The Carnage Continues

March 7, 2008

Sounds a little bit too much like FoxNews with the alarmist title and all, but I couldn’t help myself.

Anyway, the carnage I am referring to is the continued and rapid decline of Thornburg Mortgage’s share price. They hit $1.08 during trading today after it was announced they had to cover $1.777 billion in margin calls since the first of the year (they’ve only been able to cover $1.167 billion, leaving them, currently, $610 million short.)

For those of you not acquainted with margin trading here is a quick overview and here is a more detailed explanation. By no means am I a margin or derivatives expert, but I do remember a professor from business school telling me “NEVER trade on margin. It is one of the dumbest things you can do in business.” Granted, that is only his opinion, and given mortgages consist of borrowing and lending I suppose it is largely unavoidable in this industry, however, for whatever it’s worth I will always remember his words.

I have been following Thornburg since last fall and given the current turn of events conclude the following three things:

1) They could very easily go bankrupt. Duh. Having to outlay nearly $2 billion in one quarter has the chance of leveling even the soundest of companies.

2) They could be, as their CEO said today (ok, obviously he’s going to say this), suffering from the “irrational panic that has gripped the mortgage financing market that has no basis in investment reality.” If this is true and they are indeed feeling the effects of a drastic overcorrection and they can somehow limit having to cover additional calls by either raising cash or by negotiating alternative arrangements with the lenders making the calls perhaps they can remain afloat long enough to recover. It should be noted that Thornburg’s portfolio supposedly consists of “superior AAA-/AA-rated mortgage securities” - i.e. loans to higher net worth individuals with better credit and assumedly stronger financial status than the typical debt-ridden American.

3) Another, bigger company will acquire them. This happened with Countrywide earlier this year, when Bank of America stepped in and purchased them. After the announcement Countrywide’s share value more than doubled.

There may be more scenarios but these three seem the most likely. Also, in my opinion, I believe #2 or #3 are the most likely to occur. So, a question to my professor: does investing in a company that uses margin trading as part of its business model equate to trading on margin?

(Disclaimer: I picked the same 2 scenarios for K-Mart 6 years ago and ended up getting hosed for that decision so by no means do I hold any responsibility for your investment decisions, nor does any part of this post or blog constitute investment advice. Proceed at your own risk.)

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