Investment Strategy

The Prodesse Investment Strategy

We invest in what we believe to be the premier asset-backed securities in the world – US residential mortgage-backed securities issued and guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. We enhance the return on our investment in these securities by using leverage. Similar to a bank, we seek to earn positive net interest income from the difference between the yield on our securities and the cost to finance them.

Assets

Mortgage-backed securities or MBS, are ownership interests in mortgage loans made by financial institutions (savings and loans, commercial banks and mortgage bankers). When an institution has made enough loans it will “pool” or package them together and sell them to mortgage investors like Prodesse. The institution will collect the principal and interest payments made by the homeowners and forward them to the mortgage investor. All of the securities in the portfolio are guaranteed by Fannie Mae, Freddie Mac or, Ginnie Mae, which carry actual or implied AAA ratings and therefore have virtually zero credit risk exposure. When Fannie Mae and Freddie Mac, Ginnie Mae issue MBS, they guarantee that investors will receive timely principal and interest payments regardless of what happens to the underlying mortgages. Fannie Mae and Freddie Mac are shareholder-owned publicly traded corporations created by charters of the US Congress. They are commonly referred to as “Government-sponsored enterprises”, or “GSEs”, although their obligations are not guaranteed by the United States Government. Ginnie Mae, on the other hand, is a wholly-owned US Government corporation.

We take pride in the transparency of our balance sheet and the “plain vanilla” strategy we deploy in our portfolio. All of our assets can be easily priced and traded in the largest fixed income market in the world, the mortgage-backed securities market. Because of this, the quarterly net asset value we announce fairly approximates liquidation value of the company.

FIDAC MBS Barbell Strategy SM

Our investment manager structures our portfolio using the “FIDAC MBS Barbell Strategy”. At one end of the barbell are adjustable-rate and floating-rate securities. These securities tend to outperform when interest rates rise because their yields will increase as interest rates rise due to the adjustable nature of their coupons. On the other end of the barbell are fixed-rate securities. These securities generally experience capital gains when interest rates are falling, which help to offset the lower yields associated with falling interest rates.

Financing

We believe that managing the financing side of our strategy is just as important as the asset we choose. We use the repurchase markets to finance the acquisition of our investments. The repurchase market is an extremely liquid, efficient market used by most major financial institutions either for lending or borrowing money. 

Borrowing Policy

Prodesse uses leverage to enhance the returns to shareholders. For this purpose we intend to borrow amounts equal to between five and ten times our net assets.

Prodesse uses primarily short-term borrowings to fund its investments and to pledge its assets to secure such borrowings. To effect such borrowings in a cost-efficient manner, we enter into master repurchase agreements (an agreement effecting a current sale of a security with a concurrent agreement by the seller to repurchase the security at a later date at a higher fixed price reflecting the cost of funds for the term of the agreement) with various major financial institutions. The major dealers in this market include firms designated by the US Federal Reserve as ‘‘Primary Dealers’’ in US Government securities and a number of banks and other financial institutions. We borrow from a number of lenders and limit our exposure to any one lender to a maximum of 30% of overall borrowings.

We believe that managing the financing side of our strategy is just as important as the assets we choose. We use the repurchase markets to finance the acquisition of our investments. The repurchase market is an extremely liquid, efficient market used by most major financial institutions either for lending or borrowing money. FIDAC, our investment manager, has over 50 years of combined experience in this area.

Putting the Pieces Together

Why do we use leverage and how does it potentially enhance returns to the shareholders? In the example used below, let’s say we are given $1 million to invest. We would purchase a portfolio of agency securities and use them as collateral to borrow $8 million (leverage 8x) which we would use to purchase additional securities. In total we would have purchased $9 million of securities paying us a rate of 5.25% and borrowed $8 million at a cost of 4.55%. (The interest rates used in this example are for illustration purposes only. They are not indicative of rates currently available.)

Investment Model

Yield on portfolio 5.25%
Cost of borrowing -4.55%
Net interest rate spread 0.70%
Debt to equity ratio 8 times
Yield on unleveraged portion of the portfolio 5.25%
Net interest rate spread x leverage (8x) 5.60%
Gross ROE 10.85%

Without leverage we would have purchased $1 million of securities and made a total of $52,500 ($1,000,000 x 5.25%) for the year. Using leverage in the above example we earned $108,500 ($1,000,000 X 10.85%) or $56,000 more than we would have earned with no leverage.