Dynex Capital Inc. is a rather small US-based Mortgage REIT that invests in securitized residential and commercial mortgage loans and non-agency MBS. Management has a significant stake in the common stock, so it shouldn’t be surprising that the company made almost no new investments in 2006 and 2007.

As of June 30, 2009, Dynex Capital had carrying assets of $245.1 million in non-Agency MBS, which was financed with $192.5 million in securitizations and short term debt repurchase agreements. Shareholders’ equity amounted to $52.6 million or 21.5% of the total portfolio.

The most recent quarter benefited from historically wide spreads, resulting from costs of funds that are near zero. “The story of this quarter is the performance of our Agency MBS investment portfolio. We earned a net interest spread of 3.70% on Agency MBS as our borrowing costs continued to decline. Our highly seasoned non-Agency investments continue to generate solid earnings and cashflow for the Company.” In the year earlier quarter the spread was much smaller, only 1.45%. The conditional prepayment rate (CPR) also decreased from 27.3% a year earlier to 19.9% during the last quarter.

Delinquencies on Dynex’s securitized mortgage loans increased from April to June of 2009 to $15.0 million from $9.1 million at December 31, 2008, but the company incurred no credit loss during the quarter.

Shareholder equity was $136.3 million during the quarter, or 20.2% of the $672.4 million of the commercial and single family loan collateral combined. During the summer of 2006 non-Agency portfolio leverage of equity capital was therefore about 5 times, essentially unchanged to the most recent quarter, despite the horrible conditions in CRE.

There will be more on Dynex here in the coming months. Mortgage REITs are not for the faint of heart, but this is definitely one worthy of additional time and research.

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Shamefully, I haven’t done much with Agency Mortgage REITs here, but the times they are a changing. Agency REITs are killing it on net interest spreads, and that is causing higher net incomes and increased dividends. What else could an investor want, next to a portfolio of government-guaranteed mortgage debt? Not surpringly, many investors screech to a halt on mention of the latter, and that’s one of the reasons these REITs deliver high teens yields quarter after quarter.

But those who had been yawning at the mention of an Agency Mortgage REIT are probably taking a closer look now. (AGNC), which is a relatively new Agency REIT, surprised everybody on Tuesday when they announced a quarterly dividend of $1.50 per share, a whopping 76% higher than the previous quarter (the dividend is payable July 27th, and the ex-dividend date is June 30).

AGNC’s dividend increase follows dividend increases from Annaly Capital (NLY) last week and Capstead Mortgage (CMO) the week before.

What’s causing all this? The earnings driver is the so-called “steep yield curve”, as it’s known in industry speak. In this market, a steep yield curve basically means nobody wants to own anything with a maturity beyond next week, especially if it has a mortgage attached to it. This is resulting in a huge spread between short yields and long yields, and Agency Mortgage REITs are busy collecting the difference. The difference between these Mortgage REITs and others is that Agency REITs are doing it with portfolios of AAA-rated government paper, not a bunch of dodgy TRUPS and CDOs.

In AGNC’s case, the weighted average yield on its portfolio last quarter was 5.13%, but its average cost of funds was 2.11%, resulting in a margin of 3.02%. This is pretty good work if you can get it, and last quarter AGNC delivered a 24.1% return on equity for sitting in between.

AGNC is not alone. Annaly Capital Management increased its dividend last week – by 20% to $0.60 per share (payable July 29, ex-date is June 25). NLYs net interest margin went from 1.71% to 2.11%, and they rode the recovery in mortgage bonds with a $5 million gain on sale. Combined, this drove earnings to $0.63 per share, up 19% from the year-ago quarter.

CMO’s dividend increase was less spectacular, up 4% to $0.58 per share for the third quarter of 2009, but the story is the same: their net interest margin increased to 2.16%, and they have plenty of cash to invest after participating in the recent frenzy of REIT stock offerings.

Other cashed-up REITs investing in agencies, though not exclusively, include Redwood Trust (RWT) and Chimera (CIM). Incidentally, RWT sold its stock in two separate overnight offerings, the latter at a 10% discount to the previous day’s close.

Despite these rich dividends, Agency Mortgage REITs are not for widows and orphans. Concerns over the government losing its AAA rating (which Annaly management calls “gossip”), interest rate wories, news about Asians selling their dollar assets, inflation prospects, high leverage ratios and re-investment risk all amount to a big detour sign for a lot of investors. From my perspective, owning these things right now amounts to a front row seat for the greatest show on earth (at the very least), and it’s probably worth the risk.

