The gap between the perception of the risks in mortgage debt and the actual risks is now the exact opposite of where it was just before the credit crunch began.

Let’s see, there are a few positive things happening out there and I think I need to write about them before my prescription runs out…

First, it’s an election year and not too difficult to make a connection between the calendar and the $300 billion loan modification program housing bill that just passed. We also have 2% Fed Funds rate, and a whole slew of obscure but hugely important Fed programs aimed at restoring liquidity. These programs are unprecedented in scope, and all of it marks a big turnaround from the laissez-faire 5,000 former bear stearns employees days of “largely contained” subprime morgage defaults.

Things will turn around though, they always do, and I think Newcastle is one REIT that may be turning around sooner that some others. I sold NCT late in 2007, which sadly I cannot attribute to any unique insight. I simply got a margin call. That proved to be serendipitous, and a rare bit of good luck for me in what has been an otherwise miserable several months for NCT. In July, the stock hit $4.50.

But Newcastle is no Alesco, and I’ve been interested in developments there ever since the REIT cut its dividend to less than half its taxable income. REITs are required to pay out 90% of their taxable income to shareholders, so what were they planning to do with all that cash, assuming it wasn’t burned up with more losses? Could a special dividend be on the way?

That became an even more pertinent question this quarter, when NCT reported operating earnings (Non-GAAP) which were twice the dividend yet again, a big jump in cash, to $170 million, and $88 million in debt reduction, $57 of which was recourse. 13% of NCTs debt now remains recourse to the Company (less, on a percentage basis, than AHR), and half of that consists of recourse debt on liquid, AAA-implied agency securities.

The Company is also in a similar position to Northstar (The Mortgage REIT With $4 Billion Of Sweet CDOs) with respect to its CDO assets. As loans inside NCT’s CDOs get paid off, NCT has been busy replacing them with new assets that are yielding 2-3% more (N.B., NCT’s funding costs do not go up, because the poor sots who own the CDOs are stuck with their miserable LIBOR +50). NCT replaced $63 million of CDO assets in the second quarter, and they expect the higher yields on this $63 million alone will generate an additional .06/share annually in earnings.

The Company is also working on further debt reductions, which may occur through asset sales. By the end of the third quarter, if all goes according to plan, NCT plans to be back out in the market aggressively acquiring new assets. They see three primary opportunities, either (1) the repurchase of common stock, which may be the most accretive, (2) the continued repurchase of CDO debt, or (3) the acquisition of new mortgage assets. Obviously, with market spreads being what they are, the ability to do any one of these three things could prove to be lucrative.

That’s the good news, and everybody already knows the bad news – or at least they should. In March of 2007, NCT made a contrarian call on the single family mortgage market and announced a $1.7 billion purchase of subprime mortgages. Out of the entire portfolio, almost 40% of the mortgages were in California and Florida.

Back then, the stock was trading at $27. They eventually kicked out $400 million in mortgages – let’s hope they were in Stockton and Bakersfield – and closed on $1.3 in May, intending to securitize the loans and retain a $75 million residual. That never happened, and the value of those securities (among other things in their portfolio) clearly kept dropping. NCT was forced to raise cash by selling $1.8 billion of assets in Q1, including $770 million of agency-backed mortgages, which is the good stuff (implied AAA), and take huge write downs on much of the rest of their portfolio they couldn’t sell.

Those write downs continued in the second quarter, and in the end the write downs can also be a big driver of taxable income. The question swirling around NCT right now is how big a driver. NCT has now covered their full year dividend nut with just six months of operating earnings. The Company wouldn’t give guidance on full year taxable income, but they have consistently said that they intend to make distributions such that they meet meet the 90% requirement. Assuming NCT’s current porfolio marks are enough, if NCT can accomplish anything even close to its first and second quarter run rate in the third and fourth quarters, a special dividend gets added to the yield pot in Q4.

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

Disclosures: None at the time of this writing

In an earlier article (“Mortgage REIT Yields Still Look Safe, But Stick to the Seasoned Veterans”), I wrote that high yield Mortgage REITs with relatively “seasoned” portfolios offered much better safety and value than those with portfolios stuffed full of more recent vintage CMBS. Now, analysts at Barclays Capital also say that the pricing on some earlier CMBS are not fully reflecting the safety of the risk-free treasury securities that replaced the original collateral on many of those earlier vintage pools.

Later vintage CMBS is now under a very bright popular media spotlight on news that a $225 million loan for a New York City apartment complex is heading toward imminent default (“How Could My Big Beautiful Loan Go So Bad, So Quickly”). That loan suffered from egregiously aggressive 2007 underwriting standards and had virtually no hope of being repaid. As a result, “headline risk” is again high and many CMBS traders and portfolio managers are once again shooting first and asking questions later.

