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No. of Recommendations: 28
This is a long somewhat dry look at a financial services company. There is a lot of detail included that probably shouldn't be but the terms are often difficult as are the strategies and for that reason some basic ground work was laid.


Thornburg Mortgage Inc. TMA, deals in adjustable rate mortgages--both loans and securities.ARM securities represent interests in pools of ARM loans, which are publicly rated and include guarantees or other third party credit enhancements against losses from loan defaults. They deal for these with companies like Fannie Mae and Freddie Mac. ARM loans consist of securitized(collateralized) ARM loans, ARM loans collateralizing long-term debt and ARM loans held for securitization. Like traditional banking institutions,income is generated primarily from the net spread or difference between the interest income earned on ARM assets and the cost of borrowings.

They buy ARMs from investment banking firms, broker-dealers and similar financial institutions that market these assets. And they acquire ARM assets from:
*mortgage bankers
*banks
*savings and loan institutions
*home builders
*other firms involved in originating, packaging and selling mortgage loans

They originate ARM loans for their portfolio through their own correspondent lending program, which currently includes approximately 129 approved and active
correspondents, and they originate loans direct to consumers through a wholly owned mortgage loan origination subsidiary, Thornburg Mortgage Home Loans (TMHL).

Their business strategy is to acquire and originate ARM assets to hold in portfolios,
fund them using equity capital and borrowed funds, and generate earnings from
the difference, or spread, between the yield on the assets and cost of borrowing. Like
traditional banking institutions, income is generated primarily from the net spread or difference between the interest income earned on the ARM assets and the cost of
borrowings. Simply put:they make money by borrowing cheap and lending higher.

They are also a REIT for tax purposes. As a REIT they must meet the following income based tests:

1. The 75% Test. At least 75% of gross income for the taxable year must be derived from qualified REIT assets including interest, on obligations secured by mortgages on real property or interests in real property.

2. The 95% Test. In addition to deriving 75% of gross income from the sources listed above, at least an additional 20% of gross income must be derived from those sources, from dividends, interest or gains from the sale or disposition of stock or other assets that are not dealer property.

They must distribute to shareholders at least 90% of taxable income before deduction of dividends plus 90% of the excess of the net income from foreclosure property.



Products

70% of total assets are in high quality ARM assets and short-term investments.

* ARM securities and securitized ARM loans which are rated within one of the two highest rating categories by at least one of either Standard & Poor's or Moody's (can include Hybrid ARM assets, which are typically 30-year loans with a fixed rate of interest for an initial period, generally 3 to 10 years, and then convert to an adjustable-rate for the balance of their term)

*securities and securitized loans that are unrated or whose ratings have not been
updated but are determined to be of comparable quality (by the rating standards of at least one of the Rating Agencies) to a High Quality rated mortgage security, as
determined by the manager and approved by the Board of Directors
 
*ARM loans that have been deposited into a trust and have received a credit rating of AA or better from at least one Rating Agency.

All ARM loans that are acquired or originated bear an interest rate tied to an interest rate index. Most loans have periodic and lifetime limits on how much the loan interest rate can change on the interest rate reset date. The interest rate on each traditional ARM loan resets monthly, semi-annually or annually. The traditional ARM loans generally adjust to a margin over a U.S. Treasury index or a LIBOR index. The hybrid ARM loans have a fixed rate for an initial period, generally 3 to 10 years, and then convert to traditional ARM loans for their remaining term to maturity.

They securitize (lien on the property) them into pools of high quality ARM securities and retaining them as securitized ARM loans. Alternatively, they may also use loans as collateral for CDOs. The high quality ARM securities represent interests in ARM loans that are secured primarily by first liens on single-family (one-to-four units) residential properties.


Thornburg is best understood in comparison to banks. They finance the purchases and originations of ARM assets with equity capital, unsecured debt and short-term borrowings such as reverse repurchase agreements, whole loan financing facilities, floating-rate long-term collateralized debt obligations ("CDOs") and other collateralized financings that may be approved by institutional lenders. When they borrow short-term or floating rate funds to finance Hybrid ARM assets, they also enter into interest rate hedging transactions, which fix borrowing costs during the fixed rate period of the Hybrid ARM asset. TMA has a policy to operate with an "Adjusted Equity-to-Assets Ratio" of at least 8% and typically operate with a 9-10% Adjusted Equity-to-Assets Ratio(more on this later--it is a measure to rate the safety of your investment in a bank)

What did that last paragraph just say? Unfortunately this business has a specific language that must be understood to know what the business is doing. Here are some definitions.

