Where to start? First, a mea culpa: I wish I had written about this more explicitly a lot sooner. Alesco was first brought to my attention during the Accredited Home Lender fiasco (then public and trading under the symbol “LEND”). LEND had been crippled by the credit crisis, and it had just agreed to be taken private by Lonestar Funds for $12 per share. Not too long afterward, the stock plunged when Accredited inserted a “Going Concern” clause in its 10K, fueling doubts about the viability of the sale and the enforceability of the merger agreement.
The merger agreement was the entire trade, and it contained one of the most upside down Material Adverse Change clauses I had ever seen. As everyone probably knows by now, a MAC clause is meant to protect a buyer or lender from any deterioration in the business of the target. If the target’s business goes south, the deal is off.
Astonishingly, this particular MAC excluded everything a prospective buyer would typically get in that clause, including the most obvious: a material adverse change in the business or operations of LEND, or the markets in which it operates. LEND’s lawyers had specifically crafted it that way, and Lonestar agreed to it, because this was a rescue deal. Everybody already knew LEND was in big, big trouble, and LEND had intentionally boxed Lonestar into a corner with this carefully worded clause.
If Lonestar backed out, however, it would have meant certain death for LEND. In fact, after the 10K was issued, there were so many shares borrowed and sold short that no broker I spoke with would bother to look for more.
Just weeks after plunging below $5 in one particularly bad after hours session, however, LEND was in fact taken private by Lonestar for $11.75/share. It was a fascinating case of how price discovery in the public markets is often not perfect, and proof that the “market” can and often does get it very wrong.
It was also one of the inspirations for REIT Wrecks. Market dislocations of such magnitude have been rare in my experience, yet they have been much more prevalent in the schizophrenia, and possible manipulation, of today’s market than ever before. Thus, with my fresh credentials as a genius in hand from the LEND trade, and with much deeper pockets, I went in search of new opportunities in high yield REITs.
I made almost every classic mistake. I bought early, I bought big, and I bought all at once, sucked in by the prospect of a worn-out beach chair and 20% dividends landing in my account in perpetuity. I lost a lot of money, far more than I made on LEND, but one of the mistakes I did not make was to confuse the merely walking wounded with the living dead.
One of my first screens was the vintage of the REIT. 2005 and 2006 marked the absolute height of the credit hysteria, and at that time anything with a coupon attached to it could be sold to a SIV in a New York nanosecond, regardless of the underwriting.
I first wrote about this issue, too cryptically, in an article here and in Seeking Alpha. I had hoped to subtly raise awareness on the point, without picking too specifically on one REIT or another. There was already enough misery out there.
In the article, entitled Mortgage REIT Yields Still Look Safe But Stick to the Seasoned Veterans, I wrote that the research firm Real Point had reported that 40% of all delinquent and unpaid unpaid CMBS balances through February 2008 came from just two vintages: 2005 and 2006. Of those, nearly 22% of all delinquencies came from the 2006 vintage alone.
“What is the significance of all this for Mortgage REIT investors?”, I asked, answering my own rhetorical question with the next sentence: “Stick to the seasoned veterans. Those who came late to the game have been hit the hardest and will take the longest to recover (if some of them ever do) because they bought at a time when underwriting standards suffered badly, and they stuffed their portfolios full of weak, demand-driven paper.”
Remember that this whole game was about distribution. Those who originated the paper were paid to sell it almost as quickly, and everybody from the lowest analyst on up to the most senior managing director was paid a commission (i.e., a “bonus”) for each deal they unloaded.
Demand was so insatiable that the only thing that mattered was finding paper and closing deals, not whether the deal itself was any good. This was also true of the ratings agencies, third party consultants and other advisors who where all paid for their “expert” opinions. If their opinions were not expert enough, they were told to get new ones, or the managing director in charge of the deal would get new experts.
Such was the environment that Alesco faced when it commenced operations in January of 2006, right at the peak of the credit market bubble. After completion of a $111 million Rule 144A equity offering, Alesco quickly ballooned its asset base to $3.1 billion, then merged with Sunset Financial Resources, a money losing but much more conservatively levered specialty finance company. Despite this, as of June 2006, the combined company had leverage of 20:1 on a pro forma basis. For a quick reality check, Schwab, Fidelity, Etrade and others will give you just about 2:1, and no more.
Unlike the investment bankers, Alesco was on the other side of the trade. Alesco, like most other REITs, was paid to buy and manage assets. The more assets under management, the more Alesco could collect in fees. Traditional views on what constituted conservative leverage did not particularly matter. This business model dovetailed nicely with those who were being paid to sell assets by the SIV load, and since nobody was paid on performance, there was really no need to look too carefully under the hood. That was left up to you and me, with guidance from the hopelessly conflicted ratings agencies.
