The Mortgage REIT Riddle

by REIT Wrecks on September 24, 2008

This is a longish post, so get a refill before settling in. There was a great story on the downfall of AIG in on Monday, a great story because it is incredibly analagous to the price/value disconnect that has been hammering equity values in the Mortgage REIT world. As I’ve posted again and again, all Mortgage REITs are not created equally, but some superior REITs are generating historically high yields far in excess of their respective portfolio risk. Don’t misunderstand me, incredible risks remain and persist throughout in this sector, and some REITs deserve to be discounted to certain death. But not all do, and synthetic “market” indices deserve much of the blame. I have written about this extensively, and I will come back to that and the AIG story down the page so please read on if you have both time and patience.

But first, there is one other component of Mortgage REIT portfolio risk (that is, generally speaking, the risk that underlying asset values have or will continue to decline to levels that are well below loan principle amounts, forcing more write-offs because loans cannot be fully repaid) that I have not written too much about.

Accordingly, since we’re on the liquidity topic, allow me to digress for just a moment. The lack of liquidity in this market is now well known and notorious. But it’s not because there’s no money available. On the contrary, there is plenty of money. In fact, private equity funds raised record amounts of money in 2006 and 2007 for real estate investments, promising 18-20% IRRs over a three to five year investment period. Most of these funds are given three or four years to complete their investments and fill out their funds.

But private equity is not the easy business everyone thinks it is. If these funds do not fully invest their funds within that three to four year investment period, it becomes very difficult to raise new money from institutional investors. Institutions don’t like getting a bill every quarter for one and two percent management fees just for babysitting uninvested cash.

However, if these private equity players do manage to invest the funds but only generate pathetic single digit returns for their investors, they wind up facing the same issue: no new money. So these funds now have a problem. With weak commercial real estate rent growth, the velocity in capital markets gone (reducing the ability to flip), and 3-5 year holds becoming 5-7 year holds as a result, it has become impossible to generate those promised 18-20% IRRs with prices at current levels.

Therefore, many large investors need prices to drop before they can profitably invest in this market. However, sellers also know these buyers are under the gun to deploy capital before their investment period expires. This phenomenon is partly, if not mostly, responsible for the wide “bid-ask” spread in the institutional real estate market. It is an old fashioned, who blinks first face off between sophisticated buyers and sellers.

That said, the bid-ask spread is more widely a symptom of something amiss in a much more “systemic” way (I promise to use that overused word only once). Systemically (which is a variation of the above word and therefore not in violation of my solemn promise), one of the biggest elephants in the room has been the synthetic real estate debt indices managed by the Markit Group.

I believe it is no coincidence that the CMBX was soaring as Lehman mulled the sale of its commercial real estate portfolio. (see The Market Group Says Bienvenido!) for an idea of what that index was doing at that time. The index is relatively new, thinly traded and requires almost no capital to trade it. As I wrote earlier, individual speculators like Andrew Lahde (see Is Commercial Real Estate Really Dead?) could easily manipulate the index and everybody knew it (see Lack of CMBX Transparency Draws Industry Scrutiny). Throw in the ability to short credit default swaps on Lehman itself, combine that with senior LEH management in complete denial, and you get 10,000 people in New York with new business cards.

This is where the AIG story is instructive, because it relates to the point I have been writing about for much of 2008. As wrote, there was nothing fundamentally wrong with the core insurance business units of AIG. Nothing at all. What imploded the venerable insurance giant was an accumulation of misplaced bets on credit default swaps and the market’s ability to exploit that. (see Cash is King! for background on the CDS market)

As everyone knows, when the housing market collapsed, falling home prices resulted in precipitously rising foreclosures. Unfortunately for AIG, it had also insured the underlying mortgage pools with credit default swaps, and these also began to fall in value. Additionally, the credit crisis began to take its toll on leveraged loans and AIG also saw mounting losses on the leveraged loan pools it had insured. By 2007, the company was feeling serious heat.

In that context, elaborated on the essence of the Mortgage REIT riddle as it relates to AIG: if you own a portfolio of CDOs, CDSs and CMBS, and the only way to value them (or, at least, to develop a valuation that others are reasonably certain to respect), is by looking at them through the prism of an index of credit default swaps on them, you’re at the mercy of the index.

And if you’re at the mercy of that index, what if other speculators like Andrew Lahde are able to pursue self-fulfilling trading strategies by selling the index short? And what if large portfolio-hedgers are selling short the index to hedge a portfolio they can’t sell because no one will buy it, mainly because no one knows what it’s worth? Or because (in the case of Lehman, AIG and Bear Stearns), they believe you’re already dead, even if (in the case of Goldman Sachs and Morgan Stanley) you’re not even close?

Ultimately, what you would wind up with is an index that is “totally uncorrelated” to the underlying fundamentals. This is why the government is bantering back and forth about getting price discovery on so-called “hold to maturity” mortgage values, instead of current “fire sale” values. In the post “Concerns Grow on CMBS Price Manipulation,” I wrote about the effects of all this on Mortgage REIT portfolio values . Combined with mark to market accounting, many REITs were discounted far below instrinsic value. If you haven’t already seen those two posts, it would be worthwhile reading them. They represent the entirety of today’s very risky Mortgage REIT investment thesis, and last week they brought our free market financial system to the very brink of catastrophic failure.

Click here for an updated Mortgage REIT list, including current yields

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