If Frank Quattrone could start over, he would be a REIT banker. REITs staged a huge rally this quarter, almost $15 billion in new equity has been raised through 45 public offerings this year, and even the Italians are descending upon New York to list new deals. With REIT stocks now being served up like Cannolis on Columbus Day, and consumed almost as fast by shell-shocked but somehow still hungry investors, you may have one question: What is Going On?

One reason is that REITs cram down desperately need the money, and while not all are teetering on the brink insolvency, most will do almost anything for fresh cash. This includes diluting their long-suffering shareholders bang zoom! to the moon, and cutting dividends prego! to the newly annointed.

How is this happening? Some intellectual honesty is called for here: REITs were simply oversold. Furthermore, no portfolio manager that I know of was willing to scale the ramparts for General Growth, no matter how many bankers GGP put to work pounding the phones, or how much they were being paid. Still, when there’s an abundance of supply, demand needs to be stoked, and that’s exactly what’s being done. Almost all of these REIT equity offerings are being sold in “over-the-wall deals”, much like tech stocks were in the late 1990s.

“Over-the-wall” deals are pre-arranged sales with leading investors at discounted prices, executed overnight. The news hits the tape the following morning, and the stock jumps. Basically, if you’re not “over-the-wall” you’re trapped beneath it, especially if you’re short. Indeed, one goal of the strategy – to scare the pants off of short sellers – is surely working. Nobody wants to be short a company whose balance sheet can be de-levered overnight, and that (re-equitization) is the other goal.

Unlike GGP, investors are flocking to these deals like moths to a porchlight. At a securities conference several weeks ago it’s just not true, there is a free lunch Mortgage REIT management presentations were standing room only. One of them, Chimera (CIM), had just used an $850 million offering to transform itself from a smoking heap of 2007 trade confirmations into a potential Microsoft of Mortgage REITs. Another, Redwood Trust (RWT) executed not one but two new issues, the latter just days after the conference, raising almost $500 million in equity.

REIT new issues have included such varied names as Alexandria Real Estate Equities (ARE), AMB Property (AMB), Pro-Logis (PLD), SL Green (SLG), Ventas (VTR) and Vornado (VNO). The AMB deal is a good example of how the REIT equity syndicate pot is being stirred. AMB’s $575 deal combined pre-launch “over-the-wall” meetings with the chosen ones, followed by overnight execution. The deal was 80% sold before it was even offered to the public – and then upsized 24% for good measure. It was sold at a discount of 8% to previous close, which isn’t bad considering that it represented almost 50% of the current shares outstanding, and that the stock traded up 16.5% the next day, resulting in an instant 25% gain for the new shareholders.

Who’s next? Everybody wants to know. Significantly, IPOs in registration are dominated by Mortgage REITs. These include Cypress Sharpridge (agency RMBS), Invesco (agency & non agency RMBS; CMBS; TALF loans) Penny Mac (non-agency RMBS), Sutherland (agency & non-agency RMBS) and Starwood Property Trust (CMBS/RMBS). These initial public offerings will list under the symbols CYS, IVR, PMT, SPT and SLD, respectively.

Others in registration are Brookdale Senior Living (BKD) and Investors Real Estate Trust (Nasdaq: IRET). Recent shelf offerings include Northstar Realty Finance (NRF), with JMP Securities (a large investor in New York Mortgage Trust (NYMT) and manager of its mortgage assets) as sole manager.

Even crippled Anthracite (AHR) may be getting into the act. Miraculously, the company was able to restructure its secured and unsecured debt last month, and a round of fresh equity is undoubtedly next on the list. Anthracite’s cozy relationship with Blackrock, which backstopped AHR with a line of credit in its darkest days, gives it an almost unparalleled window on the Fed’s growing portfolio of “toxic” mortgage assets. In this latest game of “if you’re not inside, you’re outside” being played with REIT equity, that may be all AHR needs to push it over the finish line.

Disclosures: Long NRF at the time of this writing.

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One caveat to be aware of: Closed-End REIT Funds don’t necessarily have the same tax efficiency benefit as other mutual funds. The reason is that to the extent these funds invest in REITs, the underlying REITs pay out capital gains distributions which then must flow through to the fund investor. For that reason, check into when the capital gains get distributed and check with your tax advisor before investing. If you’d rather not play a specific REIT Index, you can buy individual REITs focused on specific property sectors.

