Description

I'm recommending the trade buy Invesco Mortgage Equity (IVR) and sell a 80-20 mix of Hatteras Financial (HTS, 80%) and Chimera Investment Corp (CIM, 20%).  For those who prefer a less complicated trade, I'd recommend shorting just HTS against IVR or an unhedged long position in IVR alone.  The core of my thesis is that IVR, which was a recent IPO, is trading at a 15% to 20% discount to its peers, does not suffer from any competitive disadvantage, and has a potential near-term catalyst that can help to realize hidden value.

There are several well established, publicly traded US REITs that invest primarily in residential mortgage backed securities (RMBS).  They come in basically two flavors, those that invest primarily in mortgages guaranteed by Freddie Mac, Fannie Mae, or Ginny Mae (agency RMBS) and those that invest primarily in non-agency RMBS:

Invesco is a recently launched fund, with a book value of $19.55 per share.  The IPO priced at $20.00, with at least two decreases in the size of the offering before pricing.  I stayed away from the IPO on the general principles that very few investment funds open up off their IPOs and that sticky deals never work, so I thought I would be able to pick the stock up at a discount to the IPO price.  I was right.  IVR broke price on the open of the first day of trading ($19.80), and has not as yet reached the $20.00 level.  The stock traded as low as $19.05 (97% of book value) last week, but recovered to the current $19.55 per share, largely on rumors that Wilbur Ross, one of whose entities manages Invesco, will be among the firms participating in the public-private investment partnership (PPIP) program (see below for more on this).

The company invests in both agency and non-agency RMBS, with its capital is divided roughly 50-50 between agency and non-agency paper.  At present, IVR has financed its agency RMBS, but not its non-agency RMBS, so the fund's assets are allocated closer to 80% agency, 20% non-agency.

Relative Valuation-Non-Agency RMBS

Chimera is the only substantial non-agency RMBS REIT.   Chimera, like the other REITs listed above, marks its RMBS portfolio to market.  Chimera's equity trades at a premium to the agency REITs, 1.40x book value for CIM, versus an average of 1.16x for the four largest agency RMBS REITs. [fn. 1]

CIM's management, as is customary in mortgage REITs, receives an annual fee of 1.5% of assets under management, without any incentive fee.  Since the fund must pay out all income realized during a year to maintain REIT status, management's options for increasing the size of the fund are limited.  The company has issued common stock twice this year, in April and in May, in each case as its price to book value approached 1.4.  While I suspect they may wait a few months before doing a third raise, the firm's willingness to raise additional funds puts a cap on their price to book multiple in the 1.4 to 1.5 range.

To the extent information is available, the main difference between IVR's non-agency book and CIM's is that CIM has financed most of its non-agency paper, whereas IVR has not borrowed against theirs.   While CIM is a more established firm with first-rate management, IVR is managed by a Wilbur Ross affiliate, so it should have very similar financing options for its non-agency book.   At present, management says that they do not like the financing terms available, so this difference appears to me to be a tactical choice, with IVR having the ability to finance its non-agency book at will, rather than an ongoing driver of relative value.

Last week, it was widely reported, though not yet confirmed, that Wilbur Ross will be one of the Fund Managers (FMs) selected for the Legacy Loan program of PPIP, in which qualifying funds will receive an equity co-investment equal to 100% of the fund's privately raised assets, plus loans from Treasury of up to 200% of the fund's privately-raised assets.  [fn. 2]  While management is understandably tight lipped about this, Invesco's management contract provides that, if it invests in a PPIP fund that is a Wilbur Ross affiliate, fees charged by that affiliate will come out of the 1.5% management fee.  If Wilbur Ross is included in the PPIP program as rumored, Invesco will probably have a slight cost advantage over Chimera in placing assets into PPIP.

I'm assigning a conservative fair value of 1.4x book, Chimera's multiple, to IVR's non-agency book, with the reservation that PPIP could provide a significant edge, so I think there's more upside potential.  My downside case is a 1.25x book multiple for Invesco's non-agency assets.

