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.

The $1.2 trillion market for collateralized debt obligations (CDOs) is draining money from investor’s portfolios faster than the mighty Limpopo River flushes monsoon rains into the Indian Ocean. Consequently, investing in a CDO is now about as popular as halitosis, and CDO assets have been marked down as fast as overwhelmed accountants can sharpen their pencils.

While this is obviously very bad for investors, it’s potentially very good for some CDO issuers who were on the other side of the trade. Why? Because these borrowers can now dress up as loan buyers trick or treat! and buy these securities back for a fraction of the price at which they were originally issued.

It’s the rough equivalent of selling your Miami condo at the height of the market in 2005, and then using that cash to buy it back several years later for half the price.

Background

CDOs were beneficial because they efficiently sliced assets such as real estate loans into several different pieces, each with a different risk profile. In practice, one BBB-rated whole loan could be sliced and diced such that there were several different tranches with much higher ratings than the single loan could earn on its own. Each piece could then be sold to different classes of investors, which optimized the overall price of the resulting debt.

Many Mortgage REITs were voracious issuers of CDOs, and they used the proceeds to fund new real estate loans, which they packaged into still more CDOs. At the height of the market, Mortgage REITs could issue CDOs at a blended cost of about LIBOR plus 50 basis points, while lending the proceeds out at LIBOR plus 250.

If everything goes according to plan, the CDO investors would earn that spread, the CDO issuer (e.g., Northstar, Newcastle) would earn fees to manage the CDO, and the same issuer would earn a spread on the subordinated equity interest that they retained in each CDO issue. In ten years or so, depending on the CDO, the loans would all pay off, and that would be that.

The CDO debt was non-recourse in many cases, which meant that the REITs enjoyed all the benefits of that cheap leverage, but none of the risks. The only thing that could really happen, in the event that enough of the underlying loans defaulted, is that the income from the equity interest held in each deal would be diverted to more senior note holders. Because of this and the fact that the CDO debt was generally “matched” to the life of the underlying loans, the CDOs would, in theory, chug along, dependably paying interest and principle for years and years.

How CDOs Work

CDOs are really pretty simple at heart, and really not much different than getting a mortgage to buy that Miami condo. Were you to buy that condo, chances are you would fund a small portion of the purchase price with equity, and then borrow the rest.

This is basically what Mortgage REITs did when they made a loan. They capitalized a very small portion of the loan with equity, and borrowed most of rest of the money by issuing CDOs to institutional “lenders”. Because the CDO debt was non-recourse, the REIT was never at risk for more than its original equity investment, which in most cases was relatively tiny. Unfortunately, and not surprisingly, this made many Mortgage REITs rather careless with their loan underwriting.

Now fast forward to 2008. The loans made by many Mortgage REITs (and others) have gone bad, so now many CDO investors are sitting on a pile of basically worthless CDO paper (it is not paying interest and principle as expected), and they are desperate for cash because of the market melt down. In fact, cash is in such short supply Bernie Madoff with it that the market cannot discriminate between good CDO debt and bad CDO debt.

Enter your friendly REIT, which offers to buy back that “worthless paper” for pennies on the dollar. Why would they do such a thing? Simple, because there are no other buyers with the same intimate knowledge of the CDO collateral.

REITs like Northstar and Newcastle have been paid all along to manage the CDO assets, so they know exactly which loans are good and which loans are bad, how many there are of each, and everything else in between. For a series of quick videos on how CDO’s work, see The Encylopedia of CDOs

Now For the Hard Bit: The Accounting

Assuming the CDO is consolidated and accounted for as a financing for GAAP purposes, the repurchase of the CDO debt allows the issuer to exinguish the CDO liability. To date, no REIT that I know of has repurchased an entire CDO issuance, so that particular CDO structure would remain intact to the extent that any CDO debt remains outstanding. The immediate accounting results for the CDO issuer (i.e., a Mortgage REIT) are:

1. Leverage ratios are reduced

2. To the extent that the debt is repurchased below par, a taxable gain is generated, and this creates taxable income

3. The remaining CDO liabilities are “marked to market” in accordance with FAS 159 (see below)

CDO debt buybacks at Grammercy Capital, Newcastle and Northstar are generating pretty significant capital gains. However, there is one very important characteristic of these capital gains that could be very significant in the case of these loss-hobbled Mortgage REITs: since the gains can be paired with capital loss carryforwards in most cases, they may not actually produce any immediate taxable income.

