the company noted that net losses at the Federal level were $500 million, while at the state level they were $400 million. What this means is that it will be a long time before Impac has to pay taxes on its earnings.

Conclusion

Impac ran up from $2 to a high of over $18 in an extremely short amount of time. I have been invested in the stock since the second quarter earnings release and have been in awe of the move up. The correction from $18 to $12 was a natural consequence of such a parabolic move. But investors should be careful not to confuse the violence of the moves with the operating potential of the company. Impac is not yet held by institutions and has no brokerage following that I know of. The uncertainty apparent in the moves more likely reflects the lack of analysis of the core businesses than it does the businesses themselves.

The current stock price of $12 prices just a 2x multiple to the annualized third quarter earnings of the mortgage origination and real estate services businesses. The fourth quarter is almost certainly going to show earnings growth from these businesses over the third. In addition, the discontinued and non-recourse businesses are running off, the company has put two lawsuits behind them, the residual trusts continue to generate excess cash (and in the off-chance there is a robust real estate recovery, have the opportunity to increase their residual distributions to the company) and the repurchase demands of Fannie Mae are expected to slow. It is my opinion that even with the impressive move in the share price over the past 4 months, there is plenty of opportunity for further appreciation going forward.