Apex Capital Finding Profit From Interest-Rate Climate

Corporate Focus
by Anthony Palazzo

It's been a Goldilocks kind of year for Apex Mortgage Capital, the Los Angeles-based company that's structured as a real estate investment trust but operates more like a bank.

With interest-rates not too high, not too low, but just right, net income of $25.2 million for the first six months of the year is more than 18 times first-half 2001 earnings, and the stock price is up 22 percent year-to-date, adjusted for dividends.

Like banks, Apex makes its money from interest-rate spreads, borrowing short-term and lending over a longer period of time. Because its "lending" consists of investing in mortgage-backed securities, Apex was allowed at its formation in 1997 to call itself a real estate investment trust. The REIT structure allows Apex to avoid paying corporate income tax, as long as it passes essentially all of its profits along to shareholders in the form of dividends.

Apex doesn't buy or sell properties, but securities issued by Fannie Mae and Freddie Mac, two government-backed companies that buy up a large portion of the home mortgages issued by lenders around the country. These agencies then package the loans into pools and sell them to investors such as Apex.

Apex's strategy is to borrow money at short-term rates, which cost it 3.29 percent in the second quarter ended June 30, and buy top-rated Fannie Mae and Freddie Mac issues, whose recent yield was 6.46 percent in the Apex portfolio.

In the second quarter, Apex had profits of $15.5 million, or 58 cents per basic share, including an $8.7 million loss on its investment portfolio. Operating earnings were $24.3 million.

Borrowing allows Apex to leverage its investments, so for every $1 in investor capital it raises, it can borrow and put to work about $10. This multiplies returns to shareholders, so while the net interest margin was 3.17 percent in the second quarter, the dividend payout to investors of 50 cents per share represented a whopping 18 percent annual yield.

In the past year or so, Apex has raised $250 million in new capital, including two stock offerings so far this year, said Chief Executive Philip A. Barach. As a result, total assets have ballooned, to $3.5 billion at the end of June from $1.5 billion at Dec. 31.

Despite great returns, investors are wary, hence the underweight stock price. Interest-rate fluctuations can affect Apex's earnings, and the environment isn't likely to improve further. "Investors recognize that probably dividends are pretty high right now, maybe they won't go higher, maybe they'll even drop over time," Barach said.

Like other REITs that invest in mortgage-backeds, Apex depends mainly on three factors for its profits, said Jim Fowler, an analyst at JMP Securities LLC in San Francisco. A steep yield curve (the difference between long-term and short-term rates on government Treasury issues); wide investment spreads between Treasury issues and mortgage-backed securities; and generally lower borrowing costs.

These three factors are always fluctuating, and their interplay determines the environment for Apex. "Last year was the perfect year, and this year's a good year," Fowler said.

Financing costs are still low, the yield curve is flatter than it was last year but still relatively steep, and investment spreads between mortgages and treasury issues aren't quite as wide as they were last year but remain favorable, he said.

Nevertheless, rising interest rates could crimp Apex's interest margins, said Bjorn Turnquist, director of research with SNL Securities in Charlottesville, Va.

Fowler is more concerned with falling rates. "We now have a historically low level of interest rates and also mortgage rates. Refinancing is picking up considerably, and every time you hit historic extremes it's hard to understand who wins and who loses."

If mortgage rates drop further, he reasons, Apex will face prepayments on the cache of loans already in its portfolio."

And what about the ultimate extreme: A talked-about housing market crash like the one faced in Texas in the mid-1980s or in California in 1990?

Barach said he's studied those events, and surprisingly, a housing bubble would be "the best thing that could happen to us."

The federal government would lower short-term borrowing costs, he predicted, lowering Apex's. At the same time, housing prices would decline, making it harder for borrowers to refinance at lower rates protecting Apex's higher-interest loan portfolio from the risk of early repayments.

General Bank Update

Management of GBC Bancorp, already under fire from institutional shareholders, hurt its credibility further with the revelation that its previously reported second quarter earnings understated loan charge-offs by $7.25 million.

Two weeks ago, GBC parent of General Bank reported a second quarter loss due to $32.7 million in net charge-offs during the quarter, including about half of a $14.5 million loan to a commodities export company. Chief Executive Peter Wu said at the time he was confident that an outside review had uncovered all of the bank's bad loans.

But now, GBC says generally accepted accounting principles require it to write off the remainder of the commodities loan when it files its 10-Q report, widening the quarterly net loss to $8 million from $3.3 million. A number of the General Bank parent's institutional shareholders have already said they have lost confidence in Peter Wu's ability to manage the bank, and they want the board to consider selling out to one of at least two suitors.



Financial Editor Anthony Palazzo can be reached at 323-549-5225, ext. 224, or at tpalazzo@labusinessjournal.com.

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