Adjustable rate mortgages:
A mortgage loan which has a coupon or interest rate that is subject to change on predetermined reset dates, on the basis of variations in a reference rate. These loans use interest rate indices as the reference rate. Adjustable rate loans may have cap and floor features, meaning the maximum rate and the minimum rates after giving effect to variations. There may also be lifetime cap and floor features. Adjustable Rate Mortgages may be strictly amortizing though some have negative amortization features.


equity capital:
Equity capital or financing is money raised by a business in exchange for a share of ownership in the company. Ownership is represented by owning shares of stock outright or having the right to convert other financial instruments into stock of that private company. Two key sources of equity capital for new and emerging businesses are angel investors and venture capital firms. Equity financing allows a business to obtain funds without incurring debt, or without having to repay a specific amount of money at a particular time.


unsecured debt:
Debt capital is represented by funds borrowed by a business that must be repaid over a period of time, usually with interest. Debt financing can be either short-term, with full repayment due in less than one year, or long-term, with repayment due over a period greater than one year. The lender does not gain an ownership interest in the business and debt obligations are typically limited to repaying the loan with interest. Loans are often secured by some or all of the assets of the company. Unsecured debt does not identify specific assets that the debt holder is entitled to in case of default. This is debt not collateralized by property.An unsecured debt is any loan or debt that has no tangible assets or property attached to it. The most common types of unsecured debt are credit cards, department store cards, student loans, medical bills, old utility bills, and personal loans .

 
short-term borrowings such as reverse repurchase agreements:
A form of secured, short-term investment in which a security is purchased with a simultaneous agreement to sell it back to the seller at a future date. The purchase and sales agreements are simultaneous but the transactions are not. The purchase is a cash transaction while the return sale is a forward transaction since it occurs at a future date. Informally known as a reverse.

The buyer/investor/lender earns interest paid at rate negotiated between the parties. Rates paid on reverse repos are short-term money market interest rates and are completely unrelated to the coupon rate paid on the instrument being purchased. Every transaction where a security is sold under an agreement to be repurchased is a repo from the seller/borrower's point of view and a reverse from the buyer/lender's point of view. Repos and reverses are often used to finance investment purchases, especially by traders.

whole loan financing facilities:
Whole loans are mortgage loans where the owner of the debt also owns the servicing rights(collecting payments and sending statements). In other words, mortgage loans that have not had the servicing separated.

floating-rate long-term collateralized debt obligations ("CDOs"):
An investment-grade security backed by a pool of bonds, loans, and other assets. CDOs do not specialize in one type of debt.

CDOs can be securitizations or re-securitizations of commercial loans, corporate bonds, other types of ABSs (asset backed security),residential MBSs (mortgage backed security), commercial MBSs, and emerging market debt.CDOs may even be backed by other CDOs.

coupon rate
(1) The rate of interest received by the holder of a security. Not necessarily the same as the yield realized by the holder.
(2) For pass-through securities, the holder's coupon rate is the gross coupon of the underlying loans less servicing fees and any agency guarantee fees.

yield
The annual return on an investment expressed as a percentage on an annual basis. For interest-bearing securities, the yield is a function of the rate; the purchase price; the income that can be earned from the reinvestment of income received prior to maturity, call, or sale; and the time from purchase to maturity, call, or sale. Different formulas or methods are used to calculate yields.

The cost of debt service paid by a borrower or issuer to a lender or investor. The rate is expressed as an annual percentage of the amount borrowed. For some notes and bonds that pay interest semiannually, the semiannual interest due to the investor used to be evidenced by a coupon that could be detached and sent for collection. Thus the cost to the issuer for notes and bonds paying semiannual interest is often called the coupon rate. Lenders or investors may receive a yield that is higher or lower than the rate.


interest rate hedging transactions

The mechanism of an interest rate swap allows each company to exploit their privileged access to one market in order to produce interest rate savings in a different market. Companies have been able to lower their nominal funding costs by using swaps in conjunction with credit quality spreads. A swap is a financial contract that obligates one party to exchange (swap) a set of payments it owns for a set of payments owned by another party.  Swap is a financial instrument, designed to hedge interest rate risk. A financial institution is exposed to interest rate risk, if the liabilities side of the balance sheet has more (or less) interest rate sensitive items than the asset side. To hedge the risk, a financial institution can use swaps to change the interest rate sensitivity of either liabilities or assets side of the balance sheet (complete hedging would require the sensitivities of both sides of the balance sheet to be exactly the same).

What makes Thornburg interesting is their aggressive use of hedging to offset future rises in interest. Since we all know this is coming, such a strategy helps make Thornburg a more attractive investment than a mortgage REIT that has not hedged against rate hikes. 
 
Hedging Strategies
 
Thornburg uses several types of hedges including swaps, interest rate cap agreements and Eurodollar transactions.

Swaps are financial products that are used to alter the exposure of investment portfolios, or any series of cash flows. The most common kind of swap is an interest rate swap. Interest rate swaps are an efficient way for an institution to manage its interest rate risk. In an interest rate swap, two parties agree to exchange periodic interest payments based on a predetermined notional(value of underlying assets) principal amount. In a typical interest rate swap one party to the transaction will pay a fixed interest rate, while the other party agrees to pay a floating rate. For example, two parties may enter into an interest rate swap in which they agree to exchange interest payments on $100 million notional principal. The term notional is used because the $100 million is not actually exchanged by the counterparties. In this swap, one counterparty may agree to pay a fixed rate of 7%. The other counterparty may agree to pay 3 month LIBOR(London Interbank Offered Rate and is the rate of interest at which banks borrow funds from other banks, in marketable size, in the London interbank market) .When TMA enters into a swap agreement, they agree to pay a fixed rate of interest and to receive a variable interest rate, generally based on LIBOR.This arrangement pays off as rates rise and exceed the fixed rate they lock in. In the future, this should start paying off rather than generating losses.