However, not only were underwriting standards much stronger in earlier vintage CMBS, but many pre-2005 CMBS loans have also been “defeased” by the original borrowers. Defeasance occurs when highly rated collateral, always AAA-rated US government securities, are deposited into an escrow account for the benefit of the lender. The treasuries are sufficient to make all remaining principal and interest payments under the loan, and the lender’s security interest in the underlying real estate is replaced by a security interest in the treasury bonds.

Why does this happen in the first place? Because of the highly restrictive provisions on repayments contained in every loan destined for CMBS pools, borrowers are “locked out” from paying off the loans for at least five years. After that, prepayment is subject to terms that protect the lender (and ultimately the CMBS investors) from “re-investment risk”, which is what happens when you get a pile of money back in an unfavorable (low) interest rate environment. Nevertheless, owners of property purchased in earlier years that had been financed via the CMBS market needed to have some way to pay off the loans and cash out when they sold, particularly in the ebullient years of 2005-2007.

This was accomplished by defeasing the loan, a practice that got off the ground for CMBS in 1999 (it was already widespread in other markets). Defeasing CMBS loans grew in popularity, and by 2002 the business had taken off. Many, many earlier vintage CMBS loans were defeased and are now backed by AAA rated government securities, instead of beaten up shopping malls full of Bennigan’s and Steve and Barry’s.

While the effect of higher credit enhancement is widely recognized, the Barclays analysts think that the market is nevertheless “grossly mispricing” heavily defeased CMBS. They contend that the 2005 to 2007 surge in defeasances left many older vintage collateral pools with over 25% in risk-free government collateral. Such risk-free assets should command a premium in today’s uncertain environment, although they say current market spreads do not reflect that or maybe the Chinese are just dumping every treasury-related security they can lay their hands on.

Pricing on high defeasance paper is roughly five to 10 basis points tighter depending on the vintage — but the analysts think that bonds with high defeasance should command an additonal a 20 to 40 basis point premium compared with non-defeased senior tranches as a result of the more favorable risk profile.

Clearly value does remain in CMBS and the collateral; the real question hovering around the room late at night is what is the value of the real estate supporting it? Analysts agree that cash flows are holding up, but that investors are simply continuing to pay less and less for those cash flows. And that whistling sound you hear in the background is just a lot of people in the graveyard, wondering how much longer that will go on.

“The future ain’t what it used to be”
Yogi Berra

Crystal River (CRZ) has had an absolutely terrible time of it. The REIT went public at $23 a share in July of 2006, and then blew through about $350 million, or almost $14 per share, in just eighteen months.

The second quarter of 2008 continued to show the unfortunate results of CRZ’s ill-timed buying spree. Book value fell even further, to just $2.46/share, after another GAAP loss of almost $90 million, driven again by continued impairment charges (including remodeled future cash flows) and mark-to-market losses. The company has been steadily selling whatever decent assets it has left in order to pay down debt, and this has added insult to injury by further reducing the quality of the earnings available for shareholders.

Consequently, the Company also announced another reduction in its quarterly dividend, this time by more than half, to just $0.10/share. The Company’s stock price has been marching relentlessly in one direction (south), and investors tempted to buy into this value trap even three or four months ago have been treated to nothing less than death by one million falling knives. or maybe just a nice pair of cement boots for crystal river’s sea of red ink

The Company announced last quarter that it was pursuing “future strategic business opportunities”, which is usually a euphemism for selling out run for the hills! or merging. Given that they called off the initiative this quarter, one can reasonably assume they found no takers.

Interestingly, however, the company did manage to generate positive operating earnings of $.67/share. The Company’s CMBS portfolio was also looking pretty good, with delinquencies of less than 1% (in line with the market, but this will surely increase), no shaky interest-only loans, and no near-term maturities to worry about. Even more interesting, however, was this little nugget in their earning release: CRZ says that all these losses may actually cause the company’s operating earnings to exceed its taxable income for the next several years.

Is this bit of accounting errata of any real consequence? For this cash-starved REIT, it is potentially very significant. IRS rules require all REITs to distribute 90% of taxable income to shareholders. If there is no taxable income, there are no distributions. However, CRZ is actually generating cash earnings from operations. Because the Company is generating tax losses, this cash operating income will now be sheltered from taxes as well as the requirement to distribute it to shareholders.

