Established in 1993 as a publicly traded mortgage REIT, Thornburg is a single-family, residential mortgage lender that originates, acquires and retains investments in adjustable rate mortgage (ARM) assets, which are mortgage loans with interest rates that change periodically based on a standard financial index.

The company concentrated its first years of operation on buying adjustable rate mortgage-backed securities exclusively, targeting the jumbo segment (loans over $322,700) of the residential mortgage market. The company’s early performance record was satisfactory, although not spectacular, and investors enjoyed modest returns on the company’s $1.4 billion in holdings.

However, Thornburg’s earnings shifted into high gear about five years ago when the company began implementing what Chairman and Chief Executive Officer Garrett Thornburg refers to as “a diversified operating strategy.” With the objectives of increasing income and diversifying Thornburg’s portfolio, the executive team began to acquire packages of ARM loans and hybrid ARMs (loans that have a three-year to 10-year period of fixed interest before converting to a traditional ARM for the remaining term) to its portfolio while maintaining the focus on jumbo loans. As the final piece in its diversification plan, Thornburg began originating single ARM loans through correspondent lenders in 1998, and in 2000 made the leap into loan origination with the establishment of Thornburg Mortgage Home Loans.

“With this strategy, we deliberately positioned ourselves to increase earnings and be consistent in dividends,” Thornburg says. “Since implementing this plan, we have experienced annual EPS [earnings per share] growth averaging 36 percent.”

By actively managing credit risk, interest rate risk and prepayment risk in both the acquisition and origination sides of the business, “We can provide sustainable, stable growth over time, regardless of what happens in the stock market or with interest rates” —Garrett Thornburg

Today, Thornburg Mortgage’s portfolio includes a mix of ARM and hybrid ARM securities and loans that TMA has acquired or originated. But there is no doubt that for the past three years, most of Thornburg Mortgage’s growth has been through its loan origination business. Since the launch of Thornburg Mortgage Home Loans, net EPS has increased from $0.88 in 1999 to $2.59 in 2002. In 2002, originated loans accounted for 40 percent of the company’s growth; by 2005 the company expects that share to rise to 70 percent.

Following an incredible 2002 performance that included a 24 percent year-over-year increase in EPS, Thornburg Mortgage is more than halfway through what promises to be another stellar year, says President and Chief Operating Officer Larry Goldstone.

Second quarter 2003 marked the eighth consecutive quarter of record earnings for the REIT with year-over-year revenue growth of 54 percent, fueled by strong portfolio growth and efficient capital raising. Net income for the second quarter increased to $41.6 million, representing $0.67 per share of common stock, a 6 percent year-over-year increase. The $0.62 per share dividend declared for the second quarter 2003 was a 9 percent year-over-year increase and a 3 percent increase over first quarter 2003.

Loan Origination Driving Growth

Retail customers looking for a new mortgage won’t find a Thornburg Mortgage Home Loan office on their local Main Street. Licensed in 46 states and the District of Columbia, Thornburg operates only through the Internet, by telephone, through financial planners or correspondence lenders, a network of selected banks, savings and loans and credit unions.

“Earlier this year we introduced our corporate affinity program as another channel for loan originations,” Goldstone adds. “We are partnering with selected companies that provide their employees Internet access to our products and features via co-branded Web sites.”

Loan origination through these channels has put TMA on the fast track for portfolio growth. In 2002, the company originated $2.3 billion in loans, a 290 percent increase over 2001, contributing to an 81 percent increase in portfolio size to $10.5 billion. In the first quarter of 2003, TMA originated $863.1 million in loans, exceeding its goal by 15 percent and expanding portfolio value to $12.4 billion.

		Upside-Downside Samplings of what analysts are saying about Thornburg Mortgage...

TMA’s loan origination business showed continued strength in the second quarter, although slowing slightly from the first quarter. Goldstone reports that between April 1 and June 30, 2003, TMA originated $814.1 million in loans, contributing significantly to $2.8 billion in portfolio growth that expanded the total to $15.2 billion. This was followed by $300 million in originations in July, and a $727.8 million pipeline of mortgage loans as of August 1 suggests that the third quarter will also make a strong showing in loan originations.

After exceeding its first quarter capital-raising goal by 63 percent and raising net proceeds of $122.2 million, TMA raised an additional $56.4 million in the second quarter. “Year-to-date we have raised $178 million in new equity capital, and we are well on our way to meeting our target for the year of $300 million,” Goldstone says.

The company makes its equity offerings through six investment banks and also relies on its dividend reinvestment program and controlled equity offerings as a source of low-cost capital. “Two controlled equity offerings in the past six years have raised $161 million, and a third program is in the works,” Goldstone reports.