Eurodollar transactions are initiated in order to fix the interest rate changes on forecasted three-month LIBOR-based liabilities. Each Eurodollar futures contract is a three-month contract with a price that represents the forecasted three-month LIBOR rate. Selling Eurodollar futures contracts locks in a future interest rate. The difference between the value of the swap and the sale of Eurodollar futures results in a gain or loss that offsets the change in the three-month LIBOR rate and "locks-in" the forecasted three-month LIBOR rate for financing purposes.

Finally, they purchase Cap agreements by incurring a one-time fee or premium.
For the fee, they receive cash payments if the interest rate index specified in the Cap agreement increases above contractually specified levels. Cap agreements have the effect of capping the interest rate on a portion of borrowings above a level specified by the Cap agreement.

At of the end of 2003, swap agreements and Eurodollar transactions had a current notional balance of $12.5 billion and a delayed swap agreement had a notional balance of $270 million that became effective in February 2004. Cap agreements have a current notional balance of $2.3 billion.Most of the $18 billion in assets is hedged. Despite declining interest rates Thornburg continues to employ a matched funding strategy as they acquire hybrid ARM assets in order to ensure stable earnings during periods of rising interest rates.They attempt to "lock-in" a spread that is expected to provide a total return at or above the threshold requirement. In order to stabilize the spread over the expected life of ARM assets, they are using hedging instruments in conjunction with borrowings to approximate the repricing characteristics of ARM assets. Due to
unfavorable interest rate declines, the net interest spread decreased from 1.58% during 2002 to 1.39% during 2003, but the company generated $76.0 million more in net interest income due to the growth in capital.

The net fair value of swap agreements at December 31, 2003 of $85.5 million included unrealized gains of $14.9 million and gross unrealized losses of $100.4 million. That was the result of fixed rates exceeding variable rates.

As of December 31, 2003, the net unrealized loss on swap agreements and deferred
gains and losses on Eurodollar transactions was a net loss of $93.2 million.


How the company comes by cash

reverse repurchase agreement market: This is the primary source of funds for TMA at present at $13.5 billion. These repurchase agreements must be based on the fair value of the mortgages underlying them. If changes occur in the fair value(down) or if interest rates go up, these borrowings are subject to margin calls. TMA is attempting to move into more collateralized debt obligation loans to decrease exposure to margin calls.

CDOs:During 2003, three CDO transactions permanently financed $3.5 billion of mortgage loans from the ARM loan portfolio. In these transactions, they issued AAA and AA rated floating-rate MBS to third party investors. Capital required to support these financings is less than the amount required by policy to support the same amount of financings in the reverse repurchase agreement market and these transactions represent permanent financing of these loans that are not subject to future margin calls. At December 31, 2003, they had $3.1 billion of CDOs outstanding at an effective cost of 1.59%.

whole loans
As of December 31, 2003 they had entered into four whole loan financing
facilities (gives them funds to purchase loans). They have a borrowing line of credit at $1.7 billion through these facilities. As of December 31, 2003, they had $369.3 million borrowed against these whole loan financing facilities at an effective cost of
2.32%.


Capital requirements for short-term financing

Adjusted Equity-to-Assets Ratio,must be maintained at a minimum of 8%. TMA's policy is to maintain a capital cushion equal to approximately twice the margin requirement. Margin requirements typically range between 4% and 5% for reverse purchase agreements. They maintain capital of at least 8%, and typically 9%, against the financing of these assets. As they replace reverse repurchase agreement borrowings with CDO financings, they will be able to free up this capital for investment.

In 2003, the company had $13.9 billion of reverse repurchase agreements outstanding with a weighted average borrowing rate of 1.25% and a weighted average remaining maturity of 4.9 months.

Screening borrowers

Borrowers make large down payments and have adequate liquid asset reserves, verified income, job stability and excellent credit (as measured by a credit report and a credit score FICO) At December 31, 2003, our borrowers had an average FICO score (scores can range from 300 to 850) of 737 .

In addition, full real estate appraisals are underwritten to ensure the property collateral is well valued, appropriate to the neighborhood and located in a stable market. Loans acquired are all first mortgages on single-family residential properties. Some have additional collateral in the form of pledged financial assets. Pledged assets are limited to marketable equity securities, investment grade bonds, cash or other approved securities. The loans are fully documented loans, with 80% or lower effective loan-to-value ratios based on independently appraised property values, or are seasoned loans with good payment history. The average original effective loan-to-value ratio of all loans was 65.3% as of December 31, 2003.

If a traditional ARM or hybrid ARM loan acquired has a loan-to-value ratio above 80%, they require the borrower to pay for private mortgage insurance or acquire additional collateral, providing additional protection against credit risk.


Growth

TMA is shifting its borrowing to CDOs. Because the CDOs only require approximately 2% of equity capital to support the CDO financing, versus the 8% to 10% policy requirement on reverse purchase agreements,the freed-up capital will be used to acquire additional assets. They expect that to retain and carry an increased amount of assets in the future as a percentage of the equity capital base.

