Investors were no doubt excited to learn that Thornburg Mortgage (NYSE:TMA) reported earnings of $424 million, or 84 cents per share, in its second quarter. To see a mortgage company produce such a huge number in this market is truly astounding, right? Well, the problem is that several special items boosted earnings. If these items are removed, the company earned only $22.7 million for the quarter.
Read on to find out how accounting rules transformed huge declines in the Thornburg's MBS portfolio into a headline-grabbing earnings number.
Special Items Anyone?
Thornburg had four special items that impacted its income statement during the quarter ending June 30, 2008:
- A fair value gain of $536.9 million related to the Principal Participation Agreement and a warrant liability.
- The company's MBS portfolio was marked down $209.6 million, offset by a $14.3 million net gain on the sale of assets.
- A fair value gain of $24.9 million related to an issue of senior notes.
- A $23.0 million gain on the extinguishment of asset-backed commercial paper debt.
The Principal Participation Agreement (PPA) is part of a capital raising plan conducted by Thornburg earlier in the year. Holders of the PPAs are entitled to receive principal payments that the company receives on its portfolio of mortgage backed securities.
How Huge Losses Become Huge Profits
Accounting rules require that the value of the PPA and the warrants and other derivatives be marked to fair value every quarter. Since the fair market value declined from last quarter, that decline is reflected in earnings as a positive number since it lowers the company's liabilities.
Thornburg was also impacted by these arcane accounting rules in the first quarter of 2008 when the mark to market caused a large loss after the value of the company's MBS portfolio fell by $1.54 billion.
Another way to look at the earnings would be to examine the net interest income (NII) that the company earned during the quarter. Thornburg earns interest on its holdings of mortgages and cash on the balance sheet, offset by the cost to fund those assets. This NII totaled $53.2 million in the quarter, down from $102.2 million in the same quarter last year. (For more finding the accurate financial picture, read Financial Statements: Earnings and Understanding The Income Statement.)
Thornburg's results also illustrate the fallacy of using a multiple of book value as a buy signal when a company has hard to value financial assets on its balance sheet. Thornburg reported a negative book value of $3.68 per share at the end of the second quarter.
The Growing Concern around this Going Concern
Thornburg still faces many obstacles to surviving the credit crisis. The company admitted as much in its most recent 10-Q filing, which contained a warning: "We have substantial doubt as to our ability to continue as a going concern."
The company received large margin calls in March 2008, and was able to satisfy these calls by signing an override agreement with its lenders. A requirement of this agreement was raising capital of $1 billion, which the company was able to do. The purpose of the override agreement was to allow the company a respite from its short-term liquidity issues and focus on its business.
Thornburg is now in a dispute with its lenders on the interpretation of that agreement, raising doubts as to whether it will be renewed when in expires in March 2009. Also, the company faces additional margin calls as ratings agencies downgrade its holdings of MBS.
Bottom Line
Many of Thornburg's peers have not been strong enough to survive the turbulence in the credit markets. Countrywide Financial faced similar issues and was bought by Bank of America (NYSE:BAC) in July 2008.While Thornburg's headline results showed strong earnings in the second quarter, the results were boosted by one-time items that required by accounting rules to be passed through the income statement. The company still faces serious obstacles to a recovery.
Find out how these bumpy times began in The Fuel That Fed The Subprime Meltdown.
