Back on the MREIT Bandwagon

[adios]

I'm selectively buying back some MREITs since yields are so attractive. I expect some turbulance but NFI yielding 17+% is worth putting up with a little turbulance. I think NFI goes x divy on May 12. NFI is positioned well for a back up in mortgage rates. Their portfolio of IO (interest only) MBS will be the earnings driver going forward. The prepay risk to this type of MBS has vanished. I like RWT at current prices as well. RWT has not paid out it's entire taxable earnings (TE) from 2003 which it is required to do by law. To make a long story short RWT's 2003 TE is paying the 2004 dividend and there should be a year end special dividend like there was last year of between $4 and $5 a share. AMC looks interesting here as well. Thinly traded relative to NFI, it is selling for less than book value, yielding around 12% with basically no leverage. Earnings and divvy are steady on AMC so noting the upper and lower ends of it's long term trading range should be done IMO. AMC is near the low end of it's multi year trading range.

[BadBoyBenny]

The Fool seems to agree with you.

http://www.fool.com/news/commentary/...ry040504cc.htm

These companies have all taken a huge drop which means it might be a good time to get interested

Do you have any opinions on the shareholder lawsuits or large short interest?

Also do you know if AMC has a strong portfolio of interest only MBS as well or will they be more sensitive to rising rates?

[adios]

Before we get too enthusiastic I'm much more wary of MREITs in a rising rate environment. I perceive good value in NFI currently but I have a target price of about $50 given that they can maintain the divvy which I believe they will for the forseeable future which for me is a year. Beyond that I don't know. RWT hit the cover off the ball this morning with their latest earnings report but let's see what these guys do in a fundamentally changed mortgage market. Although the three I like aren't particularly sensitive to slowdowns in conforming type mortgages. A flattening of the yield curve is my biggest concern and I'm not totally convinced about the job market but I'm not fighting the sentiment either.

A blurb on AMC:

Overview
AMC is a REIT managed by the same people who run CharterMac (symbol CHC). The company focuses on multifamily housing loans, making mezzanine and bridge loans, and also holding insured first mortgages secured by multifamily properties; the portfolio size is currently about 280 million. The company grows its portfolio by doing follow-on equity offerings and investing the proceeds.
More info: http://www.americanmortgageco.com

* Leverage
By the Company's own declaration of trust, it self-imposes conservative debt limits. Quoting from the annual report:
"...the Company may incur permanent indebtedness of up to 50% of total market value calculated at the time the debt is incurred. Permanent indebtedness and working capital indebtedness may not exceed 100% of the Company’s total market value."

* Dividend History
AMC paid 1.45 in 2000-2001, growing the dividend by 4% to 1.51 in 2002, and by 6% to 0.40/share/quarter (1.60 annualized) in 2003. This growth rate is somewhat deceiving, as a portion of dividends prior to 2002 have been return of capital; net income was 0.86 in 2000, grew to 1.35 in 2001, and 1.61 in 2002 (an impressive 36.8% CAGR over that period). Unfortunately that growth wasn't continued into 2003 (discussed next).

* Problems
In July, the company announced that 4 mezz loans were in default, which would lower interest income -- AMC revised its guidance for the year from 1.65-1.70/share down to 1.58-1.60/share. The stock fell from a high of 18.35 down to the range where it currently trades (at one point hitting a 52-wk low of 12.30). The dividend for the year may not be supported by net income if it comes in at the low end of management's revised estimates.
Q1:
Net income: 0.50/share
Dividend: 0.40/share
Q2:
Net income: 0.32/share
Dividend: 0.40/share
Q3:
Net income: 0.33/share
Dividend: 0.40/share

The Q4 dividend will be announced next week -- since part of AMC's dividend has been return of capital in the past, I suspect they will keep the dividend steady at 0.40 (wouldn't want to tarnish their stellar dividend history) even if Q4 net income comes in lower than the 0.45/share necessary to bring total net income for the year to 1.60 to equal the dividend.

* Catalyst
On the Q3 earnings call, the CEO gave an update on the mezz loans: AMC has foreclosed on the properties securing the loans, and is now in the process of selling them. The company expects no loss of principal, and in fact, may be able to sell the properties for greater than the principal amount. AMC had also previously announced that because AMC stock was selling at a discount to book value, the company would buy back up to 1 million shares in the open market as it sees opportunities.

* Insider trading
http://www.nasdaq.com/asp/holdings.a...p;selected=AMC
The Chairman/CEO bought 7000 shares following the stock's drop in July on the revised earnings announcement. The prices were 2000 shares @ 15.30 and 5000 shares @ 15.74 [today (12/11/2003) the stock traded in a range of 15.56 and 15.94 ]. The CEO now holds almost 120,000 shares.

