By
Lane Olafson
:
My thesis on Impac Mortgage Holdings (
IMH
) is very simple, so I am going to get straight to the point. Impac
is a mortgage originator and real estate services provider that has
been growing its origination business at an impressive rate. In
addition to its two operating segments, the company has
discontinued operations in runoff associated with its pre-2008
activities in mortgage lending and as the manager and residual
holder of non-recourse trusts.
Impac earned $1.50 per share from mortgage originations and real
estate services in the third quarter. The mortgage origination
business pulled in earnings per share of $1.04, while real estate
services business earned $0.46. Below are earnings for these two
segments over the first three quarters of 2012.
In addition to these strong numbers, growth is expected to
continue to be strong going forward. The company noted during the
third-quarter conference call that origination volumes in October
were another 22% higher than the average monthly volume in Q3.
As the earnings from the Mortgage Lending segment attest, Impac
Mortgage has seen tremendous growth in its mortgage origination
business over the past few quarters. The company has grown its
market share at an extraordinary rate. The chart below shows just
how substantially Impact has grown its origination volumes since
the beginning of 2011.
The vast majority of loans originated are sold to Fannie Mae or
packaged into Ginnie Mae securities on a servicing retained basis.
This strategy has allowed Impac to amass an impressive portfolio of
agency mortgage servicing rights. Currently, the portfolio of
servicing rights has an unpaid principal balance of $1.7 billion.
This is up substantially from Q2, as the chart below
illustrates:
I have already written an article about the opportunity in
mortgage servicing
here
. To recap that thesis as it applies here, Impac is growing its
book of servicing on Agency backed loans at a time of record low
interest rates and strict lending standards. Thus, the company is
amassing a portfolio of high quality servicing that should pay out
for years to come.
The growth story at Impac Mortgage is one of growing origination
volumes from its retail, wholesale, and correspondent channels, an
expanding portfolio of mortgage servicing rights, and future growth
opportunities in commercial mortgages in 2013. The value story at
Impac Mortgage is because the current share price of $12 only
prices in two times third-quarter earnings.
GAAP Earnings Are Misleading
With the basic thesis out of the way, let's get into the
details. The difficulty in analyzing Impac Mortgage is because the
company's GAAP earnings are obscured by a couple of factors. These
factors are similar to the ones that are obscuring the results of
many financials, originators, and mortgage servicers these
days.
In particular, Impac reported the following GAAP adjustments
last quarter that are not related to the earnings of the two
operating segments:
- Mark to market and real estate owned adjustments of
non-recourse trusts
- Legal fees and repurchase requests from its discontinued
legacy business
The adjustments and one-time charges led to significant negative
GAAP earnings from these discontinued and non-recourse operations.
Earnings of the non-recourse trusts and the discontinued legacy
business are shown in the table below.
Let's talk about each adjustment item in turn to get a clear
picture of why they do not represent recurring earnings from
operations.
Mark to Market Adjustments on Non-Recourse
Entities
GAAP earnings at Impac are misleading because they include the
mark to market and REO adjustments of trusts that the company
manages and holds residuals in, but of which the assets and
liabilities are non-recourse to the company (the company defines
these trusts as its Long-term Portfolio segment). Because these
trusts are non-recourse, the mark to market adjustments have no
economic impact on the company.
The company originated mortgages prior to 2008 and sold some of
these mortgages into trusts that bought them with funding they
received from investors they sold securities to. This was just the
sort of securitization process that was common prior to the 2008
meltdown.
The problem for financials that had originated these sorts of
securitizations is that so long as they continued to hold a
residual interest in them (which Impac does) and held a management
capacity within them (which Impac does), they had to hold them on
their balance sheet and mark the assets and liabilities to market
every quarter. I've seen the same effect for Newcastle Financial
and Gramercy Capital and it makes a cursory look at the balance
sheet and income statement of such companies confusing.