There is a saying about pissing on somebody’s leg and then telling them that it’s actually just raining, but this oxymoronic situation could wind up being very beneficial for CRZ investors. It would give management some crucial breathing room by allowing them an opportunity to reinvest that cash in the continued reduction of short term debt, or the acquisition of new, accretive higher-yielding investments. please, not again

With access to capital in this sector reduced to zero for the foreseeable future, even something is better than nothing. Significantly, the Company’s CEO, Bill Powell, announced that he would be making purchases of the stock on the open market after his blackout period ends, and he followed up with a reasonably big purchase. Reasonable, yet also pretty adventurous given CRZ’s precariously thin unrestricted cash position of $2 million (the company does have access to its revolver) and the composition nuclear waste of its investment portfolio.

I personally won’t be dumping any of my hard-earned clams into this disastrous bubble mania, bed-wetting poster child anytime soon, but it’s becoming a more interesting story. Current shareholders may soon owe a debt of gratitute to 2006 shareholders for helping to produce what could turn out to be CRZ’s most valuable asset: tax losses

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

This article, published yesterday in American Banker, pretty much sums it up. BBB CMBX spreads, which have been climbing throughout July and August (Markit Group Says “Bienvenido!”), are now about 2500 basis points over Treasuries, which would equate to just about a 30% (!) yield.

Despite the credit crisis—or perhaps because of it—there has never been a better time to invest in fixed-income products, particularly triple-A commercial mortgage-backed securities, according to portfolio managers at Putnam Investments.

The Boston unit of Power Financial Corp. acknowledged that advisers are facing a great deal of uncertainty and a tough economic climate that could take a long time to level off. Nevertheless, Putnam says fixed-income products, such as commercial mortgage-backed securities, municipal bonds, and high-yield bonds, remain very attractive.

Triple-A commercial mortgage-backed securities are attractive because they are protected from losses and “are the best levels we have seen in 20 years,” Bill Kohli, a Putnam fixed-income portfolio manager and team leader of portfolio construction, said in a conference call Tuesday. “This is an area that 10 to 20 years from now we are going to look back on at the historic type of values in these securities.”

The securities are “well-protected and fundamentally sound,” Mr. Kohli said. “We would need an event five to six times worse than the worst market ever before you would experience any type of fundamental loss.”

Unlike equity products, commercial mortgage securities will not be able to maintain their low prices for long, he said. “There is a massive liquidation going on today in terms of firms selling their fixed-income assets. Prices this cheap will disappear.”

These products are “plain vanilla, very liquid, relatively straightforward to analyze, and well-diversified,” Mr. Kohli said. “This is as close to a free lunch as you can get right now.”

Putnam expects a potential price return of 7% from triple-A commercial mortgage-backed securities, 7% from investment-grade bonds, and 13% from high-yield bonds.

“When you look at all of these sectors, the spreads are as attractive as we’ve seen … in our investment lifetime,” Mr. Kohli said.

Analysts and industry observers said that during a difficult economic crisis, investors are interested in using fixed-income products to shelter assets.

But W. Christopher Maxwell, a managing partner at the Rock Hall, Md., wealth management firm Conestoga Capital Advisors LLC, said that despite this notion, many investors and advisers are very suspicious of ratings right now and are wary about investing in any commercial mortgage securities, even if they have a triple-A rating.

“There are a lot of smart people out there that are trying to make astute judgments and trying to buy fixed-income products at a discount, but it can be quite difficult to find those values,” he said. “The difference between a successful triple-A-rated CBMS and one that is not so successful is not that big.”

Mr. Kohli said it is critical to maintain a well-diversified portfolio that includes a variety of fixed-income products.

“The fixed-income landscape is much more complicated than it was 10 to 20 years ago,” he said. “Companies need a certain degree of specialization to understand the dynamics. It is hard for a generalist or anyone who takes a general approach to grapple with all the issues in the fixed-income landscape.”

Putnam had $166 billion of assets under management as of June 30, including $75 billion of fixed-income assets.

Mr. Kohli said in addition to triple-A commercial mortgage securities, Putnam believes that there are opportunities to invest in high-yield bonds, municipal bonds, and even alternative-A mortgages.

Even though many analysts and industry observers have turned their back on the alt-A market, Putnam has been buying such assets over the past few weeks, he said.

“We are doing our homework,” Mr. Kohli said. “We are getting to know the underlying pools and the geographic distribution. We are not just buying plain vanilla alt-A. … We are dipping our toe in the water. We are really just starting to get involved.”

Geoffrey Bobroff, an analyst with Bobroff Consulting Inc. in East Greenwich, R.I., said that the alt-A market is a dangerous place to play right now, because it can be “difficult to distinguish the good from the bad.”