Selected financial statements

Balance sheet

(in thousands)
 
-------------------------------------------------------------
2003 2002 2001 2000 1999

------------ ------------ ----------- ----------- -----------
Adjustable-rate $ 18,852,166 $ 10,335,213 $ 5,732,145 $ 4,139,461 $ 4,326,098
mortgage assets
Total assets $ 19,118,799 $ 10,512,932 $ 5,803,648 $ 4,190,167 $ 4,375,965
CDOs $ 3,114,047 $ 255,415 $ 432,581 $ 603,910 $ 886,722
Senior Notes $ 251,080 -- -- -- --
Shareholders' $ 1,239,104 $ 833,042 $ 532,658 $ 317,538 $ 310,887
equity
Historical book $ 18.68 $ 16.54 $ 15.12 $ 15.30 $ 15.28
value per share

Book value per $ 16.75 $ 14.54 $ 14.02 $ 11.67 $ 11.40
share
Number of 73,985 52,763 33,305 21,572 21,490
common shares
outstanding

**During 2003, assets grew 82% from $10.5 billion to $19.1 billion and net earnings for the year increased 5% from $2.59 to $2.71 per share, on a diluted basis.

** They raised raised $432.1 million of new equity capital by issuing 18.4 million
common shares at an average net cost of $23.41 per share.

** As result of raising this new common equity,book value per common share rose 15% from $14.54 per share to $16.75 per share. Book value growth outpaced earnings growth because of a margin decline over the course of the year due to the costs associated with diversifying funding sources(more expensive CDO's) and increasing the hedged position.

** They acquired $10.3 billion of ARM securities during 2003, 99.7% of which were rated

** Residential ARM loan origination business through approved correspondents and direct originating ARM loans to retail customers assets grew 75% in 2003 to $4.0 billion, up from $2.3 billion in 2002. These loans produce more income than pools of securities and will end up improving margins.

** They own $7.3 billion in ARM loans, which amounts to 38% of the total assets.

**Book value growth outpaced earnings growth because they experienced a
margin decline over the course of the year due to the costs associated with diversifying funding sources (CDOs were more expensive than repurchase agreements) and
increasing the hedged position.




Explanation of net interest income
                            (in thousands) 
2003 2002 2001

--------- --------- ---------
Coupon interest income on ARM assets $ 621,456 $ 419,456 $ 299,911
Amortization of net premium (35,076) (19,229) (22,696)
Cash and cash equivalents 3,235 1,740 1,379

--------- --------- ---------
Interest income 589,615 401,967 278,594

--------- --------- ---------
Reverse repurchase agreements 150,985 135,346 146,577
CDOs 18,873 8,436 26,000
Whole loan financing facilities 16,904 11,260 --
Senior Notes 10,798 -- 9,459
Interest rate swaps 158,102 88,996 17,793

--------- --------- ---------
Interest expense 355,662 244,038 199,829

--------- --------- ---------
Net interest income $ 233,953 $ 157,929 $ 78,765




** This table shows the amounts they collect from interest and the interest expenses. The net interest income is the difference. Income exceeds expense.

**Net interest income increased by $76.0 million in 2003 compared to 2002. The change from 2002 to 2003 was attributable to a $187.6 million increase in interest income primarily due to an increased asset base.The rates were unfavorable but the volume of business increased. The interest rate dropped and produced less income per ARM, but they were able to borrow at better rates and increase interest bearing assets

**The increase was partially offset by a $111.6 million increase in interest expense. Included in this increase is a $69.1 million increase resulting from the impact of hedging with swap agreements and Eurodollar transactions to cover increased financing of hybrid ARM assets

**Net interest income was $79.2 million higher during 2002 compared to 2001. The change was attributable to a $123.4 million increase in interest income primarily due to an increased asset base, partially offset by a $44.2 million increase in interest expense. Hybrid ARM assets totaled $15.3 billion and $7.5 billion at December 31, 2003 and
2002, respectively.

Annual income ratios

2003 2002 2001 2000 1999
net margins 30% 30% 21% 10% 10%
growth revenue 48% 45% -4% 11%
growth net 47% 105% 100% 14%
growth EPS diluted 5% 23% 100% 19%
growth EPS cont operations 5% 24% 100% 19%
increase in interest 46% 22% -21% 12%



**Good margins
**Slowing growth in EPS and a very large jump in the number of shares used to calculate EPS. The sale of common shares was used to raise capital and fueled a lot of the acquisition growth. I would expect them to keep using this form of capital and could look for the DPS to be under pressure.