While the intent of having such entities on the balance sheet
was to increase transparency, in some ways it does the opposite
because every mark to market adjustment has to feed through into
the income statement, even though the change in value of the assets
is of no importance to the company's operations. Given that the
assets and liabilities in these trusts are currently marked at a
fair value of over $5 billion, it does not take much of a mark to
market adjustment to throw off GAAP earnings substantially.
Yet what matters is that these trusts are non-recourse to the
company. Apart from the residual interest that Impac holds in the
trusts (which I will get to in a second), the company has no
liability to them. Thus any true look at company earnings should
ignore the mark to market and asset valuation adjustments that they
cause.
The Residual in the Trusts' Spin-Off Cash
The only true economic impact that these trusts have on Impac
Mortgage is with respect to the cash residual they pay. Even though
many of the trusts have been adversely affected by the housing
collapse (in fact, Moody's
downgraded
a small number of these trusts just recently), some of the trusts
still have enough performing assets to pay a decent residual. When
the interest paid on the assets owned by the trusts exceeds the
interest required to be paid by its liabilities, and so long as all
the collateralization requirements are met, Impac receives the
excess cash as a residual payment.
These amounts are not inconsequential. In the third quarter,
Impac received $2 million in residuals from the trusts, and in the
first nine months, it received a total of $7.9 million. That works
out to $0.25 of cash in the third quarter and over $1.00 per share
of cash flow from the residuals over the first nine months. And
none of that cash is included in the $1.50 per share Q3 operating
earnings that I quoted at the beginning of the article.
Furthermore, while perhaps it is not necessarily a likely
scenario, there is a chance that Impac will realize further upside
from the trusts. Since Impac owns the right to residual cash flows,
if the trusts begin to perform better, perhaps because of an
improving housing market, Impac will capture that upside.
Admittedly it is difficult to quantify exactly how much upside, if
any, that may be, so it remains only a wildcard that investors
should keep an eye on.
Legal Fees and Repurchase Requests
In the third quarter, the company resolved two separate legal
disputes for a settlement cost of $6.1 million. While these legal
settlements were substantial, they removed two potential
litigations and left the company with no major outstanding
lawsuits.
These legal costs were considered part of discontinued
operations because they were made against the company's pre-2008
business of originating Alt-A loans. Nevertheless, the GAAP number
was affected by the settlements and they were a heavy contributor
to the negative GAAP earnings in the third quarter.
One of the points I have heard made to stir up fear about Impac
is the threat of other looming litigation. But the fact is that
Impac addressed this directly on its third quarter conference call.
Management first pointed to the rather obvious fact that any
company that originated mortgages in the period before 2008 will be
subject to at least some pending litigation these days. But
management then went on to state that "we don't have any large
lawsuits currently." They also suggested that what pending
potential litigation there was "out there hanging around" and that
they may or may not amount to anything. To get comfortable with
what remains of existing possible litigation, I would invite a read
through of the latest 10-Q and 10-K notes: Legal Proceedings. I
have read through both and see nothing out of the ordinary or
worrisome in the disclosure.
Apart from court cases, Impac continues to resolve repurchase
requests made by Fannie Mae. This should come as no surprise to
anyone, as any investor who has followed PHH Corp. (
PHH
), Bank of America (
BAC
), or any other originator of pre-2008 mortgages is well aware of
the repurchase requests of Fannie Mae. Much like PHH, the
repurchase requests are on the decline at Impac. Reserves for
repurchase requests fell from $2.3 million in Q2 to $1.8 million in
Q3. Impac noted in the third quarter 10-Q that "although the number
of repurchase requests are decreasing, the company still continues
to receive new repurchase requests while successfully disputing and
resolving others." If PHH guidance can be a guide, these requests
should continue to fall, but remain elevated from historical levels
until the end of 2013.
Growth Going Forward
In 2011 Impac got back into the mortgage origination business
primarily as a wholesale lender with a smaller retail business.
