Impac Mortgage Positioned For Optimal Growth After Restructuring
The common shares have an upside potential of more than 20 times due to the opportunity brought by the cyclical downturn in the mortgage business.
Investors and regulators are focusing on the wrong risks.
Powell aims to re-align the "Red Hot Housing Market."
Current low mortgage credit availability is keeping a lid on affordability.
Opportunities exist now for long-term investment in mortgage finance.
Impac Mortgage recently restructured, opening up new opportunities to grow.
Investors looking for a value opportunity should take a look at mortgage originators like Impac Mortgage (IMH). A rapid upward shift in interest rates has driven mortgage rates higher and reduced overall mortgage origination volume by magnitudes. The cyclical downturn has hit stock prices and presented a value proposition. The value proposition in mortgage originators is driven by a few macro factors which will be discussed below.
Impac is also a special case, as they have just completed a restructuring. While the entire sector looked weak, Impac was at the mercy of ongoing litigation around the capital structure. The recent restructuring removes much of the uncertainty about who owns the company. Shareholders have been waiting for this moment for over a decade.
Financial Regulation
They say that financial regulators and investors are always "fighting the last war." By that, they mean that we as a society are looking to the failures of the past and taking precautions to avoid the same mistakes. It's human nature. This can be best seen by the actions and statements of everyone from individual investors to regulators.
For instance, in a recent transcript from a Federal Reserve Press Conference with Jerome Powell on September 21, 2022, housing and mortgages are mentioned a total of 20 times. The most interesting part, to me, however is that cryptocurrency and Bitcoin are not even discussed.
Here's is a snippet of Fed Chair Powell calling for a housing market reset.
CHAIR POWELL. So when I say reset, I'm not looking at a particular, specific set of data or anything, what I'm really saying is that we've had a time of a red hot housing market, all over the country, where famously houses were selling to the first buyer at 10 percent above the ask, before even seeing the house. That kind of thing. So, there was a big imbalance between supply and demand and housing prices were going up at an unsustainably fast level. So the deceleration in housing prices that we're seeing should help bring sort of prices more closely in line with rents and other housing market fundamentals and that's a good thing. For the longer term what we need is supply and demand to get better aligned so that housing prices go up at a reasonable level, at a reasonable pace, and that people can afford houses again, and I think we, so we probably in the housing market have to go through a correction to get back to that place. There's also, there are also longer run issues though with the housing market. As you know, we're, it's difficult to find lots now close enough to cities and things like that, so builders are having a hard time getting zoning and lots, and workers and materials, and things like that.
After the Great Recession, the focus on regulators is still firmly planted on housing and mortgages, as part of the economy. At the same time, they are completely ignoring a bubble in a brand new asset class, cryptocurrency. At this time, the cryptocurrency bubble has grown to as much as $3 trillion and shrunk by more than $2 trillion. This article is not intended to analyze cryptocurrency. The point is that regulators are still focused on past failures and markets like housing while other issues loom.
Today, housing and mortgage credit are in a really safe and sound place. In fact, the reigns of mortgage credit could be loosened. Mortgage credit availability never returned to a fraction of the levels seen before the last crisis.
Because credit availability in the mortgage market never really bounced back, certain product offerings like home equity loans and non-qualified mortgages have lots of room to grow. This is especially true when you consider that higher rates make the expansion of mortgage credit more profitable. It's much easier and more profitable to package a group of pristine NonQM mortgages into a AAA mortgage security when you are one of the few firms offering that product.
With rates appearing to stay high for a while, regulators should really start considering pulling back the reigns a little and letting mortgage credit availability expand. In fact, consumers may be demanding this soon.
Supply and Demand
Maybe the top headline in housing for the past few months has been the rapid rise in interest rates. This is taking a bite out of mortgage demand. Overall volumes have plummeted, but like any cyclical correction, it will eventually reverse. Even this week, stocks began to rally on the hope of a Federal Reserve policy pivot. Don't get too excited yet. There's no reason to believe the pivot comes before inflation reverses course.
While rates are going up, housing prices have been resetting, but perhaps they won't fall as much as people expect. The housing market is a function of several things. Like any market, it is affected by both supply and demand.
Right now, according to Realtor.com, active home sale listings are up 26.9% year-over-year. That sounds like a huge inventory problem until you put it in context.
As the chart above clearly illustrates, active listings lag their pre-pandemic level and growth has stalled over the previous month. The number of homes actively for sale in September was 42.6% lower than the pre-pandemic 2017-2019 average. - Realtor.com
Further, pending listings are also dropping. This would make sense, as mortgage holders who purchased and refinanced with rates below 3% would need to weigh the cost of a 7% mortgage rate when deciding to move to a new home.
If people don't have access to purchase a home, the alternative is renting.
As you can see here, the rental vacancy rate has been dropping since 2010. This indicates that supply has been dropping in the rental market. The rental market is often overlooked when evaluating housing market health, but as you can see below, a multi-decade expansion in rental vacancies coincided with the expansion of the housing bubble that popped in 2008.
As Chair Powell said above, the Federal Reserve is hoping that housing prices can be more aligned with rents. Guess what? The price index for rent has been increasing and even accelerating in recent years.
The lack of supply in housing purchase markets will not be made up for with an abundant supply in the rental market. So, the reality is that there will continue to be persistent inflation in rent and mortgage payments.
Recent highs in housing starts, which is an indicator of the production of new homes, reached levels last seen in 2006. However, the rate of production stayed near multi-decade lows until 2019. This allowed the market to work through all excess inventory. Increased supply may eventually come to market but that will take time.