Quarterly income ratios

Mar 04 Dec 03 Sept 03 Jun 03
growth revenue 12% 17% 9% 13%
growth net income 8% 8% 9% 8%
growth EPS 1% 1% 1% 0%
net margin 27% 28% 30% 30%

**Good revenue growth quarter to quarter
**Margins remain high although dropping slightly-- stable and low rate on ARM loans and increased cost of borrowing(CDOs) and hedging costs

Yields and returns

2003 2002 2001 2000 1999
Yield on ARM assets 4.05% 4.63% 5.09% 7.06% 6.38%
Yield on net interest earning 1.61% 1.88% 1.67% 0.86% 0.77%
assets (Portfolio Margin)
Return on average common equity 17.31% 17.66% 16.69% 9.87% 7.38%
Noninterest expense to average 0.42% 0.45% 0.38% 0.16% 0.12%
assets

** ROE is high and much improved since 2000
** expense ratio to assets is low
** yields are declining due to lower interest rates. This has been offset by increasing volumes
** yield from net interest on assets has also declined

Equity to asset ratio

Capital adequacy is the protection provided by the company's equity capital against losses in the value of assets. This is an important ratio when evaluating financial companies. Losses in the value of the ARMS would affect shareholders and even decrease dividends.The capital adequacy is a measure of the company's ability to pay for nonperforming with relatively liquid funds.

Equity/asset ratios(E/A)

2003 2002
----------------- -----------------
Adjusted shareholders' equity $ 1,568,356 $ 903,928

----------------- -----------------
#1 Adjusted equity-to-assets ratio 9.82% 8.88%

----------------- -----------------
#2 GAAP equity-to-assets ratio 6.48% 7.92%

----------------- -----------------
#3 Ratio of historical equity plus Senior Notes to 8.53% 8.96%
historical assets

----------------- -----------------
Estimated total risk-based capital /risk-weighted assets 26.26% 34.05%


The first ratio is adjusted to include unrealized gains and losses. Unrealized gains and losses are subject to change due to the adjustable rates on ARMS. They are subject to constant changes and may or may not eventually be realized.

The second E/A measurement is GAAP equity-to-assets ratio, a calculation that
simply divides total equity by total assets. It is not adjusted for unrealized gains and losses(as is #1)While the simplest of all equity-to-assets calculations, it is not used to manage balance sheet because it includes factors such as unrealized gains and losses on assets and hedging instruments deemed to be less important to the long-term operating nature of the business, since assets are not for sale and since the unrealized gains and losses are not permanent impairments of equity or of these assets and hedging instruments. This ratio has declined since December 31, 2002 due to the use of CDO financing that allows acquisition of additional assets against the equity capital that is freed up as a result of entering into permanent financing transactions. Unsecured debt is treated as an alternative form of equity capital.

The third alternative capital utilization measurement is the ratio of historical equity plus Senior Notes to historical assets. This calculation includes senior notes as a component of long-term capital base. The measurement is calculated by dividing the sum of the assets, net unrealized gain (loss) on ARM securities and net unrealized gain on hedging instruments by the sum of shareholder's equity and senior notes. This ratio gives a complete picture of the relationship between total asset and long-term capital position.

The fourth alternative capital utilization measurement is a calculation of estimated total risk-based capital divided by risk-weighted assets, a regulatory calculation required to be made by banks and savings and loan institutions that complies with Federal Reserve Board capital requirements. Risk-based capital measures capital requirements for assets based on their credit exposure as defined by the regulation, with lower credit risk assets
requiring less capital and higher credit risk assets requiring more capital.

They are not subject to these regulatory requirements and it is interesting to see how far above the 6% to 10% (average 8%) ratios that define a bank as well-capitalized.

By any of these ratios, they appear to be well capitalized.

Off-Balance sheet commitments (backlog)

As of December 31, 2003, TMA had commitments business to purchase or originate the following amounts of ARM assets

ARM securities - agency $ 301,266
ARM securities - private high quality 301,125
ARM loans - correspondent originations 396,000
ARM loans - direct originations 51,451

-----------
$ 1,049,842


This represents future business much as backlogs do for other types of business. This is business that is in the pipeline

Nonperforming loans and other ratios

TMA did not experience any credit losses on ARM loans during 2003 and have only experienced $174,000 in credit losses since they began acquiring ARM loans in 1997. However, they also recognize that the portfolio was, on average, only approximately 16 months old. Due to this lack of seasoning and, therefore, lack of relevant historical data, they have recorded a loan loss allowance of $8.0 million as of December 31, 2003 based on industry loss experience on similar loans.


Employees

They have an interesting arrangement for employees--they have no employees. They hire a management service to manage their operations. To date since the inception of TMA , the manager has not engaged in any other activities As of December 31, 2003, the manager had 69 employees, 43 of whom were directly engaged in the activities of TMHL. The agreement is for a ten-year term, expiring July 15, 2009, with an annual review required as to performance and the reasonableness of the compensation paid.

The manager at all times is subject to the supervision of the Board of Directors.It is responsible for operations and performs all services and activities relating to the management of assets and operations. The manager receives an annual base management fee based on average shareholders' equity. The base management fee formula is subject to an annual increase based on any increase in the Consumer Price Index over the previous twelve-month period. The operating expenses that the manager is required to pay include the compensation of personnel who are performing management services and the cost of office space, equipment and other personnel required for the management of our day-to-day operations. During 2003, operating expenses as a percent of average assets were 0.42%, compared to 0.45% during 2002.
                          
2003 2002 2001 2000 1999

--------- --------- -------- -------- --------
Noninterest expense to average 0.42% 0.45% 0.38% 0.16% 0.12%
assets

Stock options and lack of

TMA does not grant stock options Instead they use bonuses in the form of phantom stock and stock appreciation rights. These are explained below.


