Description

This is a short dated bond idea in an unloved space – mortgage REITs.

MFA Financial is an internally-managed REIT invested in residential mortgage loans and securities. The pitch here is for the 6.25% convertible bonds due 6/15/24. At a price of 92, these bonds yield 12.4% (+776bps) for <1.5 year paper. Recourse financing is $3.5 billion, or net debt of $3.0 billion. Behind the bonds are preferreds (at face) and equity market capitalization summing to $1.55 billion. See capital structure below. The way I look at it is recourse debt as a percentage of EV is 66% and this is further cushioned by loan LTVs of <60%.  

The assets are split into several buckets. The residential whole loans include purchased performing and credit deteriorated loans and purchased non-performing loans. Besides this, the company holds REOs, residential mortgage securities, mortgage servicing assets, cash and participations in securitization trusts.

Here’s a chart which breaks down the loan by type and shows the margin of safety due to sound underwriting (LTV + FICO scores) and home price appreciation.

The non-QM loans are 96% current and are heavily weighted towards California (58%) and Florida (14%). New business purpose loans (single-family and fix-and-flip) are produced by Lima One, an originator and servicer acquired 18 months ago by MFA. This has resulted in improvements in delinquencies and allows MFA to create loans well-below the cost to purchase. This funded $520 million of new originations in 3Q (LTVs of 67% and FICOs of 743) and an estimated low $400s in 4Q.   

The legacy non-performing and re-performing loans are split between 39% performing (i.e. less than 60 days delinquent), 47% in liquidation/REP and 14% non-performing (i.e. >60 days delinquent).  

Due to fixed rate debt and swaps, 99% of financing is effectively fixed rate. Loan financing is roughly 1/3 non-MTM and 2/3 MTM. The company continues to access the securitization market with nine transactions ytd and >$2.7 billion of UPB ($3 billion over the last 12 months) across various loan types. This market continues to be open to the company with ROEs of low double digits.

Here’s the capital structure ex securitized debt.

As mentioned already, total assets consist of loans, securities, MSRs and cash. As a creditor I like to focus on the balance sheet.

Here’s my breakdown of the various assets.  

The book value of participations in securitizations adds another $650 million+.

I’m less concerned with net interest margin and consensus numbers because this paper is so short-dated. The next question one might ask is what about interest rate exposure. Since 9/30, the 10yr is roughly flat. Previously, since MFA lends long and borrows short, management entered into swaps ($3.2 billion notional) to cushion any interest rate increases. Per the “shock table” in the 10Q, a 100 bps increase in rates would result in manageable losses of $109 million.

The short writeup is partially a function of the short-dated converts being an easier investment than the stock. The shares trade well below book value of ~$15.31 due to the aforementioned concerns over higher interest rates. Unfortunately, the company wasted capital on poorly timed share repurchases (>$100 million) as they evidently believed the stock was cheap at far higher levels.

Per the 3Q call, the share repurchases appear mostly completed. By design, the $434 million cash on hand provides a good liquidity buffer. The low LTV portfolio along with housing price appreciation provides a mitigant to potential losses. With the maturity of the converts approaching, my sense is management could repurchase bonds in the open market and/or look to refinance the paper before 2H 2023 when it goes current on the balance sheet. The relatively small size of the convert helps too. Besides cash, the agency paper offers a source of liquidity should the company need it. Additionally, management could let the book run off a bit to generate excess cash to handle the maturity.

In any event, I think the converts yielding 12% are an attractive investment with limited duration and credit risk. 

Catalyst

Open market repurchases

Time