Why does housing supply matter? In the lending business, you want your collateral to retain it's value. Back in 2009, mortgage loans were backed by assets that rapidly depreciated. The reason was that there was simply too much supply. Even Warren Buffett joked that to fix the 2009 housing and mortgage crisis, we could have 'blown up a bunch of houses.'
Expansion of Mortgage Credit
After the housing market hits the equilibrium level suggested by Powell above, we may be sitting at a higher level of interest rates that is consistent with long-term historical levels. Mortgages may no longer be offered with bargain rates. Housing affordability may be negatively affected. One of the only tools available will be a modest re-expansion of mortgage credit availability. This is also known as NonQM.
Impac Mortgage (IMH) may be the best investment opportunity in mortgage finance right now. Few are paying attention to this company which is poised to be a leader in NonQM markets.
At this time, Impac Mortgage has at least five NonQM lending programs. These programs focus on pristine home loans that don't conform to conventional lending standards. For instance, one program targets some buyers who are paid as contractors and issued a 1099 instead of W2 for tax purposes. Another program targets jumbo home loans larger than the conforming loan limit. All of the programs have minimum FICO scores and strict underwriting guidelines.
The intent of these programs is to offer home buyers with options that exist parallel to federally-backed lending programs. If a buyer qualifies for a loan from Fannie, Freddie, or FHA, then they will likely get that loan. However, when someone needs a place to live and their financial situation exists just outside the conforming loan box, Impac provides alternative loan options to provide access for purchasing or refinancing a home.
Impac's Rebuilt Balance Sheet
After many years, Impac just restructured their balance sheet. As part of the recent restructuring, many Impac shareholders, including myself, tendered our preferred shares to exchange preferred stock for a combination of warrants, common stock, and/or a new cash-like preferred security. Prior to the restructuring, the common drifted down to about 25 cents a share, reflecting the risk of the deal's failure. It's not hard to understand why since the restructuring deal took about a decade to come together.
This particular situation came about due to a flawed tender offer in 2009. That tender offer came quickly and shareholders felt that it wasn't fair. The recently announced tender offer has been brewing for years and the rough details were discussed for many months before anything became serious. The company has acknowledged long ago that the preferred stock needed to be restructured. It's been thirteen years since the Great Recession and nobody would have predicted the restructuring would take this long to finalize.
The bargain basement price for Impac's common stock would surprise many common shareholders than bought the stock over $20 in 2015.
One of the biggest issues the company had to resolve was that they were not in compliance with the debt covenants around their warehouse lending lines, mostly due to issues with their balance sheet. Impac owed a cumulative undeclared dividend of $19.9 million to the Preferred B holders. They also had a large $15 million note due to the largest shareholder that needed to be renegotiated. Without the warehouse lending lines being active, they wouldn't have been able to repay this amount through operating earnings.
So, for the reasons stated above, it was critical that the shareholders moved forward with the restructuring plan. If the deal had failed, the company would have taken a much different path.
What was the benefit of the restructuring plan?
After the Great Recession, the company's stock was also in the bargain bin. That's when Richard Pickup stepped in and started buying. Mr. Pickup generously offered a few cash injections which helped the company move forward from the financial crisis. In 2014, they even purchased CashCall Mortgage. In 2015, they earned $80 million, quickly reversing a prior year loss.
The company had a few good years after that, but the shareholder lawsuits took a bite out of things starting in 2018 when it became apparent they would not go in the company's favor. The triggering event for the company's reversal in operations was a Baltimore court ruling in July 2018 that awarded cumulative dividends to the Preferred B shareholders. This was four years ago and the company has not returned to this same level of profitability since.
The point being that this small company can rapidly change course and return to profitability if the conditions line up properly. They have done it before. The missing piece is a clean balance sheet in this case. The restructuring event on October 20th is a catalyst that sets them on the correct course. It will remove the uncertainty around the three classes of equity and align all shareholders in the same pursuits.
Further, when they return to profitability, there is a good chance that they can utilize their deferred tax assets. The current valuation allowance on the deferred tax asset is $257.3 million.
A valuation allowance on an asset essentially removes it's value. This is an accounting adjustment that indicates the asset is impaired. This valuation allowance could be reversed if the company determines that it is more likely than not that they will be profitable enough to utilize the asset. When that happens, the full amount of the asset will be recognized in GAAP Earnings and become a portion of the stock's book value.
To compute the value of the deferred tax asset per share, one must be able to compute the number of total shares. As of 6/30/2022, the company had a total of 21.5 million common stock shares. The conversion offers for the Preferred B and Preferred C shares will issue an additional 8.9 million and 1.8 million common shares, respectively. Therefore, the newly issued shares will total 32 million, as of October 26th. There are also an additional 2.1 million in warrants that will be issued to Preferred C stockholders, bringing total potential diluted shares to 34.2 million.
With the deferred tax asset being worth $257.3 million in total, the deferred tax asset is worth around $6 to $8 per share after restructuring the preferred stock. This could be a significant value driver for stockholders buying at this price. Further, returning to a base level of profitability seen in prior years would generate $1.50 to $2.00 in GAAP EPS (after dilution). Even at a low multiple, the proper valuation on the stock would be higher than $6 to $8 per share. At today's common prices, the common has a potential upside of more than 20 times and that's the bottom line of why you would want to own it.
You bro, you holding for the long haul on Impact?