Burton Greenwald, a Philadelphia analyst with BJ Greenwald Associates, said Putnam is taking a “calculated gamble” by investing in alt-A products to stand out and improve their profile after several years of outflows caused by the poor performance of the company’s equity funds.

“Putnam has gone through more than three years of getting hit in the face every time they stick their head out of the trenches,” Mr. Greenwald said. “Their equity hasn’t shown signs of a turnaround, but they are recognized for having a strong fixed-income record. Now they want to really allow that to shine.”

Thailia Meehan, a Putnam portfolio manager and team leader of its tax-exempt strategy, said that municipal bonds remain an attractive investment option, because they are inexpensive when compared with Treasuries.

There is a tremendous buying opportunity when it comes to A-rated and triple-B-rated municipal bonds, Ms. Meehan said. A lot of investors were underweighted in municipal bonds heading into the credit cycle, she said, and this could be a good opportunity to balance a portfolio.

“This is a terrific opportunity, and we are taking advantage of it,” she said. “We are buying high-quality munis at attractive levels. We haven’t dipped down to lower-quality munis on the curve.”

Mr. Kohli said that it remains a very tumultuous economic market, and that it is difficult to make predictions, but he is confident fixed-income products will remain attractive options for advisers and investors.

“I’d love to tell you that three months from now or three weeks from now we will have the most attractive levels,” he said.

He added: “But I am comfortable saying that over a three-year or five-year horizon, the growth opportunities are phenomenal. They are off the chart.”

In the first quarter of 2007, subprime mortgages provided the first sign of trouble in the credit markets as falling housing prices began to hit borrowers hard. But in the first quarter of 2008, home-equity lines of credit became the new canary in the coal mine. Lenders such as National City have frozen existing home equity lines of credit, and as housing troubles show no signs of abating, these commercial banks are rushing for the HELOC exits with hedge fund-like alacrity.

Indeed, as real wages continue to fall with the recent increase in oil and food prices, the gap between home prices and median income continues to be way out of whack – despite the continuing decline in home prices. Folks, the bottom in housing is simply nowhere in sight.

Amplifying the point was Financial Security Assurance Ltd., which last month said that loss projections for these home equity loans rose in the first quarter. Embattled FSA increased its loss estimate by $355 million in the first quarter, as losses were particularly high in eight of its insured securities backed by home-equity lines of credit.

As everyone knows, these loans consist of lines of credit secured by home equity, which has been disappearing faster than high paying jobs on Wall Street. So far, FSA has paid $104.2 million in net claims on the transactions. Robert P. Cochran, chairman and chief executive of FSA, said that “since the beginning of 2008, these transactions have experienced much higher default rates than ever observed in the past.”

Moody’s then corroborated FSAs public trouble with a news release of its own, disclosing that losses in some of its insured home equity loan transactions had also risen rapidly. Moody’s Investors Services boosted its average loss expectations for securities backed by subprime second mortgages to 17% for 2005 vintage subprime pools, 42% for 2006 vintage pools, and to 45% for 2007 loan pools.

As I wrote earlier, these delinquency figures broken out by vintage illustrate the absolute imperative of investing in Mortgage REITs that have been around the block a few times. Those REITs that started up in the halcyon days of 2005 and 2006 simply have a huge hurdle to overcome: portfolios that are now stuffed full of weak, demand-driven paper. Their workout teams had better be good and well rested, because it looks like they will be busy into the next decade.

Indeed, Ambac cited one transaction where it said delinquencies topped 81% of loans. Significantly, both Ambac and MBIA said they were looking into some loans to see if they lived up to the standards of the securitization agreements. Since many of the underlying loans in question were originated by Countrywide Financial Corp (CFC), one must wonder how carefully Bank of America (BAC) read the investor put provisions in these deals before agreeing to purchase the Company.

Luckily for FSA, it avoided one of the most risky areas of the CMBS market: writing credit default swaps on CDOs backed by all these imploding mortgage loans. However, FSA did write credit default swaps on corporate risk and took a negative market value adjustment of $317.9 million in the first quarter.

In my two earlier articles on mark to market accounting, Mr Market Trips on Mark to Market and the more detailed follow-up How Markit Turned Mr. Market into Mr. Magoo, I emphasized that unlike realized losses, these market value losses only reflect decreases in the market value of the securities in question, not actual cash losses. Consequently, those losses have the potential to reverse if the market moves in the other direction. Thus, in FSA’s case, their $317.9 million negative mark could potentially be erased, or even become a future gain, if credit spreads tighten.

