Housing misery yields gains

Pssst! Want to buy some toxic assets?

It may be tough to imagine a more unappealing investment come-on than home mortgages. Housing prices continue to fall, and rising foreclosures suggest the market won't improve anytime soon. Persistent high unemployment means a shortage of motivated and qualified buyers to suck up unsold inventory.

But even in misery there is opportunity.

The folks at Two Harbors Investment Corp. understood this back when the uncertain value of home mortgages was leading to the failures of Bear Stearns and Lehman Bros., and the panic on Wall Street was palpable.

"We saw the opportunity in 2008," said Thomas Siering, Two Harbors' chief executive. Today, it's reaping the returns of acting when others stood still. The company recently completed its second stock offering in three months, raising a combined total of $416 million from investors.

Two Harbors is a real estate investment trust (REIT) whose shares are listed on the New York Stock Exchange. But the real appeal for investors is that it represents a public face of sorts for Pine River Capital Management, a Minnetonka hedge fund with $4.1 billion under management. Founded in 2002, Pine River is run by analysts and portfolio managers like Siering, who learned the ropes of investing in out-of-favor or distressed assets at Cargill and EBF & Associates, also based in Minnetonka.

Few assets were as distressed in 2008 as bonds secured by trillions of dollars' worth of homeowner mortgages. Collapsing real estate prices coupled with a dawning realization that lenders had said yes to any and all borrowers meant that nobody was quite sure what anything was worth anymore.

Two Harbors is incorporated in Maryland but has no employees. Pine River runs the company and receives a management fee of 1.5 percent of equity under management. Assets totaled $1.8 billion at the end of 2010, while equity was $382 million. The name signals the company's Minnesota ties (the company is also a new sponsor of Grandma's Marathon), as well as its investment strategy.

The first harbor represents the sheltered confines of agency RMBS. Competition for these is intense because the government guarantees mean there's no credit risk; the yield on this portfolio was 3.8 percent during the last three months of 2010.

Many REITs limit themselves exclusively to this sector, but 25 percent of Two Harbors' portfolio is in considerably riskier non-agency securities. This is where Pine River's experience and expertise come into play.

Steve Kuhn, one of the company's chief investment officers, was part of a Goldman Sachs team that managed $40 billion worth of mortgage-backed securities. His partner, Bill Roth, started his career at Salomon Brothers, the first Wall Street firm to sell mortgage-backed securities. They've both been through good and bad credit cycles and use that experience to stress test any portfolio they're considering.

"We've spent a lot of time and money building proprietary systems that help us analyze the market," Siering said. The company looks at things such as prepayment trends, fixed vs. floating interest rates, geographic concentration and average credit scores. It buys only one of every 10 securities it looks at, and it assumes home prices will fall another 10 percent nationally in 2011. Even then, "We can incur significant defaults and impairments and still make money for our shareholders," Siering said.

REITs attract investors seeking high dividend yields, and on this front -- 16.3 percent based on the closing price at the end of 2010 -- Two Harbors hasn't failed to deliver. All seven of the analysts who follow the company have a buy rating on its shares.

Two Harbors represents Pine River's first foray into the world of publicly traded companies, and Siering says he has enjoyed the experience thus far.

"It's been very satisfying," he said. "It's not easy for the retail investor to gain access to the residential mortgage-backed securities market. We think we deliver something to the market that's important."