For those of you who are pursuing more intrepid REIT investing strategies, the case of Redwood Trust (RWT) may be relevant. The news is old only because it occured on March 16th, but the thesis is definitely more eternal.

Redwood’s primary business is investing in the absolute eye of the storm: single family residential real estate loans. Redwood’s current portfolio totals about $133 billion in loans to over 300,000 miscreants whose sole redeeming quality in 2005 and 2006 was their ability to sign where indicated. RWT also invests in a variety of other residential and commercial real estate loans and securities.

Like AIG, RWT has also rented out its balance sheet in order to credit-enhance single family RMBS, although unlike AIG they appear to have actually kept track of their potential liabilities under these arrangements.

On March 16th, JP Morgan initiated coverage of RWT with an Overwieght rating and an $18 price target. The reason? Debt maturities, or more accurately the lack of them. After raising equity in January, Redwood had 65% of its equity in cash with its only recourse debt maturing 28 years from now. This is the theme of the moment, if not the millenium.

Compare RWT to MAC, which is struggling to refinance 2010 debt maturities, or GGP, which is technically insolvent due to near-term maturities. The market has been unkind to both of the latter, while RWT has held up well, in spite of the January dilution and its focus on one of the most unhealthy sectors of the mortgage market.

The lack of leverage will also allow Redwood to weather future volatility by avoiding mark-to-market-related margin calls. “As RWT does not lever its purchases with short-term recourse financing, the company avoids margin call risk brought on by declines in mark-to-market asset values,” JP Morgan said in its report.

The cash raised in January has also allowed Redwood to be a true opportunistic player. According to JP Morgan, RWT recently purchased prime credit enhanced AAA-rated mortgage-backed securities at about 65 cents on the dollar. RWT projects returns of 10-18% on those assets, which were underwritten for further home price declines and worsening consumer credit.

RWT intends to continue these mortgage investments, targeting 10-20% unlevered returns. However, the current market turmoil has kept RWT from betting the bank, giving the Company plenty of dry powder going forward.

“We believe Redwood’s dedicated team of mortgage credit professionals is well positioned with a clean balance sheet to take advantage of the ongoing dislocation in the housing market, and the lack of leverage will allow the company to weather future volatility by avoiding mark-to-market-related liquidity risks,” JPMorgan said.

If investing in REIT stocks takes you in the direction of RWT, you will be the beneficiary of a well-covered 6% yield. Click here for a complete Mortgage REIT list including current yields.

Disclosures: None
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Both Bloomberg and the Wall Street Journal published stories on Monday warning of increasing trouble in the land of commercial real estate. It’s going to be pretty bad, there’s no doubt about it. But why is it bad and who is it really going to hurt? The Bloomberg headline claimed defaults could triple, but how much you care about that depends on where you sit in the food chain.

REIS, a consulting firm boasting a peripatetic chief economist with the best enunciation I have ever heard, evidently supplied data to Bloomberg showing that commercial loan defaults will rise dramatically if property-level net operating incomes (“NOI”) drop by even 5%. That’s a rosy forecast, given what’s going on with the economy. For the time being however, let’s assume they’re correct because there is really no dispute that NOI will weaken in this environment.

All things being equal, when NOI drops, the value of the underlying property also drops. Let’s say you own a property with $6 million in NOI. And let’s also say the “market” capitalization rate for that property is 6%, which is about where cap rates were, broadly speaking, during the boom. That means you have a property worth $100 million ($6MM in NOI/.06). However, if your NOI drops 5% to $5.7MM, your property is now worth only $95 million ($5.7MM/.06).

Could this really be what persuaded a bunch of New York City real estate tycoons to beg for a meeting, hats in hand, with a Senator from Brooklyn? Unfortunately, it wasn’t, because the above example assumes all else is equal, which is not the case. What if you threw in a few more wildcards, like the collapse of the CMBS market and rising cap rates? Then you’d have a story, and blessed be the prophets, it’s all right here on REIT Wrecks!

So what’s going on with the CMBS market? The short answer is nothing, really, and that’s a big part of the problem. During the boom years, CMBS grew to become a $225 billion source of capital to the commercial real estate market. Some were optimistically predicting that it would crash through $300 billion in annual issuance by 2008. What actually happened couldn’t have been more different, but it did crash.