Managing Risk

As mentioned previously, Thornburg Mortgage maintains portfolio diversity by purchasing both traditional and hybrid ARMs as mortgage-backed securities and bulk loan packages on the wholesale market. Hybrid ARMs now comprise 78 percent of Thornburg Mortgage’s portfolio.

Increasing the percentage of hybrid ARMs in the portfolio has “positive profitability implications,” according to Credit Suisse/First Boston research analyst Moshe Orenbuch. “The company earns a higher coupon on these loans, which earns the company a higher spread [that] the company can sustain over the fixed rate portion of the asset’s life (roughly the next three to five years),” Moshe notes in his second quarter report on TMA. He pegs the yield differential between hybrid products and generic ARMs as 150 to 200 basis points.

“We go to great lengths to minimize our exposure to both credit risk and interest rate risk,” Goldstone says. “However, reducing risk costs something, which lowers our return on capital. But, we think that operating in as low a risk fashion as we can, especially when compared to our lending peers, will maximize shareholder value.” —Larry Goldstone

Currently, TMA’s acquisitions are yielding a 14 percent to 16 percent return on equity, and originated assets are generating a 16 percent to 20 percent return. By actively managing credit risk, interest rate risk and prepayment risk in both the acquisition and origination sides of the business, “We can provide sustainable, stable growth over time, regardless of what happens in the stock market or with interest rates,” Thornburg says.

This is possible, he says, because TMA faithfully adheres to three fundamental principles that keep risk in check. “We don’t take credit risk, we purchase only securities with an AA rating or above, and we don’t take interest rate risk,” he says.

To manage credit risk, Thornburg Mortgage focuses on only high quality, single-family residential ARM securities and loans, yielding a portfolio of extremely secure assets. (Nearly 100 percent of its portfolio is AA-, AAA-rated or government guaranteed ARM assets.) The company does not purchase or originate subprime mortgages, second mortgages or derivative products such as interest-only strips. While these products may provide higher short-term returns, their volatility and substantial risk are not compatible with Thornburg Mortgage’s business plan, Goldstone says.

“Thornburg had no credit losses in the second quarter, and has only experienced credit losses of $174,000 over the past five years (on $5 billion in loans), when the company began acquiring whole loans in its mortgage portfolio,” according to Orenbuch.

Without exception, purchased loans must be fully documented and meet TMA’s internal credit standards. The company’s correspondent lenders specialize in servicing A-quality borrowers, and all loans are underwritten according to internal guidelines. The average loan-to-value ratio is below 70 percent, and borrowers typically have high credit scores and considerable cash reserves.

The quality of TMA’s assets keeps the company’s delinquency rate consistently below the industry average. The company weighs in with a 0.09 percent rate for the second quarter, compared with the national residential mortgage 60-day plus delinquency average of 1.5 percent across all mortgage lenders.

Overall, Thornburg Mortgage “is doing a great job,” comments Bill Camp, an A.G. Edwards & Sons analyst who followed the company for several years. However, he cautions that the company is not immune to the impact of changes in market fundamentals. “If the fundamentals are there, they [TMA] will outperform, but if they aren’t there, they can’t,” he says. “They are still tied to the mortgage world, and there is a risk that things will slow down.”

Impact of Interest Rates

The primary risk on the horizon for all mortgage companies is the looming threat of rising interest rates. Interest rate fluctuations can have a significant impact on mortgage REIT earnings—when rates go up, the spread between cost of funds and profit on assets narrows. “We control our exposure to interest rate fluctuations by purchasing and originating only adjustable rate mortgages,” Goldstone says. The yields on ARM assets, along with financing costs, respond similarly to changes in underlying market interest rates, creating a natural hedge against interest rate risk.

Goldstone notes that TMA further controls the impact of fluctuating interest rates by avoiding short-term borrowing to fund its acquisitions. “We match the maturities of our borrowings with the repricing of our assets [e.g., five-year ARMs matched with borrowed funds with a five-year maturity]. By borrowing funds with maturities that match the interest adjustment periods on the ARM assets that we acquire, we have been able to keep our net portfolio spread relatively constant despite the current low interest rates,” he explains.

Hybrid ARMs with a fixed interest rate in Thornburg Mortgage’s portfolio are funded with fixed rate borrowings with comparable maturities. Of the $7.6 billion the company currently has secured in long-term, fixed-rate financing, the average maturity is about three years. This means that funding costs are locked in for the fixed-rate period of the hybrid ARMs so that earnings will be protected when interest rates rise.

“We go to great lengths to minimize our exposure to both credit risk and interest rate risk,” Goldstone says. “However, reducing risk costs something, which lowers our return on capital. But, we think that operating in as low a risk fashion as we can, especially when compared to our lending peers, will maximize shareholder value. So, our return on equity may be lower, but our price/earnings multiple should be higher and our dividend yield lower because we have less risk. This should result in a higher stock price and better growth rate of earnings and dividends over time.”

