Mortgage REITs & Custer’s Last Stand

by REIT Wrecks on September 28, 2008

With news Sunday of a breakthrough, finally, on what Hank Paulson is calling the “Troubled Asset Recovery Plan”, it looks like the government will officially be in the Mortgage REIT business by Tuesday or Wednesday. This will undoubtedly bring significant, long term changes to the Mortgage REIT business. And while some Mortgage REITs may have survived the wrath of the markets, they may not be able to survive the wrath of the regulators. The draft of the bill was not yet online when I wrote this, but in addition to industry carrots (government money), the bill will also include many sticks, which could include denial of REMIC (tax free) status for investors in certain mortgage securitization programs that refuse to participate in this giant rehab program.

With all the news coming out of Washington and Wall Street, and the dramatic impact it will have on REITs, it’s easy to miss other even more dramatic changes that have been percolating in the background. In addition to this attempt to cure the current crisis, the government and its allies are also devoting a lot of time and energy to making certain it never happens again. This effort will push many REITs toward their inevitable Little Bighorns, but REITs like Capital Source (CSE) have already positioned themselves to be beneficiaries of the profound, warp-speed changes occurring in the markets. Please read on.

It’s now pretty clear now that many financial institutions were encouraged to create assets that never should have existed. This artificial demand for assets helped lead to the dramatically reduced lending standards which fueled the crisis. Mortgage REITs proliferated in this environment, and the CDOs they and many banks issued were made possible in part (see The Encyclopedia of CDOs) by accounting regulations that officials thought they had fixed after the Enron fiasco. While the Enron mess did cause fundamental accounting rule changes that made it much tougher to set up off-balance sheet special purpose entities (“SPEs”), those changes did not completely eliminate the ability to create SPEs.

Now, it looks like that may effectively happen for Mortgage REITs. On September 15th, the Financial Accounting Standards Board (“FASB”) issued proposed changes to SPE accounting that will make it much tougher to not only invest in CMBS and other asset backed securitizations, but also to issue CMBS and similar debt securities (e.g., CDOs, CLOs). The ability to issue these types of securities was the life blood of Mortgage REITs. FASB is soliciting comments to these proposed changes until November 15, at which time the board will draft final changes to SPE accounting guidelines and they will become part of GAAP. In spite of the FASB’s 60 day “comment period” the formal issuance of the proposal means that the changes are now effectively etched in stone.

The official promulgation is known as FASB 140, and these changes to it will fundamentally alter the Mortgage REIT business by changing the rules for so called “qualified special purpose entities”, or QSPEs. Mortgage REITs haven’t been able to issue CDOs for many months now, but this proposed rule change will make it much, much tougher to successfully fund the business model, which relies on an old fashioned arbitrage of yield vs. cost of funds.

FASB is not alone in its reform efforts. The IMF, The Bank of England, the Securities and Exchange Commission, the President’s Working Group and other groups have jumped on the bandwagon. And since March, FASB staffers have been gathering data and assessing whether current accounting standards helped mask the true risk of securitizations vehicles like CDOs and CLOs.

The under-the-radar bombshell is that FASB has apparently decided to “eliminate the concept of the QSPE” in the revised financial-accounting standard, FAS 140, and also to “remove the related scope exemption from FIN 46R,” according to FASB director of technical activities Russ Goldin. FASB is sill studying actual implementation and disclosure issues, but it seems pretty clear those unpriceable, illiquid CDOs, CLOs and CDSs are headed home to the balance sheet.

You may think this is “angels dancing on the head of a pin” accounting theory, but it has enormous potential impact on markets, and specifically on Mortgage REITs. Nobody knows how many trillions of dollars worth of toxic CDOs and CLOs are buried in the mud, but the elimation QSPEs will almost certainly turn that mud into government-owned cement.

Not only that, the law of unintended consequences will undoubtedly come into play here, especially when one considers the speed at which these changes are being implemented. Just as the old structures were under-consolidated, so could these new regulations cause them to be over-consolidated. To the extent this continues, it will permanently increase the cost of leverage. Many Mortgage REITs retained about 2% of the CDOs they issued, but consolidation would require them to account for the entire transaction on their already strained balance sheets.

To be sure, these changes affect only GAAP income and book value, not operating cash flow, which remains far more important. So from a fundamental perspective it doesn’t change the Mortgage REIT investment thesis immediately. But the formal elimination of a critical funding source will also finally force fundamental changes in the Mortgage REIT business by permanently cutting them off from the cheap, long term funding on which they relied. This means that deposits, the sole province of banks, will once again become the dominant source of funding residential and commercial mortgages for at least the next few years.

But many Mortgage REITs won’t be able to survive that long. While Grammercy Capital Corp’s (GKK) ill-timed, almost suicidal acquisition of American Financial Realty Trust (which owns properties leased to rapidly disappearing banks and brokerages) doesn’t look so good now that the banking world is in hyper-consolidation mode, it did move GKK closer toward a more sustainable Hybrid REIT model (see Hybrid REIT definition). Hybrid REITs are more viable than a “pure” Mortgage REIT model due to the lower reliance on spread arbitrage. Hybrid REITs own hard assets, whose value can be increased with actual, hands-on work and creativity. Going the Hybrid REIT route may be one viable avenue to avoid the other possible alternative: slow, agonizing portfolio run off. Northstar Realty Finance, still one of my all-time favorites, has a net lease and land investment platform – and the knowledge – that could be expanded to take advantage of this Hybrid REIT strategy.

However, while going the Hybrid REIT route may be one option, in this environment becoming a bank is definitely the best option. For that reason, Capital Source (CSE) looks much more interesting now, since they have been working hard all year at transforming themselves from a CLO/CDO-dependent REIT into a full-fledged deposit-taking bank. In May, CSE took a huge step toward that goal by finally closing the on-again, off-again acquisition of Tier One Bank, which gave CSE control over Tier One’s 69 retail banking offices in Nebraska, Iowa and Kansas, as well as their deposits [Update: The transaction did not close. See comments].

In late July, CapitalSource Bank formally commenced operations, announcing at the same time the transformative acquisition of $5.2 billion of retail deposits, 22 additional retail bank branches and approximately $5.2 billion in cash and other assets from Fremont Investment & Loan (FIL). As of July, newly formed CapitalSource Bank had Tier 1 risk-based capital ratio of more than 15.6%. This greatly enhanced liquidity will allow Capital Source to jettison the old CLO funding model and fully leverage its successful high yield loan originations platform with a very low cost retail deposit base. The bank is fully certified and chartered by state and local regulators. Capital Source has been beaten up like all the rest of the financials, but they now have a much more valuable and viable business model. CSE deserves a very, very close look by any REIT investor looking to capitalize on these unprecedented disclocations in the credit markets.

The breakthrough in Washington is NOT a panacea for Mortgage REITs, and changes to FAS 140 will fundamentally alter the Mortgage REIT playing field. Despite my well-founded fears to the contrary, capitalism is alive and well, and those REITs that can successfully adapt to the new environment will undoubtedly survive and thrive. But those that can’t will (and should) wither and die. So rather than sit back on Monday and watch your REIT portfolio value rocket higher on the weekend news [Update: So much for THAT pipedream], I would be thinking seriously about Tuesday and Wednesday, when reality will be settling in once again. The next few years will be one tough, hard, long slog for the Mortgage REIT business and for the country as a whole. The opportunities to profit will be many, but the old model is definitely gone for good.

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

Mortgage REIT list
Disclosure: Long NRF at the time of publication

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