* Rating: buy
At this time next year, AMC should be back on track, with the principal from the bad loans reinvested and earning interest once again; with growing net income and dividends, I expect the stock will once again trade at a premium to book value. Current dividend yield is ~10%, the dividend may grow 6% in 2004 if the company earns 1.70 (the high end of prior 2003 guidance), and if the stock price also appreciates by 6%, total return is quite favorable for a 1-year hold (although this is a longer-term holding for me) with acceptable down-side risk being that the stock trades right around its book value of 15.54.


Also you may be interested in the article that was originally posted on the Motley Fool site and was quickly edited. This created quite a stir yesterday. The original Motley Fool article, note the references to Rocker and Greenberg that were removed.

NovaStar's Wild Ride
After a few wild weeks of accusations, conspiracy theories, inquiries, and lawsuits, NovaStar's shareholders have been on a wild ride. Clearly the market is not pricing NovaStar appropriately, but some shareholders think there is more to the story than just a complex business model.

By Craig Cunningham
May 4, 2004

NovaStar Financial (NYSE: NFI (rating, news)) certainly has been making the headlines lately, and it is hard to find much good news. Quite a turnaround, given that 45 days or so ago the company's stock was trading up to $70, on news of a record 2003 and record January and February originations. So how did it all turn so quickly, and how did perception get so skewed?

The perception
For more than a year, CBS Marketwatch's Herb Greenberg has been writing critical stories about the company, but the blow that sent the stock reeling was an article written in The Wall Street Journal. The Journal depicted NovaStar as a non-compliant "subprime mortgage lender that makes high risk loans to people with poor credit" teetering on the edge financial ruin complete with phantom branch locations that didn't actually exist and regulators hot on their heels. NovaStar shares dropped more than 30% that day.

Not more than two days later, the hoard of killer lawyers descended upon NovaStar led by none other than the notorious law firm Milberg-Weiss. Milberg enjoys the distinction of being labeled modern day "squeegee boys" by one Florida judge. Even more notable is an investigation about their representation of a plaintiff in a San Francisco court. It seems that the lead plaintiff suing a company for stock fraud was actually a hedge fund heavily short the stock and ready to profit from a fall.

NovaStar fell further after the company disclosed an informal SEC inquiry -- essentially a predictable information request asking for clarification of some of the WSJ allegations. Despite the SEC's warning to not construe the investigation as an indication that any laws have been broken, some seem ready to lock NovaStar in solitary.

Investors in American Capital Strategies (Nasdaq: ACAS (rating, news)) and Allied Capital (NYSE: ALD (rating, news)) are probably nodding their heads in unison, as the presence of Herb Greenberg articles, class action lawsuits, SEC investigations, and short sellers seems all too familiar. Indeed, these companies have been accused of a variety of misdeeds, which also include risky lending, lack of disclosure, funding the dividend with public stock offerings, and of course the obligatory shouting of Ponzi! Ponzi!

The funny thing about NovaStar in particular is that if you actually read their first quarter report -- nestled in-between a few Herb Greenberg articles and some class action announcements -- their numbers are actually quite good, and beat analyst estimates handily. The company reported a record dividend, record liquidity, record loan production, increased loans under management, and increased earnings. Not too shabby for a company supposedly going down in flames.


The reality
One problem is that NovaStar is greatly misunderstood by many investors. Mortgage REITs (real estate investment trusts) are a special type of REIT that don't actually own property, but invest in mortgages in a variety of ways. NovaStar originates mortgages in the non-conforming market with a focus on debt consolidation loans. NovaStar splits up the loans into their respective principal and interest portions, packages the principal portion as bonds, and sells them to institutional investors. The interest pieces are held in a portfolio of securities that represent the spread between the rates on the securities they sell and the loans they originate. This mortgage investment portfolio is responsible for 88% of the dividend and is a key metric for growth.

As a mortgage originator, some may be quick to point to the "risks" of rising rates. Originations will drop, the dividend will fall, and the short sellers will laugh all the way to the bank -- that's the theory, anyway. As always, reality is a bit different than traditional wisdom. First, subprime borrowers are typically less sensitive to interest rate adjustments than prime borrowers, so the overnight demise of subprime originations is likely overstated.

Secondly, as interest rates rise, more borrowers will be bumped into the subprime category since the cost of borrowing will be greater, thus increasing the population of subprime borrowers.

Third, NovaStar relies on debt consolidation more than any other type of loan. As long as mortgage interest remains tax deductible and lower than consumer financing rates, this will likely remain a popular option for borrowers.

Lastly, the all-important mortgage investment portfolio is stocked with interest only (I/O) strips. The curious thing about I/O's is that they become more valuable in a rising rate environment. This is because as rates rise, refinancings drop off the map, so the expected life of those interest securities becomes much longer. Just think: Who would refinance a mortgage at 6% to one at 8% if they could avoid it?

