Misery Continues for Big Mortgage Players

Talks of a Countrywide buyout may have bolstered mortgage stocks on Jan. 10, but one big deal won't cure the sector's ills

Talk that Bank of America (BAC) may be close to cementing a deal to buy Countrywide Financial (CFC) may have rescued stocks of mortgage lenders from their lows on Jan. 10, but no one expects the acquisition to save the mortgage industry as a whole from an extended period of pain as the housing slump runs its course.

And while there's little similarity between Countrywide and companies like Thornburg Mortgage (TMA), which aren't seen at serious risk of going under, investors' aversion to all kinds of mortgage debt has caught the various players in the industry in the same net.

Given continued deterioration in the credit markets, it's hard to fault the market for hammering shares of Thornburg after the company's Jan. 9 announcement that it plans to raise $200 million in capital through two public offerings.

After all, Thornburg's announcement came fast on the heels of a rumor that Countrywide would soon be filing for bankruptcy protection, a rumor the nation's largest mortgage lender denied. That talk of insolvency dissipated quickly on Jan. 10 after the Wall Street Journal reported that BofA is in "advanced talks" to acquire Countrywide.

It was a $2 billion investment by BofA last August, in the form of a non-voting convertible preferred security yielding 7.25% annually, and which is convertible into a 16% equity interest in Countrywide, that's widely believed to be the reason for the company's survival to this point.

Volatile activity in Countrywide shares has raised eyebrows on the Street in recent days and shone a spotlight on the mortgage sector. The shares swooned amid bankruptcy rumors on Jan. 8 and fell further after a Jan. 9 update in which the company said payments in December were overdue on 7% of the total loans it services, compared with 6.3% in November and 5% a year earlier. Foreclosures were pending on 1% of all loans serviced, up from 0.65% a year before.

The steep drop in Countrywide's market cap over the past year to roughly $5 billion makes it attractively priced, even if its assets may be worth less than its liabilities, Standard & Poor's said in a research note on Jan. 10.

While Countrywide's being acquired by Bank of America won't shorten the process the housing sector needs to go through to right itself, a deal could still provide some comfort.

Talk that BofA was interested in buying Countrywide enabled shares of the troubled mortgage lender to bounce back from being down nearly 6% to a 51.4% gain to $7.75 at the close of trading on Jan. 10.

"We believe that a solvent Countrywide is good for the overall market, since a failure of the company could have further negative implications for the housing market," the S&P note said.

Still, it's not really fair to paint Thornburg and Countrywide with the same brush. Unlike Countrywide, Thornburg originates or buys mortgages to wealthy homeowners with top-notch credit quality. The high quality of its assets ensures access to necessary financing from securities dealers, notes Bose George, an equity analyst at Keefe Bruyette & Woods.

Nor has Thornburg been tainted by questions about dubious lending practices that may have encouraged borrowers to take on mortgages they couldn't afford. Thornburg, based in Santa Fe, N.M., issues only jumbo-sized mortgages, worth at least $417,000, though many of them still have adjustable rates.

But in a credit environment that has investors generally avoiding mortgage debt, market perception of the distinctions between the two companies have blurred.

On Jan. 9, Thornburg said it would launch two public offerings concurrently to raise about $200 million in long-term capital. One offering will be for an additional 4.5 million shares of its existing convertible, redeemable preferred stock and the second is for 11 million shares of common stock.

The majority of the net proceeds of the offerings will be used to finance the acquisition or origination of additional adjustable-rate mortgages, Thornburg said in its news release. The rest of the money will cover liquidity needs and working capital, possibly including repayment of maturing debt obligations, it said.

Investors may have balked at the dilutive effect the additional shares will have on Thornburg's earnings per share, and the stock initially sank on the news on Jan. 10. The BofA news later in the day helped Thornburg shares regain some ground, and the stock closed 4.6% lower at $8.38 after having fallen as much as 12% earlier in the day.

Thornburg, which is structured as a Real Estate Investment Trust, surprised the market in mid-October when it eliminated its dividend, citing the need to conserve cash for further events related to the credit crisis. But during the fourth quarter, the company successfully met all of its margin calls - or requirements to boost the collateral it posts on loans - from lenders thanks to $500 million in cash it had raised by selling $21.9 billion worth of assets in August, said George at KBW.

In December, the company declared a 25-cent common dividend for the fourth quarter, though its book value dropped substantially as the value of its asset and swaps fell during the quarter.

Company executives recently spoke of attractive investment opportunities with returns on equity between 15% and 20%, George wrote in a Jan. 10 research note. (KBW expects to provide investment banking services to Thornburg within the next three months and makes a market in its securities.)

Although Thornburg said it was raising capital in order to buy assets, Bose said that he thinks part of the market's concern is that the company might want some excess capital on hand in case credit market conditions continue to worsen.

A profusion of weak data from mortgage companies has put pressure on Thornburg's stock price, and asset values prices and liquidity have been extremely weak since the beginning of this year, George said.

Although it acknowledged the attractive yields new investments will probably offer, Standard & Poor's said on Thursday that it had concerns about earnings-per-share dilution stemming from the equity offering at a price below S&P's book value estimate. The stock research outfit reaffirmed its hold rating on the stock but trimmed its 12-month target price to $9 from $10 to reflect lower peer multiples. (S&P, like BusinessWeek, is a division of The McGraw-Hill Companies (MHP).)

Thornburg's book value remains at risk due to lingering hostility from the financing market and the threat to its swap values posed by declining interest rates, Credit Suisse analyst Moshe Orenbuch said in a Jan. 10 research note.

He predicted Thornburg shares would trade at a discount to their $8.20 book value and reiterated his underperform rating and $5 price target. (Credit Suisse does and seeks to do business with the companies covered in its research reports.)

Market perception may become more positive if the company is able to get sufficiently strong returns on the assets it buys, which will be mortgage-backed securities from the secondary market, said George at KBW.

As for Countrywide, analysts may have to follow it from afar as just another name in the giant BofA stable.