How I bought the mortgages the banks don’t want via Prodesse (PRD)

Important: What follows is not a recommendation to buy or sell Prodesse Investment Limited. I’m just a private investor, storing and sharing notes. Read my disclaimer.

Name: Prodesse Investment Limited Ticker: PRD
Listed in: London (FTSE Small Cap) Business: Investment Entities
More information: Digital Look / Google Finance
Official Site: Prodesse Investment

Key numbers for Prodesse (18/12/08)

Share price: 266.50p
Market cap: £83 million
Total assets: £1096 million
Net Asset Value per share: 351p
High/low (12 months): 448.50p / 266.50p
Yield: 16.2%

Summary of Prodesse’s business

First off, for this write-up of Prodesse I’m repeating my usual warning, with underlining: I am not an advisor, nor an expert. This is my amateur analysis of Prodesse, for your entertainment only.

Prodesse looks a very risky share, and it’s hard for professionals let alone amateur investors to assess its true value. It is an investment trust that buys AAA mortgage-backed securities (MBS) in the US, principally those of Fannie Mae and Freddie Mac.

If alarm bells aren’t already going off, they should be. The collapse of confidence in MBS market is what triggered the global credit crunch.

Prodesse only invests in top-rated MBS, but half of the problem has been nobody fully believes these ratings anymore, hence MBS have been marked down significantly. Besides cutting off the main source of money for mortgage lending (which caused Northern Rock to fail), this has also forced banks to declare huge write-downs on their devalued assets, and to return to the market for recapitalization.

(The other half of the problem are the lower-rated ‘sub-prime’ mortgages that are defaulting in huge numbers).

It all looks a toxic soup to wade into, but a couple of years ago MBS seemed a very boring investment. That’s exactly why so many institutions around the world ended up with MBS on their books.

It’s not even like Prodesse was set up to make spectacular returns. According to the company FAQ:

The investment objective is to achieve distributable income yield on net assets (in US dollar terms) of at least 3.5% greater than the yield on the ten-year US Treasury on an annualised basis while preserving net asset value (in US dollar terms) over the long term.

Prodesse aimed to make up these returns through leverage. You’ll note from the key numbers above that the assets under management is over £1 billion, while the company has a market cap of less than £100 million.

You’ll also notice that:

• Prodesse is apparently trading for 25% less than its asset value per share
• It is yielding over 16%

What this tells me, particularly the huge yield in excess of Prodesse’s target, is that the market is skeptical about Prodesse’s business model. Hardly shocking news; these are mortgage backed securities we’re talking about. Hiring six-year old boys to sweep chimneys would probably be less controversial right now.

The share price is at a 12-month low, having fallen nearly 20% in a week. I believe this is due to a failed bid to windup the trust.

Here’s a snippet from the FT on how hedge fund Polygon, which owned 25% of Prodesse, proposed Prodesse should be dissolved:

The struggling $4bn (£2.5bn) hedge fund, Polygon Global Opportunities, closed to investor redemptions last week and is now in the process of selling assets and winding down the fund in order to pay back investors.

It proposed this week that Prodesse, a Guernsey domiciled investment company with nearly $2bn under management in which it has a 24 per cent stake, should sell assets and return cash to shareholders.

The wind-up proposal was rejected at the Prodesse EGM on December 4th 2008.

The Chairman of Prodesse, John Hallam, made the following statement:

“We are pleased that the majority of our shareholders have accepted the Board’s recommendation to reject the proposals put forth at this EGM, and we thank them for their continued support and understanding of the risks and merits of Prodesse’s strategy.

While the Company has not been immune to the challenges of global market conditions, the application of its investment strategy has enabled it to produce consistently superior distributable income to shareholders. As the benefits of economic and government policy continue to take hold in the market, we believe that investors in mortgage-backed assets which are protected by an assumed 100% US Federal Government guarantee such as those of the Company are set to be rewarded.”

I suspect the recent share price weakness is due to the rebel hedge funds selling out of their holdings, or at least no longer actively buying in the market to try and get enough shares to swing the now-defeated vote.

Is Prodesse a sub-prime investment?

The main driver behind my investment in Prodesse is Warren Buffett‘s maxim to “Be greedy when others are fearful”.

I don’t believe I can assess the business better than the big fund managers who are also invested in the trust, including F&C, Blackrock, Artemis and Jupiter.

What I am hoping is that the 16% yield is due to the noxious smell attached to the very idea of mortgage-backed securities.

As we approach the end of this crazy year, how many fund managers want to explain to clients why they’re exposed to MBS, which “everyone knows are toxic”? Few, I suspect. Many would rather buy US treasuries and look cautious, despite the very low yields on government bonds.

There are some big risks with Prodesse, for sure:

• The MBS of Fannie and Freddie are assumed to be 100% guaranteed by the US government. But the US government could renege on this assumed guarantee.
• Leverage might kill Prodesse, even if the MBS payments are guaranteed for the long-term, due to further falling asset prices in the meantime. (This has happened with hedge fund faced with redemptions).
• The US housing market and economy might get so bad that even AAA securities become inherently worthless.
• AAA mortgage-backed securities might be much less safe than thought. (Probably the biggest risk I feel, as this recent article by Michael Lewis highlighted).

Against that, I’d set out a few crumbs of comfort:

• The US government is pumping the economy full of money.
• I doubt the US would renege on its assumed guarantee of Fannie and Freddie in the light of its drive to get the credit market going again.
• The hedge funds that blew up were typically leveraged up 30 times or more. Prodesse is more like 10-12 times leveraged.
• Credit markets are gradually thawing (see the fall in Libor), which should bode well for future affordable financing requirements by Prodesse.
• US Federal Reserve interest rates of just 0.25% should help both mortgage holders and holders of mortgage-backed securities.

If Prodesse can keep its dividend payments (or at least not cut them too far) and stay solvent for the long-term, I am betting that eventually the share price will go up as the income from its MBS look more secure.

I’ve read that certain AAA mortgage-backed securities assume a 30% default rate, far higher than anything ever actually seen in this class of borrower. Even if we’re entering a second Great Depression, default rates of 50% in such securities would therefore see the MBS maturing at 80 cents in the dollar (as I understand it!) which should put a floor under the value of Prodesse’s assets.

More positively, if AAA mortgage-backed securities start trading near-par again, I think that would result in a re-rating of Prodesse’s assets.

Let’s not be niaive. If we do eventually go through a re-run of the 1930s with 25% unemployment and mass migration across the United States, Prodesse will likely be a terrible investment. (As would almost everything else!)

So much remains uncertain about the economy, the supply of credit, and the ‘AAA-ness’ of these prime MBS, that a big investment seems foolish. I’ve been burnt by a couple of exotic investment trusts in the past year (Japanese and Eastern European REITs, to be specific), where I was only protected from huge losses by my position being extremely modest.

For that reason, my investment in Prodesse is small, at less than 1% of my current net worth

I bought at 275p a share, so I am already showing a small loss. Time will tell if that’s a hint of worse to come.

Update (19/12/08): Prodesse is now down to 235 pence in the 24 hours since I wrote this article. Clearly the markets aren’t moved by my posts yet! (That was a joke, in case not clear). I think the fall is due to shares being dumped by institutions and trackers ahead of Prodesse being demoted to the small cap index after the close of markets today. As such, it would be the same company as yesterday but at a cheaper price. However I might be wrong – as ever, do your own research.

Note: I take no responsibility for the accuracy of this post. Read my disclaimer.