Relative Valuation-Non-Agency RMBS

There is, in my view, little to chose among the agency-REITs.  Their business is relatively straightforward, and their business models are nearly identical, so I can't explain why Capstead and Hattaras trade at such higher price to book multiples than do NLY and ANH.   In my opinion, CMO and HTS both make fine shorts against Invesco.  I recommended Hattaras as the short primarily because it has sold equity into the "green shoots" rally, so management seems ready to dilute shareholders if price to book rises, while it's harder to read Capstead's intentions.  I have IVR's fair value for its agency book at the average of the four major agency RMBS REITs, 1.16x book, with a downside case of 1.05x book, just below the lowest multiple of the four.

Sum of the Pieces

My base case multiple for IVR is 80% x 1.16 = 0.93x for the agency portfolio and 20% x 1.4 = 0.28 for its non-agency RMBS, for a total of 1.21 times book value, or $23.66, a 21% premium to today's closing price.  My downside case is 80% x 1.05 + 20% x 1.25 = 1.09 x book, or $21.31, a 9% premium to today's price.  Please note that these are relative valuations, based on the assumption of a short position in Hattaras and Chimera, so there is more downside to an unhedged long position in Invesco.

Liquidity/Borrow

CIM, HTS, and CMO are all liquid and easy to borrow.  IVR has traded around $1 million per day for the last three sessions.  It is possible that volume may drop off somewhat as short-term IPO participants sell their shares to longer-term investors.

Risks:   The main risk is that, if Wilbur Ross is not among the firms selected to participate in PPIP, the stock may slide for the same reason that it is up $0.50 from its bottom on the rumors that Wilbur Ross will be a PPIP manager.  Secondarily, because the IPO was done in a smaller size than management had hoped, they may raise additional funds if their price to book ratio rises substantially above 1.0x book.

A related note:  VIC members interested in this idea might want to look at Captiol Acquisition Co. (ticker CLA), a SPAC that intends to acquire a REIT shell and invest the funds in RMBS.  I know some of the people involved and have a high regard for their abilities, but I do not have a position at present and am not recommending the stock.  There are several issues at play in CLA, among which are the uncertainty of getting a deal approved by shareholders and the possibility of the company trading below book if the acquisition is consummated, much as IVR traded below book.  I can address CLA further in comments if anyone is interested.

Full disclosure:  The firm at which I work has positions in several mortgage REITs, with one exception, none of those positions are at odds with what I have said here.   The exception is CIM, where our firm is net long (though the account that I manage is more arbitrage-oriented, and short CIM for the reasons described above), because we expect that PPIP and expansion of the TALF program to include RMBS will be positive for Chimera.  I do not recommend a naked short of any of the mortgage REITs at present, including CIM.Footnote:

1.  My firm is primarily an equity shop, and I'm not comfortable right now addressing whether it is worth shorting CIM against a portfolio of non-agency RMBS (certainly it's not practical for most individual investors who are VIC members) to arbitrage the price to book spread.   If I find interesting opportunities in which I have confidence as I study the RMBS debt market, I'll post them.

2.  The arm of PPIP described in the text is the "Legacy Securities"program. In addition, under PPIC, purchasers of qualifying bank loans and asset backed securities will receive non-recourse financing from FDIC, but this isn't a major factor in evaluating IVR. Details of PPIP are available at http://www.financialstability.gov/roadtostability/publicprivatefund.html. 

Under TALF, the Term Asset the Federal Reserve provides non-recourse loans to finance purchases of eligible asset backed securities.  Details are available on the Federal Reserve Bank of New York's website at http://www.newyorkfed.org/markets/talf_faq.html.  TALF is currently not open to RMBS holders, though qualifying commercial mortgage backed securities (CMBSs) are eligible collateral.  The Fed will currently finance up to 85% of the value of a CMBS under TALF. 

Catalyst

PPIP, especially if Wilbur Ross is selected as an FM.  Even if Ross is not selected, PPIP will have a big effect on the RMBS market, providing another opportunity for the relative values of the mortgage REITs to come into line.