The term "beer goggles" refers to a person who, having imbibed too much alcohol, suddenly finds members of the opposite sex much more attractive. Oftentimes, investors get "dividend goggles," when a juicy dividend yield seduces the investor into overlooking other flaws, such as the company's financial strength or ability to maintain that dividend yield. However, I think investors who wake up in the morning after buying Thornburg Mortgage (NYSE:TMA) shares won't be too frightened by what they see.

Company snapshot
Thornburg, as a REIT, pays out all of its profits in a tax-efficient manner. It also makes very big loans to people with very good credit (prime borrowers only, no Alt-A or subprime). Thornburg also deals solely with "trickier" adjustable rate and hybrid adjustable rate mortgages, where teaser rates and floating interest payments can make the mortgage rate volatile.

Because Thornburg is only a mortgage lender, and doesn't do mortgage banking (it holds originated loans on its own books and doesn't sell them), it doesn't book gains on sale, which means management doesn't have to make predictions about future early payment default rates, something that has tripped up other mortgage bankers.

How strong is credit quality?
Credit quality is the most important red flag when looking at a mortgage lender. According to a recent AG Edwards analyst presentation, Thornburg's typical borrower might take out a $630,000 loan on a nearly $1 million home, which equals about 33% down. Their annual median income is $200,000, and their average age is 47 years old.

Because Thornburg's borrowers have high incomes and a lot of equity in their houses, they tend to pay off their debt on time. In the first quarter, Thornburg's 60-day plus delinquency rate was a miniscule 11 basis points, with no loan losses. In fact, the company hasn't reported a loan loss for a stunning 21 quarters.

Does Thornburg have a moat?
I don't think any mortgage lender has a wide moat. At the end of the day, borrowers are extremely disloyal, because mortgages are commodities. Competition is fierce, switching costs are almost zero, and many costs are variable, so no single lender has an insurmountable economies of scale cost advantage. Furthermore, Thornburg buys bulk loans from industry juggernauts like Citigroup (NYSE:C), Wells Fargo (NYSE:WFC), and Countrywide (NYSE:CFC), so it's not like they can squeeze their suppliers.

That said, I don't think it's a knock against Thornburg that the company doesn't have a daunting moat. The company admits that it doesn't have an edge in terms of managing credit or interest rate risk -- so they avoid those risks as much as possible. Instead, the company focuses on the things it can control. For instance, Thornburg's paperless lending platform helps to cut expenses to only 20 basis points of assets.

Thornburg also seeks to occupy and defend its niche of offering flexible underwriting. The company notes that it doesn't do "blackbox" underwriting, and doesn't use Fannie's (NYSE:FNM) or Freddie's (NYSE:FRE) underwriting software, but instead personalizes their underwriting with an actual person who can work with the borrower to meet their needs. As a result, Thornburg can do things like let borrowers pledge investment assets instead of forcing them to liquidate their stocks and bonds to pay the down payment.

Although this flexibility comes with a cost -- Thornburg's cost of origination might be two times a typical lender's -- because Thornburg's average loan size is $1 million, Thornburg's expenses are extremely competitive with the industry in terms of basis points. So Thornburg's niche strategy does help protect it from fierce industry competition.

Financial engineering 101
Thornburg has also positioned itself well for growth. The company has branched out so that it has five acquisition channels to acquire loans, and three sources of financing: reverse repurchases, commercial paper, and securitizations.

The magic of securitization is that Thornburg basically takes its mortgage loans and repackages them into what's known as a collateralized mortgage obligation (CMO). Basically, CMOs are useful because they offer more flexibility. Like airline seats, CMO investors can choose whether they want the highest class (safest and most expensive), pieces of the CMO, or the cheaper, lower class slices. Thornburg generally sells all the "higher class (most senior)" levels of the CMO and retains the residual interest. In other words, they get all the excess cash flow after the other investors get paid off, but get nothing if cash flow falls short because of mortgage defaults or prepayments.

The best thing about securitizing loans is that it is "permanent" financing. Thornburg sells the CMO to investors, so ownership transfers and Thornburg doesn't have to worry about capital or margin calls -- something that tripped up New Century and forced it into bankruptcy.

Because securitization financing is permanent, Thornburg doesn't have to put up much collateral when it borrows money via securitization. Thornburg typically pledges $0.08 in equity for every $1 dollar it borrows via reverse repurchase or commercial paper (which is not permanent financing), but only pledges about $0.02 for every dollar it borrows via CMO. This $0.06 difference becomes huge when multiplied over the $19 billion in CMO financing Thornburg has done to date, which has freed up $1.3 billion in equity. This extra $1.3 billion in equity allowed Thornburg to put an additional $14 billion of assets on the books, and has created almost $100 million in incremental net income.

Thornburg shares are definitely interesting. The company posted $0.62 earnings per share in the first quarter and paid a $0.68 dividend -- so shares are trading at a 9.2% and 10% run-rate earnings and dividend yield. The mortgage industry has been suffering from credit problems, excess capacity, flat yield curve, and margin compression. Since it's much more likely that we're closer to the bottom of the cycle than the top, Thornburg's dividend yield looks very tempting -- even after taking off the dividend goggles.

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. Fannie Mae is a Motley Fool Inside Value recommendation. The Motley Fool has a disclosure policy.