Camp predicts that TMA will continue to grow, but at a slower pace than in recent history. “Dividends will be fine, as long as [the company] is growing,” Camp says. “But, investors should expect a modest increase in dividends, nothing like what we have seen in the past.”

Adds Orenbuch, “When interest rates rise, TMA’s stock will not do well, although the company will continue to do well.”

Thornburg says he anticipates challenges ahead as interest rates rise, but not to the extent that the company’s growth and dividends will be significantly impacted. “The low interest rate environment has allowed us to quickly build our origination business,” he admits. “When rates go higher it will be more challenging to capture market share and grow, but we expect dividends to still be strong due to our portfolio management strategies.”

The negative effects of higher interest rates will be partially offset by a significantly lower prepayment risk. In the current low interest rate environment, “we have minimized prepayment risk by purchasing and originating assets near par and by buying from lenders with a history of low prepayment rates,” Goldstone explains. “As interest rates rise, prepayment risk will decline so that we will be able to maintain the current size of our portfolio with fewer assets.” Another plus for higher interest rates: “An increase in interest rates also would allow us to acquire higher yielding assets,” he adds.

Rising mortgage loan rates that narrow the spread between long and short-term rates could squeeze profit margins for mortgage REITs that lend long and borrow short. But Goldstone points out that TMA operates in such a way that it would not be affected significantly by any narrowing of the spread. “Unlike many mortgage REITs that borrow short and lend long, we lend and borrow at the same point on the yield curve,” he says. Narrowing of the spread between short and long-term interest rates is not much of a concern for us.”

Despite the company’s steps to protect itself from interest rate fluctuations, Camp suggests that the company is still vulnerable to market perception risk. “While market fundamentals and the wider use of derivative instruments to hedge against interest rate changes could help insulate fundamentals, some equity holders may still choose to exit the mortgage REIT sector in a rising interest rate environment, which could cause the shares to trade lower,” according to Camp.

Cautious Optimism Prevails

Coming off a record year and an outstanding first half, Thornburg Mortgage’s management team, including Goldstone and Thornburg, believes the company can continue to deliver, despite an uncertain interest rate environment. In April, TMA revised guidance for 2003, estimating a $0.67 per share dividend for the second quarter and $2.60 per share for the year.

Second quarter results have divided investment analysts on the question of whether the company can sustain revenue growth. “They have three more really good quarters when they will outperform, then we will see modest growth,” Camp reiterates. He predicts that total returns will “settle down” to around 10 percent.

Several months ago, A.G. Edwards backed off on its rating of Thornburg, downgrading the stock from “Buy” to “Hold” and citing the high probability of deterioration in the mortgage lending environment. A.G Edwards reduced its 2003 EPS forecast to $2.71 from $2.76 and the 2004 EPS from $2.80 to $2.77.

Overall, analysts with Thomson First Call gave Thornburg Mortgage a 2003 EPS estimate of $2.61 in April, with estimates ranging from $2.54 to $2.66 per share; that was upgraded to $2.69 in June and to $2.70 in August, based on company guidance of $2.66 to $2.72. TMA holds to its expectations of finishing at the higher end of that range, Goldstone says. “We accomplished a lot in the second quarter that set the stage for a strong second half.”

Positioned to Meet Challenges

Thornburg has ambitious plans for the rest of 2003 and into 2004, regardless of how interest rates move. For starters, the company plans to increase its origination business by 15 percent to 20 percent this year and achieve $7 billion in originations by 2005, despite national economic forecasts that predict a 25 percent decline in new mortgages. Goldstone believes that interest rate cuts by the Fed, Thornburg’s major marketing initiative to build direct lending relationships with financial planners and the company’s first advertising campaign will create a positive synergy that will help the company reach its goals. Investors should see the results as stable to slightly higher profits for the rest of the year, he says.

As phenomenal as its growth in the ARM market has been, the company has captured only about 1 percent of the $200 billion annual ARM market. Thornburg Mortgage has set its sights on expanding its market share to 2 percent.

The problem with this scenario, Camp notes, is that the company may end up with a bigger piece of a shrinking pie. “In a business where volume is falling, gaining market share may not be growth,” he says

Still, the origination business is the key to Thornburg Mortgage’s future success and growth, Orenbuch says. “Thornburg’s ability to control origination has allowed it to expand its portfolio, and the company has done it with controlled risk,” he says. “Although there was some skepticism at first, it seems to be working well. Thornburg has built an operating model that puts them in a better position [than other mortgage REITs] for going forward.”