The CMBS market actually collapsed, and commercial real estate lending volumes continue to contract. In fact, those 2008 deals you see on the chart, all $12.1 billion of them, were largely the result of lenders desperately trying to unload the loans they made in 2007. One of the last of those deals, J.P. Morgan Chase Commercial Mortgage Securities Trust 2008-C2, closed in May of 2008 and 20% of its commercial real estate loans defaulted within just 6 months.

Clearly, huge demand for CMBS led to a decrease in underwriting standards, including (among other things), a relaxing of traditional loan-to-value criteria. Moody’s estimated that the gap between the Moodys LTV and underwritten LTVs reached record in the first quarter of 2007 (nearly 45%). The Moody’s estimate of actual LTV also reached a record of 106.5%.

These poorly underwritten loans are still out there and in a few of short years, many of them will start to mature. Unfortunately, no lender will touch them now because they are practically radioactive. At the same time that a huge source of capital has disappeared from the market, borrowing costs have soared, making whatever capital there is out there relatively expensive. You can enlarge the chart a bit by clicking on it. Nevertheless, the lines going up and to the right tell the story: money is more much more expensive.

This is happening at the same time that cap rates, which were compressed down around that 6% mark, are now correcting. Cap rates averaged 8.3% between 1986 and 2008, but they fell below 6% in the first quarter of 2007.

This is a toxic mix for those New York City real estate tycoons, and the reason they made the trip to see Chuck Schumer from Brooklyn is simple: they are all about to lose a TON of money.

If NOI decreases by 5%, that’s a few less dinners at the Palace Hotel. However, if that happens at the same time that cap rates revert to historic averages and borrowing standards suddenly tighten, they can forget about dinner at the Palace because they’ll all be sleeping outside on the sidewalk.

Here is that $6 million in NOI at a 6% cap rate during the boom years. Everything looks great, and we’ve got our $100 million:

Ok, but what happens now that things have changed? If you still want your 15.6% Levered IRR (and that’s a big if), what would that deal look like today? Cap rates are definitely headed north, most likely back to their 8.3% average, and loan to values are definitely headed south, probably close to 50% for office and retail (Pro Logis recently did project level industrial debt at 50% LTV).

Adjusting for the new reality, that $100 million deal is $36 million in the hole. If NOI drops by 5%, the problem gets a whole lot worse. This is the wall against which many equity investors and developers have backed themselves into, particularly those with near-term debt maturities.

While REIS was emphasizing NOI growth, or lack thereof, in the Bloomberg story, the canary in the coal mine for the Wall Street Journal was Foresight Analytics warning about near-term debt maturities. The Journal’s story emphasised 2009 maturities that could have trouble getting refinanced. However, while there will definitely be demand for refinancing next year, it will start to get really interesting in 2010. About $180 billion in 2005-2007 CMBS loans will start to mature then, and a little more than half of those are variable rate deals. These are the Alt-A’s of the commercial world, and they were underwritten for a completely different solar system.

The good news is that if you’re a lender in the above example with a well-underwritten 70% LTV loan, things aren’t looking nearly so bad. You’re only down about 10%, and you get the asset to play with, while the developer/owner is completely wiped out. This could lead to the ultimate irony for all those that have been burned on Mortgage REITs: those loan defaults aren’t looking so bad after all! Thanks to Piping Rock Partners for compiling and assembling the data in this post

Disclosures: None at the time of publication
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Mortgage REIT CBRE Realty Finance has been fatally stung by its aggressive commercial real estate loan origination activities, which began at the worst possible time: 2005. CRTYZ.OB hardly has a nice ring to it, but on November 7th, the New York Stock Exchange permanently de-listed CBF (CBRE Realty Finance) due to its inability to satisfy the NYSE’s minimum share price and market cap. It now trades rather ignominiously on the pink sheets, but probably not for long.

If you’re an investor, don’t feel too badly. Arbor Realty Trust (ABR), which is now in a heap of trouble for its purchase of Extended Stay Hotels in a joint venture with the Lightstone Group, bid $8/share for CBF last fall in a nasty battle for control of the stuggling Mortgage REIT. CBF fought Arbor’s bid off, but the new CRTYZ.OB closed yesterday at 18 cents a share.

