Preferred Share Risk Rating and Target Updates

Shortly before PennyMac Mortgage Trust (PMT) announced their plans, readers selected preferred share updates as the top area of interest. The PMT announcement slowed the process, but it is complete now.

We updated 3 things:

1. Fixed-to-floating terminology for shares that might not float.

2. Risk Ratings

3. Price Targets

The risk ratings and price target adjustments are all included in the big image at the end for people who want the cliff notes. The exact targets are already live in the Google Sheets.

Terminology

Previously, we only had the following:

1. Blank spaces for fixed-rate shares.

2. Bond

3. Floating

4. FTF

We’ve expanded the list to:

1. Blank spaces for fixed-rate shares.

2. Bond

3. Floating: Shares are floating.

4. FTF: Fixed-to-Float, same as always.

5. FTFP: Fixed-to-Float Probably. Management hasn’t been explicit enough that they are definitively including CIM-B in the shares that will be on SOFR + 26.161 basis points.

6. FTR: Fixed-to-Reset for shares that will reset every 5 years using the 5-year Treasury rate. This applies to AGNCL, EFC-B, EFC-C, and RITM-D.

7. FTL: Fixed-to-Lawsuit. The company intends to keep paying out the fixed rate. That may change if they face legal pressure. This only applies to PMT-A and PMT-B.

8. FTBS: Fixed-to-BullS… The company appears (to me) to be hinting that they want to wait until they see how rates play out over the next several years before deciding if their shares are fixed-rate or floating-rate. They have an incentive to pick whichever is worst for the shareholders. Consequently, these shares get neither the upside from a certain fixed rate if yields go down nor a much higher dividend rate if rates remain elevated. This only applies to TWO-A and TWO-B. Note: If CIM remains silent on the matter of CIM-B, it could be added to this category.

Risk Ratings

Zero risk ratings were decreased. 16 ratings were increased by 0.5 points or 1 point. 

Reasons for moving risk ratings boiled down to two major categories:

1. Shares were in the FTL or FTBS category. That’s PMT-A, PMT-B, TWO-A, and TWO-B. I did not change the risk rating on TWO-C, so TWO-C has a lower risk rating than TWO-A and TWO-B.

2. The ratio of either common equity or common share market capitalization (so book value or share prices) relative to preferred share liquidation value was too weak. These REITs had time to fix the ratios but didn’t get it done. This includes all preferred shares from CIM, NYMT, GPMT, and CHMI.

I’ll highlight this using the last 2 years to demonstrate the size of the trend. Most individual quarters were much smaller losses, but they added up.

Chimera Investment Corporation

Over the last 2 years, CIM’s book value per common share declined by 36%. During the same period the number of common shares decreased by about 4%. Consequently, common equity is down 39%. On the other hand, they have the same amount of preferred equity outstanding. That eats into the coverage for investors and results in the risk rating going up from 3 to 3.5. If the trend continues, they could move to a 4.0. I would like to see CIM selling off some of their investments into the market and repurchasing CIM-B and CIM-D in the open market.

New York Mortgage Trust

Over the last 2 years, NYMT’s book value per common share declined 34%. Shares outstanding fell by 4%. Not great. Meanwhile, NYMT increased the total outstanding preferred shares by about 6%. They made a tiny dent in the additional preferred shares this year, but it wasn’t nearly enough. Somebody explain to me how NYMT expects to earn a better return on their investments than they would earn by repurchasing NYMTL at $19.02. 

If they wait and call the shares when they start floating on 10/15/2026, the shareholder would have a 19.5% yield-to-call. Choosing not to buy them back is obviously a garbage decision. As a REIT, you don’t finance your business that way. Whatever assets they may buy offer a vastly worse risk/reward profile than repurchasing NYMTL. 

Of course, NYMT could just not call the shares with a 6.13% spread. How great does that sound? Not great. Welcome to mortgage REIT management 101. Your assets are not as useful at closing out those preferred shares.

Think NYMT could just pull a PMT? Maybe NYMTL won’t use SOFR? Shares were issued with the floating rate based on SOFR instead of LIBOR. There is no option to not use SOFR when the contract states it will use SOFR.

Granite Point Mortgage Trust

Over the last 2 years, book value per common share dropped 19%. Shares outstanding are down 6%. I’m a fan of management repurchasing common shares as well. However, they should be buying back preferred shares also. They had just over 0 preferred equity two years ago, so the increase in percentage terms isn’t realistic. As it stands, coverage using book value per share is still quite respectable. However, coverage using the common share price is extremely weak. 

That’s not a viable accounting comparison. Companies don’t use the share price to repay preferred shares. However, if GPMT were trading above book value, it would signal a stronger REIT. If GPMT were above book value, they could issue new common shares to repurchase the preferred equity. If they were above book value, that would be a perfect decision.

Poor decisions from management resulted in common shares getting a risk rating of 5.0. They are the only mortgage REIT under coverage with a 5.0 risk rating. It shouldn’t be surprising to see the preferred share risk rating increase. Preferred shares are graded on a harsher scale than common shares, so it is possible for the preferred shares to have a similar or higher risk rating than the common shares.

Let’s consider an asset GPMT might originate:

How about a hypothetical loan for 4 years at 9%?

If GPMT gets repaid in full and reinvests immediately, they earn 41% over those 4 years. We’re assuming they fund that position with equity, so there is no interest cost.

What if they repurchase GPMT-A at $17.22? They have a gain of 45.1% today. That’s better than the total they would’ve earned over 4 years lending at 9%. That’s before we consider the dividend savings. If we factor in the stripped yield being slightly over 10%, GPMT-A would save another 40.6% over 4 years. Assuming they reinvest the proceeds at the same rate, it would increase to 47.27% over 4 years.

There’s your choice:

1. Hopefully, earn 9% annually for 4 years for taking on credit risk.

2. Gain 45.1% today and save another 10% annually for 4 years (and more afterward) by repurchasing shares that are ahead of your common shareholder.

Which one do common shareholders want? This was not a tough decision.

As a bonus, you could lay off basically everyone who works in originations because GPMT doesn’t need to originate any new loans. Sorry, that’s not a bonus to the employees. It’s a bonus to the common shareholder.

We own a little bit of GPMT and GPMT-A. Why? There’s a big discount to the value of the assets. A firm with more capable management (sorry, truth hurts) could buy GPMT out and earn a great return by winding down the business.

Remember, we sat in AAIC for quite a while waiting patiently (sometimes less patiently) for the massive discount to book value to be resolved. When it happened, we had a huge gain (40% or so) in a single day.