The company's detractors also suggest that NovaStar will be eaten alive by delinquencies. Again, a quick check of the facts indicates otherwise. While originating high quality non-conforming loans is tricky, NovaStar has managed to keep delinquencies in check. In fact, as of Sept 30th last year, NovaStar had a portfolio delinquency rate of 2.8%. Not impressed? Countrywide (NYSE: CFC) had a rate of 3.75% across its entire portfolio and 12.57% in its subprime portfolio for the same time period.

NovaStar's success has not gone unnoticed as Moody's recognized NovaStar's lending arm with a SQ2 rating, the second-highest rating in the industry. The award cited the company's "strong collection ability, above average loss mitigation on loans, and average foreclosure timeline management. Additionally, for 2003, Standard & Poor's rated NovaStar's loan servicing program as "strong" which is their highest rating.

Many longs see a short squeeze brewing termed the mother of all short squeezes (or MOASS). In April, NovaStar's already high short interest spiked from roughly 4.4 million shares to a stunningly high 5.5 million shares, and that's for a company with just fewer than 25 million total shares outstanding. With a whopping yield north of 16%, it could be quite an expensive short to carry, and covering en masse could send the stock streaking higher.

A conspiracy afoot?
Now, I won't pretend the topics of structured finance, securitization, and mortgage backed securities are easy to understand, but understanding certainly isn't helped when the norm is innuendo, half-truths, and outright factual errors spouted by journalists with an apparent agenda.

One recent example is how the WSJ erroneously reported that NovaStar uses public offerings to pay their dividend, which is untrue and debunked by the company the very next day. The WSJ article also stated that Novastar paid out more than they earned in 2003. This statement is also provably false and requires only a quick look at the company reports and a basic understanding of the difference between taxable and GAAP earnings. Taxable earnings for 2003 were $5.54 per share, and the company actually paid $4.87 per share in dividends.

Finally, Greenburg wrote an article with the headline stating that Novastar had been sued by their mortgage insurer. This was completely false as Novastar actually filed claim against their insurer, not the other way around. After this report was published, shares tumbled four points, and it took 40 minutes for the article to be corrected.

Greenberg has been one of the main critics of NovaStar's operation and has written numerous articles about the company. Many longs see more than a little conflict of interest since Herb's former employer is TheStreet.com (Nasdaq: TSCM). You see, the top institutional holder of TheStreet.com is Rocker Partners, and fund manager David Rocker is widely presumed to have a large short position in NovaStar. The complexities of NovaStar's business confused more than just the longs as Mr. Rocker called in on an earnings call and started asking about subprime auto loans.

David Rocker also controls Compass and Helmsman Holdings, two offshore hedge funds not bound by U.S. reporting or trading restrictions. Other off-tangent questions advanced by representatives of these funds involved why NFI (rating, news) doesn't have a CFO, suggesting non-compliance with Sarbanes-Oxley. Truth be told, NFI (rating, news) is in compliance with Sarbanes-Oxley, and this has never been an issue as the CEO Scott Hartman takes legal responsibility for the financial reports. Many wonder aloud why Rocker Partners, who was obviously so critical of NovaStar, previously held over 5% of the outstanding shares of NovaStar, and more importantly why the majority of these shares lacked voting rights. Some point to odd trading patterns, striping at the bell, and abnormal trading volume and believe that those holding the large short position are to blame.

A beacon of light
Investors seeking to alleviate some of the confusion decided to create websites about mortgage REITs. One such site is www.mreits.com that includes a daily recap of events for mortgage REITs to include a handy comparison based on yield. FYI, NovaStar is trading at a 59.2% discount to peers currently. Another site www.nfi-info.net is Greenberg's favorite apparently because it has an entire section devoted to him. Herb was critical of the person that is the webmaster for the site because of their decision to remain anonymous. Apparently, anonymity is reserved only for his "short sources," and someone must be held responsible if NFI (rating, news) doesn't "perform as billed."

As always, don't forget the Fool's Real Estate & REITs discussion board for some insightful conversation.

Fool contributor Craig Cunningham owns shares of NovaStar Financial. He went from the happiest place on earth in the Hudson Valley of New York to a place known only as Bliss in West Texas. Please send him some words of encouragement. The opinions represented here are not necessarily the opinions of The Motley Fool. The Fool has a disclosure policy.

[AceHigh]

[ QUOTE ]
I perceive good value in NFI currently but I have a target price of about $50

[/ QUOTE ]

I just bought back into NFI earlier this week. $50 is right around what I figured fair value for the company, maybe a little higher.

Check out IMH, similiar to NFI without the variance.