Shortly after that $0.18 close yesterday, the Company made its misery official and complete by announcing that it had suspended its quarterly cash dividend in order to “maintain the Company’s financial flexibility”. The Company will definitely need the cash. Fortunately, most remaining investors gave up at the end of the third quarter when CBRE Realty Finance reported that it was just barely meeting the over collateralization tests on its two CDOs (See “What is a CDO”).

From the Company’s September 30, 2008 10Q:

Our most restrictive covenants on our CDOs had an asset over collateralization ratio of 1.16x and 1.13x for CDO I and CDO II, respectively, compared to minimum requirements of 1.12x and 1.10x.

If CBF/CRTYZ.OB fails these “O/C” tests, the cash flow from these CDOs will be diverted to the more senior tranches in these deals. These CDOs will then be in technical default, and in this environment it’s really only a matter of time before senior bond holders foreclose on the remaining collateral and wipe out CBF’s equity. Scroll down for links to more news, research and analysis on REIT Dividends.

Disclosure: None, thank goodness.

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Money Management Letter reported last week that The New Jersey Division of Investment has authorized a $1 billion allocation to commercial real estate that will be deployed over the course of next year. The move roughly doubles New Jersey’s current 5% allocation, said Kathy Jassem, portfolio manager. A significant portion of the allocation will be channeled to commercial real estate debt, including CMBS.

Blackrock, one of the world’s largest bond fund managers, has also backed up the truck on CMBS. The value in CMBS is an intriguing story, and you should check out Deal Junkie if you want to know more about the fundamentals in commercial real estate.

“We didn’t know where real estate values were headed but we could clearly see there was value in the debt,” Jassem said. Meanwhile, spreads on AAA-rated commercial mortgage-backed securities are at record levels, and the CMBX continues to forecast a grim future of enormous bread lines and rattling tin cups.

So what gives? Why is the State of New Jersey and others stepping in where so many fear to tread? The reason is that the fundamentals are just not as bad as the CMBX and AAA CMBS imply.

Actual delinquencies remain low, and while I have written previously about the number of interest-only CMBS loans coming due in the next several years, it’s also true that the overall number of loans coming due in the next couple of years will also be somewhat low. This is giving many investors reason to believe.

According to JP Morgan, of the more than $600 billion of outstanding CMBS fixed-rate debt, only $16 billion is scheduled to mature in 2008 and $19 billion in 2009 (for a total of $35 billion). Scheduled maturities of fixed-rate CMBS debt reach peaks of $98 billion in 2015, $128 billion in 2016 and $127 billion in 2017. 65% to 85% of those loans are interest-only for the entire or partial term. As for the near future, 80% of the loans maturing in 2008 and 2009 have been amortizing over the full term, significantly bettering the odds that these loans can be refinanced.

Unfortunately, however, there is also some bad news: Wachovia has identified $30 billion of large-loan floating-rate deals that mature before May 2009, the majority of which were originated in 2006 and 2007. These were the go-go years and high profile defaults in several 2007-vintage loans were what caused much of the recent spread contagion. Wachovia also says that 95% of those loans have extension options, although it remains to be seen whether borrowers will be able meet the terms necessary to extend them (minumum LTV, DSCR, etc).

As far as defaults go, the delinquency rate on CMBS still remains low (for now). Fitch’s loan delinquency index was only 0.45% at the end of September. This is only slightly above the historic low of .27% (set in January of 2008). Currently, only 488 loans, totaling $2.5 billion in unpaid principal, are delinquent. This is small potatoes compared to the $562 billion in Fitch’s rated portfolio (which consists of over 40,000 individual loans).

Fitch also reported an additional 246 nondelinquent loans that are in special servicing due to imminent default or other nonmonetary reasons, and while not all of them will become delinquent, if they did the delinquency rate would double to .90%. This would still be only slightly above the historical average of .78% to .79%.

As I’ve written about ad-nauseum already, 2005-2007 loans will certainly bring challenges. Not only did originations in those years dramatically exceed the volume of previous years, but underwriting standards across the commercial real estate industry eased just as property valuations peaked and loans were increasingly written with interest-only provisions as noted above.

Historically, CMBS deals see defaults peak in years 3-8, with most of those coming about year 7. Everyone already knows this as tail risk, and it is accounted for in loss severity models. Now however, there is a disturbing trend of 2005-2007 loans being transferred to special servicing just one or two years after securitization. Goldman Sachs has projected that losses on commercial mortgages originated in 2007 could reach 11%. In fact, according to Larry Kay, director of structured finance ratings at Standard & Poor’s, 2005, 2006, 2007 vintage years comprised about 45% of all delinquencies.

