After years of using its low cost structure and real estate investment trust status to buy securities in the secondary market, Thornburg Mortgage Asset Corp. is gradually working its way back down the supply food chain, acquiring assets closer to their origination source and turning them into high-quality securities.

"We're kind of growing our own grapes to make our own wine," said Garrett Thornburg, founder and chief executive officer of the company.

Santa Fe, N.M.-based Thornburg, a REIT with a $4.6 billion portfolio of adjustable-rate mortgages and mortgage-backed securities, has recently started a program of originating loans through correspondence, utilizing the likes of banking giants Citibank, First Union, Fleet, among others, to originate ARMs to Thornburg's exact specifications.

The company also plans to begin a direct retail lending program in the early part of next year, implementing an Internet origination service in order to directly acquire loans underwritten to the company's high standards.

A Self-Sufficient Method

Boasting the lowest expense ratio of any mortgage holder in the country, the REIT's strategy of pooling these loans together, producing high quality securities and holding on to them in order to reduce financing costs, has worked like a charm so far, says Thornburg, and will be the company's main focus going forward.

"This is the most efficient method for us, and it is a fundamental part of our core strategy," explained Thornburg. "In this way, we also completely define the credit risk, since we may have some subordinated piece that carries its own insurance for these loans. It becomes very efficiently financed, and it is an excellent way to use the securitization process for our own stuff."

"We are not selling these securities to third party investors," added Deborah Burns, the director of the company's securitization business. "They want too high a yield and we get too low a price. We want to have the flexibility to securitize mortgage assets that we deem to be good performing, good quality, low-risk loans, maintaining them in our portfolio and financing them in alternative ways."

The company intends to continue securitizing its ARM product, but it hopes to move away from a dependence on buying MBS, trying instead to develop a more diversified approach that gives it the ability to take advantage of whatever market conditions exist at a particular time.

"Our objective is to finance only 20% to 25% of our product through capital market debt obligations," said Larry Goldstone, Thornburg's president and chief operating officer. "The other 80% will be through the reverse repurchase agreement market. We are dedicating most of our resources to the bulk acquisition of whole loans for our portfolio to reduce our cost, as well as securitization, to produce very liquid mortgage passthrough securities."

Investors Ignore Long-Term Performance

Despite the fact that the REIT's earnings have improved and that, in the long run, increases in short-term interest rates will actually push the company to a higher earning level, a continual volatility in Thornburg's stock has caused investors to focus on the short-term, where higher interest rates have caused disappointing earnings performance lately.

"It's amazing to us that everyone is looking at earnings for Amazon.com until 2025, but they're not willing to look at next March as to what this means for us," Thornburg said. "We have been tested under extreme market conditions, and we're still making money, so I don't think people understand how resilient our strategy is, how high a quality portfolio we have and how efficient we are.

"We have a Wal-Mart' cost structure which lets us have a Tiffany' strategy and assets," he quipped.

Investors have been somewhat disappointed with the company's stock recently: Thornburg's cost of financing has shot up recently due to higher interest rates, and there has been a definite reluctance on the part of the dealer community to want to provide financing. However, with an expense ratio of 12 - compared with 400 for most commercial banks and almost 200 for savings and loan institutions - the company has total control over its processes and achieves it goals with a small core group.

"The mortgage REIT sector has been the baby thrown out with the bath water, in my opinion. Because of our REIT status, we do not pay taxes, and so we have a very matched-up interest with our shareholders," Thornburg explained. "The more dividends they get, the higher return they get, and the more incentive fees we get. Otherwise, we'd live on bread and gruel."

Still, according to data compiled by First Call/Thomson Financial, Thornburg will be posting net income of 27 cents a share for the third quarter, which is being considered an earnings miss.

"The investor side is defensive," said Goldstone. "Unfortunately, we're not as aggressive as we are ordinarily, mainly because there is a significant Y2K psychological concern, and investors in mortgages are on the sidelines."

The Third Leg of the Stool

Still, the company has a plan up its sleeve to lure investors back and firm up its earnings. Thornburg's goal of "going direct" with its lending initiatives is the "third leg of the stool" for the company's strategy, says Burns.

"First, we buy ARM loans and securities in the market in bulk, then we are beginning to buy ARM securities through a correspondence lending program with 20 banks, and now we expect to be doing direct retail lending, sourcing mortgage loans for securitization," she explained.

By virtue of being the ultimate long-term investor of the asset, Thornburg is able to offer the retail customer very attractive interest rates, cutting out the middleman that usually exists between originator and investor.

"Usually a Street firm takes a slice of the pie, which results in higher interest rate product for the retail customer," Burns said. "When we go directly to the customer with the prices we can offer them, we are effectively cutting out the middle people."

"No matter what our method is, the most important thing to us remains the underlying quality of the mortgage," added Thornburg. "We are always looking at whether there is a good borrower with a good credit. But as to what investors are looking for recently?

"I wish I knew."

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