Early in 2012, it expanded into correspondent lending. In the third
quarter, it focused on expanding the retail channel. The success
the company has had in each segment is evident in the growth over
the last nine months:
The company is focused on increasing its purchase money business
(loans made on homes being purchased). While refinancing of course
makes up a majority of the origination business right now (74% in
Q3 vs. 26% purchase money business), the company has made specific
mention on both the Q2 and Q3 conference calls, as well as in the
excerpt below from the third quarter 10-Q, that its focus is on
developing relationships with realtors and brokers. And that it is
focusing growth on the purchase money business in order to take
advantage of the nascent housing recovery:
The company continues to expand its purchase money channel
capabilities by leveraging proprietary technology to increase its
realtor relationships. As of September 30, 2012, the Company has
over 1,000 realtors using our technology. Our goal is to use our
technology to facilitate relationships between our retail loan
officers and realtors to drive more purchase money lending
volume.
While some might question the sustainability of the refinancing
business over the long run, what I think is happening at Impac is
better seen as a market share story. The company is taking market
share from competitors at an extremely fast rate, expanding into
new states and new origination channels. Keep in mind that the last
five years have been terribly hard for individual mortgage brokers
and smaller correspondent lenders, who have been hit with changing
and increasing regulation that have squeezed operating margins.
With the regulatory environment unlikely to improve, things are
only going to get tougher for smaller operators. Meanwhile, some of
the larger banks have stepped back from aspects of the mortgage
business, particularly the correspondent side. Impac is positioned
to take advantage of this dearth of competition and so far it has
done just that, scooping up market share at an impressive rate.
In addition to growth in its traditional channels, Impac has
begun to offer reverse mortgages, jumbo mortgages and 203K
mortgages (which are FHA guaranteed loans used to rehabilitate
damaged properties). A final growth initiative was mentioned for
the first time during the third-quarter conference call. In
response to a question, management confirmed that they have begun
to refocus attention on commercial mortgage originations. The
commercial real estate business used to be a large segment for
Impac before 2008. The company said that it is originating loans
right now, and that it is currently "in the process of creating
programs for 2013 will lead to the reemergence" of the segment. One
has to wonder how closely the company can duplicate the success it
has had in the residential business.
Net Operating Losses
Lastly, one advantage of having survived the collapse of the
housing market is that the company has extremely large net
operating losses that it can apply against future earnings. During
the third-quarter conference call, the company noted that net
losses at the federal level were $500 million, while at the state
level they were $400 million. What this means is that it will be a
long time before Impac has to pay taxes on its earnings.
Conclusion
Impac ran up from $2 to a high of over $18 in an extremely short
amount of time. I have been invested in the stock since the
second-quarter earnings release and have been in awe of the move
up. The correction from $18 to $12 was a natural consequence of
such a parabolic move. But investors should be careful not to
confuse the violence of the moves with the operating potential of
the company. Impac is not yet held by institutions and has no
brokerage following that I know of. The uncertainty apparent in the
moves more likely reflects the lack of analysis of the core
businesses than it does the businesses themselves.
The current stock price of $12 prices just a two times multiple
to the annualized third-quarter earnings of the mortgage
origination and real estate services businesses. The fourth quarter
is almost certainly going to show earnings growth from these
businesses over the third. In addition, the discontinued and
non-recourse businesses are running off, the company has put two
lawsuits behind it, the residual trusts continue to generate excess
cash (and in the off chance there is a robust real estate recovery,
have the opportunity to increase their residual distributions to
the company), and the repurchase demands of Fannie Mae are expected
to slow. It is my opinion that even with the impressive move in the
share price over the past four months, there is plenty of
opportunity for further appreciation going forward.
Disclosure:
I am long [[IMH]]. I wrote this article myself, and it expresses my
own opinions. I am not receiving compensation for it. I have no
business relationship with any company whose stock is mentioned in
this article.
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