However, when viewed against issuance, the rate of delinquency from recent vintages is not so alarming because they represent just a fraction of the tremendous volume generated during those years. Earlier this year, loans 60 days or more delinquent amounted to just 0.25% of 2005 volume, 0.12% in the 2006 vintage and 0.05% for 2007, according to Fitch.

“Issuance volume is a very important factor when determining which vintages may have credit issues,” said Susan Merrick, managing director at Fitch. “Certain recent vintages may have delinquent loans, but when compared to the large volume of issuance in these years, the proportion is very small.”

Where does Fitch see the most delinquencies? Loans originated in 1998 had the largest amount of delinquencies at $257.6 million, or 16.7% of all delinquent CMBS loans. That equates to a 1.43% delinquency rate for the 1998 vintage, the most of any year. The next highest delinquency rates compared with the outstanding balances in each vintage year were 2001 at 0.81%, 1997 at 0.74%, 2000 at 0.56%, and 2004, 0.49%.

That CMBS delinquencies will rise is not in dispute, only because they have been at historical lows for so long. But most of the troubles do appear to be confined to the 2005-2007 vintages, and even if the current overall default rate doubled, it would still be in line with historial averages. That is allowing some rather savvy investors to see through the hysteria and pick through the bargain bin. Some beaten up REITs are even getting into the act by repurchasing their own CDO debt.

Interestingly enough, Jassem (the State of New Jersey portfolio manager) was originally interested in allocating 1% to REITs but the recent market volatility kept her at bay. “We’re willing to miss out on the first 10% of the upside,” she said, explaining that the fund will wait until she can clearly see the REIT bottom in the rear view mirror.

No wonder the original plan what plan? was only three pages long. It turns out that there was no plan. When I heard the news that Treasury had reversed course on the Troubled Asset Recovery component of the Troubled Asset Recovery Plan, that and writing an article with the above title were the first things that popped into my head. Sadly, those two things were also all I could think of while I was cowering under my desk, without food and water, waiting for it all to end. REITs of course got absolutely crushed, and now it looks like many REITs are now headed for the dreaded “.BB” designation. I keep hoping in vain to someday drown in dividends, but that’s unlikely to happen if REITs are swimming in the Pink (sheets that is).

The story of the insanity in commercial mortgages that ensued after the about face now been covered everywhere, including the Wall Street Journal, the Washington Post, and Bloomberg, which was the most strident in blaming it all on Paulson. Sadly, spreading blame won’t help; only spreading money will (and maybe some Prozac too, if I could only afford to see the doctor).

What follows is a relatively cogent article consisting of the most juicy bits from those three above articles.

“A lot of very foolish loans were originated between 2005 and 2007, and many of those loans begin to mature in 2010,” said Mike Kirby, director of research at Green Street Advisors, a commercial real estate research firm. “You have a significant amount of debt maturing at that time and yet you don’t have a market to replace that debt.”

The price of commercial real-estate-debt securities has fallen so far that it has set off a debate among investors as to whether now is the time to get back into the market. Triple-A commercial mortgage-backed securities are trading at roughly 70 cents on the dollar, meaning they would produce a 20% return if held to term.

The default rate on commercial mortgages remains near its historical low, although it is increasing. Overall, the number of commercial mortgages packaged into securities that are 30 days or more past due rose to 0.64% in October from 0.39% at the end of last year. That is the highest delinquency rate in two years but still far from the kind of carnage that occurred during the commercial real-estate collapse of the early 1990s. Back then the cumulative default rate on loans made in 1986 reached 36%.

The trading levels of CMBS bonds imply a cumulative loss rate of as much as 40% on top-rated bonds, which means that at least 70% of the underlying loan pool would have to go into default, [emphasis added] said Richard Parkus, head of CMBS research at Deutsche Bank Securities Inc. But he, like other market observers, views that as an unlikely scenario. …

The spreads between the CMBX, a credit market index that tracks the values of commercial real-estate bonds, widened to another record level Thursday. And CMBS bonds with triple-A ratings now yield more than 14 percentage points above yields on 10-year U.S. Treasury notes, according to Trepp, a New York company that tracks the commercial real-estate-finance market. That compares with a 1.5 percentage point spread one year ago and an 8.3 percentage point spread just one week ago.