And here is the story within the story: according to FSA CEO Cochran, that has already begun happening. Credit spreads have “tightened significantly since the end of the quarter,” which would mean that FSA could end up recording a positive market value adjustment on its balance sheet in the second quarter. “It is hard to give a number where we stand now, but no doubt it would be positive,” Cochran said.

As the CMBX and ABX continue to tighten, and LIBOR and TED spreads get back to normal, positive market value adjustments (which would be reported as non-cash gains) will become more common. This will be particularly true for seasoned mortgage REITs that stuck to their knitting and resisted temptation with disciplined credit standards. Combined with the additional clarity arising from the adoption of FAS 159, book values will start looking a little more appetizing in the next few quarters.

Good news does not sell nearly as well as bad news, so I guess the traditional news outlets don’t focus on it as much. It sure is fun to write about it though, and it’s just as important as the opposite truths we’ve been hearing so much about. REIT Wrecks has your back!

REITWrecks: March 11, 2008

Investing in REITs is not for the faint of heart these days. Write-downs are easier to come by than cheap commissions, and huge losses are more common than ice cubes in a fresh cocktail. And while you may need a cocktail if you own any of these stocks, calculating GAAP book value for these REITs will definitely cause any sober accountant to reach for the liquor cabinet.

Nevertheless, it pays to understand the confusion, as there are tremendous opportunities being created by the maelstrom in REIT Stocks. Some of the confusion is being aided and abetted by the by the Financial Accounting Standards Board, the folks who create our beloved Generally Accepted Accounting Principles (GAAP). They recently developed FAS 159 to help reduce this confusion, and it is being implemented as of this quarter by many REITs.

FAS 159 was designed to provide a more accurate picture of the real economic value of investments in debt and equity securities, the very lifeblood of real estate investment trusts. It permits eligible entities to measure many financial instruments at fair value – not just assets but liabilities too. FAS 159 will apply to many types of liabilities, but in the REIT world it will have particular relevance to CDO liabilities and corporate REIT debt.

As every reader knows, cheap, long-term, non-recourse CDO financings were the financial equivalent of pouring gasoline onto the credit bubble inferno in the first half of this decade. As every reader also knows, investing in a CDO is now about as popular as halitosis, and CDO assets have been marked down as fast as the accountants can sharpen their pencils

However, until the implementation of FAS 159 this quarter, Mortgage REITs which had issued CDOs were required to mark down the value of the CDO assets but were unable to mark down the value of the paired liabilities. This really didn’t make any sense: after all, if the assets were being marked down on one side of the balance sheet by the investors, why was the issuer still obligated to carry the paired debt obligation at full value on the other side? The same logic held true for the corporate debt of equity REITs

FAS 159 does not provide the perfect measure of a REIT’s economic book value, and not all CDOs are created equal (some have varying levels of recourse that could, in some circumstances, impair the equity interests beyond the value of the original investment), but it does address some important issues in the REIT Wrecks world.

In the case of Redwood Trust (RWT), pre FAS 159 accounting caused the REIT to report a net loss of $1.1 billion and a negative net book value of $22.18 per share as of year end. That’s right, negative. A full $1 billion of the net loss was attributed to the write down of its Acadia CDO assets. Most tellingly, the net loss attributed to Acadia vastly exceeded RWT’s $118 million net investment in the Acadia CDOs. This accounting convention completely distorts the real economic value of the transactions and RWT’s business propositions going forward: since RWT’s credit risk is limited soley to its own equity interests, it is difficult to comprehend how the REIT could lose more than its original investment.

Implementing FAS 159 at RWT results in a positive, and more accurate, book value of $23.18. This is a huge swing and illustrates not only the importance of the new accounting standard, but also the folly of relying purely on GAAP. RWT’s results have been clouded by these huge GAAP write downs and net losses, which do not correlate to actual economic value. I also believe RWT is extremely well managed, and the stock deserves a close look by any investor interested in this space.

Another great example of FAS 159’s impact is Alesco Financial (AFN). Upon the adoption of FAS 159, AFN expects to add approximately $2.7 billion, or $45.03 per share, to stockholders equity. Much of that comes from writing down the liabilities paired with its accident-prone Kleros CDO assets. The investors in these CDO assets have absolutely no recourse to AFN, and therefore AFN’s exposure to Kleros is limited to its net investment. Alesco has all sorts of other more serious trouble, and were it not for that, the Kleros CDOs would be nothing more than a public relations problem. FAS 159 won’t help that, but it will help investors assess the true economic value of AFN and many other REITs in a more realistic manner.

Click here for a Mortgage REIT list, including current yields.

mortgage reits, reits, reit

Disclosure: None