As the calendar bade farewell to 2007, a lot of this bad news was already out. It was the second half of the story that had yet to unfold: the troubles with TruPs. These securities were meant to be the bedrock of Alesco’s portfolio, as they had supposedly been issued by a bunch of conservative Midwestern banks and insurance companies run by bespectacled, conservative gentlemen (and women) right out of “It’s A Wonderful Life”. How could those deals possibly go wrong?
I decided to have some fun with this issue, regrettably, in an article entitled The Trouble With TruPs. That article dealt with what I thought were relatively well-known troubles in the portfolios of smaller regional and local banks. Shut out of more traditional forms of higher risk, commercial real estate lending by the cheaper CMBS conduits, CP conduits, and SIVs, many of these banks were forced to travel down the credit curve with even higher risk loans to local developers, flippers and rehabbers. This left many of them overexposed to the housing market, and they are now paying the price.
What I did not dwell on was yet another conflict, and these conflicted tentacles spread from the Cohen house, into Alesco, the banks themselves, and through the regulators who were supposed to police it all.
With respect to the Cohen’s conflict, in the banking world, those who originate paper often consider themselves to be at the top of the food chain. On the other hand, those who buy paper are sometimes known as “mullets”, the dumb fish who will eat anything thrown in their direction, or alternatively as “stuffees”, those who can be stuffed full of something not wanted by others.
When it came to TruPs, the Cohens were truly at the top of the food chain. As of 2005, according to Fitch, Cohen Financial was a market leader in this esoteric market with an almost 35% share. Cohen originated these deals, and was paid a fee to create them, which is an almost endless gravy train so long as there are willing buyers for the paper. Enter mindless Alesco, levered at 20:1.
As for the banks, they were incredibly attracted to TruPs because the regulators allowed them to treat this obligation as equity, not debt. This enabled them to classify TruPs as equity capital for for Tier 1 capital purposes. Tier 1 capital is exactly what its name implies, capital comprised of equity, disclosed reserves and retained earnings. It is typically not debt, and it is what helps regulators determine how much a bank can leverage its assets.
Without the traditional checks and balances of a true, disciplined portfolio lender examining the credit and loan book of each individual TruPs obligor against the prudent extension of credit, the market flourished. Banks issued as much as they could, regulators signed off when they classified this obligation as “equity” capital, and TruPs intermediaries like the Cohens were only happy to oblige so long as there was some place to stuff the paper. Once again, there was no need to look too closely under the hood.
Which brings me, finally, to the point of this article. Alesco announced today that four more banks had deferred their TruPs payments, in addition to IndyMac, which resulted in the over-collateralization tests being triggered in two more CDOs in which Alesco holds equity interests, bringing the total in technical default to six (four of them are a result of IndyMac’s previously announced deferral). According to the Alesco press release, one of the CDO over-collateralization failures has since been cured.
Despite the one cure, the fact that these additional deferrals occured at all seems like material information to me, and worthy of a press release, given that the dividend, which is attracting investors like moths to a space shuttle launch, is hanging in the balance. One should ask: why wasn’t this information disclosed by management earlier, and what else are we left to look for under the hood in this buyer-beware business?
Alesco management goes on to state, incredulously, and despite the drumbeat of bad news surrounding the health of regional banks and insurance companies in general, that it expects all six of the the remaining defaulted CDOs to cure the over collateralization tests within the next 3 to 35 quarters. 35 quarters is 8.75 years, for those of you who are unsure. The assumptions underlying this statement? Even more unbelievably: that there will be “no additional deferrals”.
The implications of these “no additional deferral” assumptions on AFN’s dividend are enormous. For the year ended December 31, 2007 the six affected CDOs contributed 43%of AFN’s adjusted earnings. The simple truth is this: AFN’s dividend looks increasingly unsafe, as does its REIT status.
Rather than engaging in an academic debate over the fate of the banks and whether or not there will be additional deferrals, the health of the CDOs, etc., (which banks are involved, how much they owe, where they are headquartered, whether they will pay, who are the underlying obligors, and whether the weighted average of 3 and 35 quarters by loan average life is actually 17.9 quarters, or 4.49 years and therefore involves much less speculation on the part of management, etc.), I think AFN shareholders should ask themselves two very simple questions:
1. Has Alesco management done what they said they would do, and if not, why not?
2. Have management’s interests always been aligned with shareholders, and if not, why not?
For the time being, the dividend is intact, though discounted heavily and appropriately by the market, and REIT status is secure through 2008. Yet something is clearly afoot, and has been for some time. The share price has continued to drop, and at this rate it is likely to break the buck very soon.
Nevertheless, as shareholders, there are other avenues for value recovery, and certainly better places for your money. Better to be a realist for yourself than an apologist for AFN’s conflicted management.