At current prices, all the loans could default within 18 months and a buyer wouldn’t lose money, according to Lisa Pendergast, an analyst at the Greenwich, Connecticut-based unit of Royal Bank of Scotland Plc. That’s assuming foreclosure recoveries of 37 percent, compared with the typical 60 percent.

“The default levels implied by where these bonds are trading mean we will all be living in boxes,” said Eric Johnson, president of 40/86 Advisors Inc. in Carmel, Indiana.

“There is evidence that short-sellers are targeting this market because they know they can push it around,” said James Grady, managing director in New York at Deutsche Asset Management, which has about $240 billion of fixed-income assets under management.

“Recent speculative conditions reminds us of the summer when oil was $140 a barrel, and many parties were calling for $200,” Darrell Wheeler, of Citigroup wrote. “Commercial real estate conditions are deteriorating, but we cannot justify recently cheap levels.”

Let’s hope so. I have bills to pay.

Governments around the world have gone on a coordinated offensive of truculent press releases in an effort to combat the growing credit crisis. Mortgage REIT prices also popped again on Friday, NCT was up over 60%, RAS and RSO were both up over 30% and NRF was up almost 40%. But this is not the first time this has happened in REIT land, which has basically been short heaven for 18 months. Three weeks ago, NCT was the largest percentage gainer on the NYSE, almost doubling as shorts rushed to cover. Last week however, NCT was pushed back below $3 in a renewed and relentless selling assault. But this week should signal the beginning of the end of the easy short pickings in Mortgage REITs.

The price floor will be put in with the worldwide, coordinated focus on the problem, including the U.S. Treasury’s new focus on direct recapitalization of U.S. banks with a voluntary program of government-sponsored equity investments and world-wide guarantees of interbank lending. The U.S Treasury’s direct equity approach not only avoids the politically awkward “socialization” of private bank losses by allowing potential government equity participation in a recovery, but it also allows the banks to exercise some discretion in terms of selling assets into a fire sale market. However, the treasury is also moving forward on its program of purchasing both mortgage backed securities and whole mortgage loans.

There were numerous other news items this morning, but few as relevant to beleaguered REIT investors as the staff position rushed out by FASB entitled “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active”. The guidance was rushed because regulators and policy makers wanted it out in time for companies to use in computing third quarter earnings, which should make this earnings season incredibly interesting – yet AGAIN!

The FASB staff position clarifies the application of FAS 157 where there are limited or no observable inputs for marking certain assets to market. The guidance does not eliminate Fair Market Value Accounting, but it does provide management with much more discretion with respect applying the convention when pricing illiquid assets. This discretion includes ability to use internal assumptions with respect to future cashflows, which would mean employing generally more benign estimates than what the “market” is currently imposing (see Is Commercial Real Estate Really Dead?).

The guidance specifically allows management to use internal cash flow models and assumptions to estimate fair value when there is limited market data available, or market data that is characterized by extremely wide “bid-ask” spreads.

“When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable,” according to the FASB.

Determining whether a market is or isn’t active requires judgment based on factors such as the spread between buyers and sellers. It provides that transactions in inactive markets “may be inputs when measuring fair value, but would likely not be determinative.”

Another issue addressed by the guidance is how much weight to give to distressed sales when estimating the fair value of holdings. The guidance specifies that distressed sales or forced liquidations “are not orderly transactions” and “are not determinative when measuring fair value.”

The guidance emphasizes transaction-level analysis, allowing performing transactions to be marked according to the value of that particular asset. Accordingly, these performing deals will no longer be considered “stressed” simply because the entire market is stressed. For commercial mortgage assets, including whole loans and CMBS, this allows management to consider overall default rates (still at historical lows), collateral characteristics and the underlying obligors on each underlying mortgage. Applying this discretion to portfolios that have few, if any, defaults and high quality collateral will obviously result in meaningful increases in GAAP earnings this quarter compared to previous quarters as previous distressed marks are reversed.

This amendment is huge for financials and for REITs in particular. The wholesale elimination of Fair Market Accounting would have removed a critical component of transparency from our markets, which obviously would have been detrimental. But amending it in such a way as to prevent portfolio valuations from being held hostage by a “market” that refuses to function is a constructive step. Now more than ever, management quality will be key in evaluating REIT investments. But for those REITs that make the grade, we could very well see a Mortgage REIT melt-up that could rival the melt down that has been in progress for so long.

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