No. of Recommendations: 2
I'm not familiar with HCM, their business model, or risks.

But I can make some general observations about MREITs, and some detail about another MREIT...

There are several details in GAAP that are less than optimal for MREITs.

It is my understanding (from message boards & conference calls) that GAAP requires a MREITs to report gains/losses in the market value of their mortgage portfolio (e.g. fluctuations due to interest rates). However, GAAP prohibits a MREIT from reporting as earnings, the counteractive fluctuation in derivatives used to hedge. With TI (taxable income) the derivative's fluctuation is included.

Also, with GAAP they deduct estimated future losses - TI only allows the deduction of realized losses.

These lead to a big discrepancy between GAAP earnings and TI for MREITs.

A company I am somewhat familiar with is NFI (another MREIT). Basically, NFI is a MBS (mortgage backed security) generating engine. They originate subprime mortgages, but that is just to supply the MBS side of the business. They earn a spread servicing the bonds (where the primary income comes from). As they pool the mortgages, and issue bonds, they buy derivatives to hedge against the LIBOR. As I understand it, they would be at risk to sudden and large moves in the interest rates. Otherwise their hedging protects their spread regardless of where rates go.

Their GAAP earnings are quite low (Q3-04: $.89), and TI is high (Q3-04: $2.67). Some of that was because of the interest rate hikes. The market value of the portfolio declined, but (for GAAP) they could not counteract that by reporting the increased value in their hedging. As far as cash flow and “real” earnings are concerned, the rate moves were a non-issue; counteracted by their hedging.

Another contributing factor to their GAAP/TI difference is that they are making big year over year increases in loan originations. That causes the realized losses on the loans to be much lower than the estimated future losses on the newly originated loans.

A case can be made that neither GAAP or TI is good for measuring a MREIT, but REITs are required to pay out 90% of TI through dividends.

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