Phantom Stock

Phantom stock is simply a promise to pay a bonus in the form of the equivalent of either the value of company shares or the increase in that value over a period of time. For example, a company could promise a new employee a bonus every five years equal to the increase in the equity value of the firm times some percentage of total payroll at that point. Or it could promise to pay an amount equal to the value of a fixed number of shares set at the time the promise is made. Other equity or allocation formulas could be used as well. The taxation of the bonus would be much like any other cash bonus--it is taxed as ordinary income at the time it is received. Phantom stock may reflect dividends and stock splits. Phantom stock payments are usually made at a fixed, predetermined date.

Stock Appreciation Rights

A stock appreciation right (SAR) is much like phantom stock, except it provides the right to the monetary equivalent of the increase in the value of a specified number of shares over a specified period of time. As with phantom stock, this is normally paid out in cash, but it could be paid in shares. SARs often can be exercised any time after they vest. SARs are often granted in tandem with stock options to help finance the purchase of the options and/or pay tax if any is due upon exercise of the options; these SARs sometimes are called "tandem SARs."

One of the great advantages of these plans is their flexibility. But that flexibility is also their greatest challenge.

The company must record a compensation charge on its income statement as the employee's interest in the award increases. So from the time the grant is made until the award is paid out, the company records the value of the percentage of the promised shares or increase in the value of the shares, pro-rated over the term of the award. In each year, the value is adjusted to reflect the additional pro-rata share of the award the employee has earned, plus or minus any adjustments to value arising from the rise of fall in share price. Unlike accounting for variable award stock options, where a charge is amortized only over a vesting period, with phantom stock and SARs, the charge builds up during the vesting period, then after vesting all additional stock price increases are taken as they occur. when the vesting is triggered by a performance event, such as a profit target. In this case, the company must estimate the expected amount earned based on progress towards the target. The accounting treatment is more complicated if the vesting occurs gradually. Now each tranche of vested awards is treated as a separate award. Appreciation is allocated to each award pro-rata to time over which it is earned.


The benefit to the company in maximizing this alternative to stock option issuance is the reduction in share price dilution associated with option stock.  Earnings per share is calculated on a fully diluted basis.  Although financial accounting rules require the accrual of charges against earnings for liabilities under phantom Stock and share appreciation rights, these accruals and the underlying liabilities decline in periods of share value decreases unlike the number of outstanding option shares.

In January 2003 TMA decided to discontinue stock options grants. They grant Dividend Equivalent Rights ("DERs"), Stock Appreciation Rights ("SARs") and Phantom Stock Rights ("PSRs") instead. Under the plan, management directors, executive officers and key management employees receive an aggregate grant of PSRs equivalent to the value of options to purchase common stock for that number of shares equal to 3% of new common shares sold to the public.

Prior to April 1, 2003, these individuals had also received an aggregate grant of DERs equal to 2.25% of new common shares sold to the public. In March 2003, the compensation committee voted to discontinue granting additional DERs to these individuals for new common shares sold to the public after March 31, 2003.

The PSRs vest over either a two or three-year period, determined by the Compensation Committee at the time of grant, at a rate of one-half or one-third at the end of each year, respectively. PSRs granted after October 20, 2003 do not earn a dividend until they are vested.

As of December 31, 2003, there were 1,475,022 DERs outstanding all of which were vested, and 682,334 PSRs outstanding, of which 489,775 were vested. The company recorded an expense associated with DERs and PSRs of $9.9 million, $4.1 million and $1.5 million for the years ended December 31, 2003, 2002 and 2001, respectively. Of the expense recorded in 2003, $4.7 million was the amount of dividend equivalents paid on DERs and PSRs, $1.7 million was the amortization of unvested PSRs and $3.5 million was the impact of the increase in the company's common stock price on the value of the PSRs which was recorded as a fair value adjustment.


The most significant single increase in operating expenses in 2003 was the $10.4 million increase in the performance-based fee that the manager earned as a result of achieving a return on shareholders' equity in excess of the threshold as defined in the management agreement contract. Return on equity prior to the effect of the
performance-based fee of $27.9 million for 2003 was 20.10%, whereas the threshold, the average 10-year treasury rate plus 1%, was 4.02%.

The remaining $13.1 million increase in operating expenses from 2002 to 2003 related primarily to increased base management fees, expanded operations of TMHL, expenses associated with issuance of DERs(issuance now discontinued)and PSRs. The base management fee paid increased $3.7 million due to increased average shareholders'
equity,

TMHL's operations increased $2.2 million, and issuance of DERs and PSRs together with improved stock price accounted for $5.8 million of the increase.