Immediate taxable income would would be distributable, but since loss carryforwards can be paired with the capital gains, one of the main obstacles to buying back REIT CDO debt is eliminated (i.e., where to come up with the cash to pay required REIT dividends on “phantom” taxable income that is suddenly higher than actual operating cash flow? See REIT Definition for more information on REIT dividend requirements).

Accordingly, quality, solvent, senior CDO debt backed by loans that are generating very attractive cash yields can now be bought back at pennies on the dollar, without any immediate obligation to distribute the “phantom” taxable gains produced by the extinguishment of debt. For those REITs with cash, this could be a very effective way to stabilize cash fows, and by extension, dividends. See REIT Taxable Income Definition Unlocking Opportunities? for more scintillating detail on this topic.

More Accounting: FAS 159

These CDO repurchases have real world implications for FAS 159. For more background, read FAS 159 Demystified. The applicability of FAS 159, or any complex accounting provision, is case by case. Those who argue against the validity of FAS 159 accounting have a pretty simple argument. In theory, these people believe that distressed beached, sunburnt, shriveled whales Mortgage REITs will never, ever have enough cash to buy back the billions of dollars of CDO debt they issued, even at pennies on the dollar. So why mark it down as if they could?

Furthermore, people argue, even if they did manage to come up with the cash, they would have to account for the discount as an immediate taxable gain (i.e., the gain on the debt repurchase must be distributed as dividends). Without the loss carryforwards discussed above, this presents cash-flow issues, as the required dividend would most likely exceed actual cash earnings. (In the interest of 100% accuracy, the tax code allows REITs to elect to retain earnings from capital gains, but they rarely make that election, and if they did the code would then require the REIT to pay income tax on those earnings at the full corporate rate.)

But neither can FAS 159 be dismissed completely out of hand. It just doesn’t make sense to penalize REITs for an amount that exceeds (in the case of a CDO) their net economic investment in a specific transaction. Back to that Miami condo: if you lost it to the bank, you would only include your equity in the loss. Since you borrowed the rest in the form of a loan, how could you “lose” it, especially if the lender had no personal recourse to you? The money was never yours in the first place, and now you can just walk away with no further obligation. Mortgage REIT equity investments in CDOs are very similar. Not only did they invest a very small amount of equity, but the debt was also completely non-recourse. So who cares??

Moreover, FAS 159 is not just goofy accounting theory, as evidenced by Grammercy Capital’s (GKK) partial buyback of it’s own CDO debt in the second quarter of 2008. Northstar (NRF), Newcastle (NCT) and Crystal River (CRZ) have also repurchased their own CDO debt. All of these deals proved that FAS 159 can actually be converted to economic reality, and that even distressed beached, sunburnt, shriveled whales REITs can find a way around the frozen capital markets.

GKK’s deal was a little different in that they used normal, every day depreciation losses in the portfolio of recently acquired American Financial Realty Trust to shelter the gains on the debt. GKK can do this because the purchase of AFR turned them into a hybrid REIT. Other Mortgage REITs with portfolios of operating real estate include NFR, RSO and RAS, although the latter two have much smaller portfolios. Presumably, GKK could also have matched the gains against its enormous loss carry forwards. But were it not for those depreciation losses, or the loss carryforwards and the fees paid to the bankers who printed the AFR trade the buyback could most likely never have been done. Sadly, the purchase of AFR was horribly timed, and it will be difficult for GKK to survive.

Loss Rationalization

Forget about all the accounting however; CDO buybacks are just an incredibly good trade. The CDO market allowed Mortgage REITs to basically sell their liabilities (debt) short at LIBOR plus 50. That debt was used to make loans. Now, these same REITs can repurchase that same debt for .20 to .40 cents on the dollar, allowing them to earn LIBOR plus 750-1000, net, to the extent the underlying loans are still paying interest and principle.

In theory, REITs still have to pay themselves par to collapse the entire CDO structure, but in practice investors are accepting far less just to be rid of this bad memory. So “par” is just as much of a fiction now as it was then. Listen to one of Northstar’s convertible bond holders attempt to publicly negotiate a buyback of NRF’s convertible debt on the Q3 2008 earnings call. If and when you do, you’ll realize it’s really just a matter of who wants “out” more, and it’s pretty clear that Hamamoto, the CEO, felt that he owned the play. He sold the debt at the top of the market, and now he is sitting on $250 million in very precious cash. The nice thing about being the CDO manager is that you know when to hold ’em (Northstar), and you know when to fold ’em (Alesco). Thanks to Piping Rock Partners for much of the independent research that produced this post

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