Income statement




2003 2002 2001


Interest income from ARM assets and cash equivalents $ 589,615 $ 401,967 $ 278,594
Interest expense on borrowed funds (355,662) (244,038) (199,829)

Net interest income 233,953 157,929 78,765

Fee income 1,883 592 49
Gain on ARM assets, net 6,005 903 1
Hedging expense (693) (1,426) (1,337)
Provision for credit losses (3,137) -- (653)
Management fee (11,510) (7,831) (4,897)
Performance fee (27,897) (17,518) (6,716)
Long-term incentive awards (9,923) (4,114) (1,454)
Other operating expenses (12,177) (8,519) (5,096)

Net income before cumulative effect of change in accounting 176,504 120,016 58,662
principle
Cumulative effect of change in accounting principle -- -- (202)

NET INCOME $ 176,504 $ 120,016 $ 58,460

Net income $ 176,504 $ 120,016 $ 58,460
Dividend on preferred stock (3,340) (6,679) (6,679)


Net income available to common shareholders $ 173,164 $ 113,337 $ 51,781

Basic earnings per share:
Net income $ 2.73 $ 2.60 $ 2.09
Average number of shares outstanding 63,485 43,590 24,754

Diluted earnings per share
Net income $ 2.71 $ 2.59 $ 2.09
Average number of shares outstanding 65,217 46,350 24,803
.

Income statement included to show the effect of the performance fees and long term incentives on net income available to shareholders. TMA has elected to discontinue granting options and now expenses all management compensation. This seems a very aboveboard way to deal with shareholders. The bonuses and compensation together with other operating expenses still come in below average for financial institutions (namely banks)

Future and company plans

According to the Mortgage Bankers Association, in 2003, mortgage originations industry-wide reached an unprecedented $3.8 trillion, a 53% increase over the $2.5 trillion originated in 2002. This record activity was primarily the result of low interest rates, which provided borrowers an opportunity to refinance their mortgage debt. For 2004, the MBA is forecasting that overall residential loan originations will decline 47% to $2.0 trillion based on an assumption that refinancing activity will decline by 73%, generally as a result of higher interest rates and the belief that most people who had an opportunity to refinance have done so. The same forecast also estimates that residential ARM loan origination will only decline 25% in 2004, since in a higher interest rate environment, ARM products become more attractive relative to 30-year fixed rate mortgage products. Although the impact of this outlook is difficult to determine, TMA believes loan origination volume will only decline by approximately 8% in 2004 to $3.7 billion. Outperformance relies on keeping competitive mortgage interest rates. They are able to lend in 48 states and the District of Columbia versus 42 states at the end of 2002, and expect to obtain lending approval in the two remaining states by the first quarter of 2004. In addition, they increased their network of approved and active correspondents (more lenders) to 129 from 93 a year ago, grown the internal sales force to help generate more loan production through correspondents, financial planners, corporate affinity groups and residential home builders, and are increasing the marketing budget from $2.1 million in 2003 to $4.0 million in 2004. They plan to grow the percentage of originated assets because they more profitable than purchased mortgage assets-- $3.7 billion loan origination is the goal. If they are able to reach that figure, 40% of the portfolio would be originations compared to 26% in 2004.


Effects of interest rate changes

1. Borrowings may react to changes in interest rates sooner than ARM assets. The rate increase allowed by the adjustment schedule on an ARM may lag behind the increased cost of borrowing. TMA could be faced with a situation where borrowing costs more and they are unable to raise rates to off set it. And the rate on ARMs may be capped at 1%-2% where borrowing has no such constraints.

2.Interest rates can also affect the net return on hybrid ARM assets (net of the cost of financing Hybrid ARM assets). If the hybrid ARMs are prepaid in a declining interest rate environment(which happens often) the newly acquires hybrids will be originated at lower rates and not provide the same high yield as the higher priced hybrids.

In contrast, during an increasing interest rate environment, hybrid ARM assets may prepay slower than expected, requiring financing by TMA at a higher amount of hybrid ARM assets than originally anticipated. If they have to borrow at higher rates for the hybrids, then the net return will be lower.

3. Interest rate changes can also affect the availability and pricing of ARM assets, which affects investment opportunities. During a rising interest rate environment, there may be less total loan origination and refinance activity. At the same time, a rising interest rate environment may result in a larger percentage of ARM products being originated, mitigating the impact of lower overall loan origination and refinance activity.

4. Declining interest rates can favor fixed rate mortgage products, but there may be above average loan origination and refinancing volume in the industry such that even a small percentage of ARM product volume may result in sufficient investment
opportunities.

5.A flat yield curve may be an adverse environment for ARM products because there may be little incentive for a consumer to choose an ARM product over a 30 year fixed-rate mortgage loan and in a steep yield curve environment, ARM products may enjoy an above average advantage over 30 year fixed-rate mortgage loans

6. The rate of prepayment on mortgage assets may increase if interest rates decline or if the difference between long-term and short-term interest rates diminishes. Increased prepayments would cause faster amortization on the premiums paid resulting in a
reduced yield

7. The rate of prepayment on mortgage assets may decrease if interest rates rise or if the difference between long-term and short-term interest rates increases. Decreased prepayments would cause amortization of the premiums paid over a longer time period, resulting in an increased yield on our mortgage assets.

In a rising interest rate environments where prepayments are declining, not only would the interest rate on the ARM assets portfolio increase to re-establish a spread over the higher interest rates, but the yield also would rise due to slower prepayments.

Payout ratio

Dividends to net income
$157.898/173.164= 91.2%


As a REIT they have strict guidelines about the amount paid to shareholders. They must pay at least 90% of taxable income as dividends to common shareholders. While this type of ratio would be considered high for a bank, it is standard for a REIT.A 90% payout for a different type of financial institution would leave them short of capital in the form of retained earnings. TMA's principal sources of liquidity are the reverse repurchase
agreement market, the issuance of CDOs, whole loan financing facilities as well as principal and interest payments from ARM assets. They have also raised capital from the sale of large blocks of common shares.They raised $432.1 million of new equity capital in 2003 by issuing 18.4 million common shares at an average net cost of $23.41 per share. This does dilute shareholder earnings. But it is a source of capital that does not include interest payments. I would hate to see them get into the habit of issuing 15 to 20 million shares for capital every year. This is a question I would(and will) ask management before investing.

Loan loss reserves

For a bank, the loan loss reserve is typically around 1.5%. The loan loss reserve for TMA is $8 million on $7.3 billion in ARM loans. This is only 0.1% and appears to be adequate at present since total losses are $174,000 since 1997. It might be prudent to look for increased coverage as the rates of foreclosure are beginning to climb.

Nonperforming loans,gross loans and reserve

The company reports $3.5 million in loans in foreclosure for 2003. This is 0.05% of their ARM loans and 0.02% of total assets. They do not have any 60-90 day delinquencies art the end of the fiscal year. I would look for foreclosure activity to rise. As a percentage of the reserve it represents 44%. In my opinion, they should be looking at increasing the reserves. It appears to adequate for present purposes.

Net margin ratio

This is a measure of management efficiency. It is a measure of the financial company's ability to manage it's earnings on various types of income generating products. In the case of a bank this is spread out between such things as invested fund and loans. For TMA, the interest earning assets are their ARM loans. The amount is $14.3 billion. The net interest income is $2.4 billion and the ratio is 16.9%.The industry average for banks is around 5%. The loans pay much better than invested funds that banks have to mix with loans.

Operating expenses and total income

This measures a the cost of running the company with its total income. The ratio is 34.8%. In general, the ratio should be below 60%. The costs are well controlled. The other consideration here is that the company expenses its bonuses and does not grant options. This adds to the expense, but has not become overly generous as evidenced by the ratio.

ROE and ROA

The ROE is the total net income divided by shareholder equity and is 14.2%.That is a little low(around 15% is consider respectable). The ROA is 1%. In the financial services industry, between 1% and 2% is common.

Growth and dividend discount model

Because of the REIT structure and the tendency of the company to sell shares to raise capital, it i difficult to predict what will be paid in dividends from year to year. Here is how it has played out since 1997:

Valuation
 

1997 1998 1999 2000 2001 2002 2003
EPS $1.94 $0.75 $0.88 $1.05 $2.09 $2.59 $2.71
Dividend paid $1.97 $0.91 $0.92 $0.94 $2.00 $2.29 $2.49
Growth in DPS -53% +1% +2.1% +108% +14.5% +8.7%
Avg annual yield 9.4% 7.4% 10.0% 11.1% 13.6% 11.6% 10.3%

Arithmetic average growth in DPS per year 13%
growth in 6 years 26%
Valueline predicts 3.6% in 2004 and 2.7% in 2005.
growth fundamental 1.5% ROE*retention ratio

Valuing TMA is difficult. The unsettled nature of interest rate hikes(just how high and how fast) coupled with the effect on the consumer make estimating future growth in dividends difficult. They must payout 90% but we can't really know what the net income is going to look like with so many shifting variables. The dividend could decrease if the borrowing/lending environment becomes unfavorable. If the cost of borrowing outstrips the adjustments on the ARMs and originations slow due to softening consumerism, then they could show declines in net income available to shareholders and dividends. TMA is trying to prepare for this uncertain future with hedging and increasing reliance on loan origination to improve the spreads. If the volume falls off, this may not offset losses.

The valuation was kept deliberately conservative, but did not account for possibly
negative returns. It is a combination of historical growth, fundamental growth and outside predictions of growth(Valueline).

These are the assumptions:

**Riskfree rate 4.5%
**Market risk premium 5.5%
**Beta 1
**Initial growth rate period is 5 years and includes 10% historical growth, 20% fundamental growth and 70% outside prediction at 2.5% for 5 years. If growth becomes negative, then all these inputs are invalid. The dividend has never decreased since 1998 even when revenue was decreased.
**Stable growth is 3%
**Payout ratio is 90%
**Retention ratio is 10%
**ROE is 14.2%

The value of the stock is $38.34.

Current price is $27.19 with a PE of 9.95

52 week high was $31.28

In spite of the conservative inputs, the value from the 2 stage dividend growth calculations is high. The company fell hard in Sept 03 to $21 and again in April and May 04 to around $24.Considering the unsettled nature of interest rate increases, the softening market for mortgages and the looming specter of increasing numbers of foreclosures, a discount to the calculated price would be essential. A 40% discount would make TMA attractive and put the price at $23.That would be above the 52 week low of $21. Since the dividend yield is not assured and since price appreciation is likely to suffer depending on the interest rates, a large discount would be appropriate for taking on these risks.

I need a drink

>^..^<
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