Muddled REIT Book Values Create Opportunities
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
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
Labels: 159, AFN, High Yield, High Yield Dividends, High Yield Mortgage REITs, High Yield REITs, RWT
posted by REIT Wrecks at
5:29 PM
6 Comments:
Can you please provide an example and an explanation of a type of liability that RWT can write down?
Thanks.
Sure, the post mentions the Acadia CDO liabilities as an example. This is the structured debt that was used to purchase the Acadia CDO assets. Mark to market accounting requires the assets to be marked down to fair value, but until now the liabilities had to be carried at face value. They can now be adjusted (down) to fair value, and the reduction in those liabilities increases shareholder equity. I hope this helps, if it's still unclear let me know. Thanks, REIT Wrecks
REIT Wrecks, like the site, like the general idea. This post however I have to disagree with. While I think it was a lousy prior implementation where the assets were marked to market and the liabilities held at face, in my opinion this change does little to clarify the picture.
In the example that you have cited, RWT, they as issuer do not have the right to call the liabilities at market value. I haven't gone through the OMs in detail but generally you can call after the non-call period (or for consolidation, tax and other special redemptions) at Par + Accrued.
Why is this important? Because they will have to pay their investors the entire face value of their bonds before their equity sees a nickel. I suppose that an issuer could go out and acquire the issued bonds in the open market, ammend the deal and then sell the underlying assets to raise the proceeds to pay off the bond acquisition. However as someone with a lot of experience in this space I can tell you it's bloody unlikely to happen.
Honestly this latest development just further cocks up the initial mistake FAS made of having CDO Assets marked to market. Wouldn't the more rational approach be to just value the equity interest in a CDO as the PV of the expected CF to the equity using a market appropriate discount rate? This approach would avoid the absurd situations that you have outlined where a REIT has book exposure in excess of their investment in the deal. It also would prevent the situation where you perversely attribute value to an asset because the classes more senior have lost value. Does it really make sense that if my BBB class is trading at $.20 that my equity class should trade at $.75?
CDOs were set up to be match term funded vehicles for REITs so that they could avoid mark to market fluctuations. Applying a mark to market to the underlying makes zero sense to this guy.
Thanks for that comment and for taking the time and effort to write it in a coherent way.
Yes, I have no idea why FASB/IASB doesn't just fess up and say "we screwed up"; using the PV of the cash flows to value the equity is really the only way to assign an economic value to it. Why would it be worth anything more or less?
Moreover, since cash flow pv's are already the basis for a number of "bedrock" accounting principles here in the U.S., I have no idea why they don't just implement it with some EITF bulletin. Perhaps somebody who reads these comments will have some insight on the reason.
However, at least in the case of the RWT and AFN CDOs referenced in the original post, the accounting/call debate is academic. The deals are in default and the assets will, in all likelihood, be liquidated.
RWT and AFN have already written off their equity interests in these vehicles as a result and as far as the debt goes, it's non-recourse so they're never going to have to pay it back anyway.
Thus, I think marking down the liabilities in these CDOs does accurately reflect the economics of the deals as they stand (fall?).
The reason I chose these two cases to illustrate the incredibly twisted accounting is because they are defaulted and non-recourse (I noted in the original post that not all CDOs are created equal), and I thought it would easier in terms of the point I was making with the post.
But you're right, I didn't adequately address the right to call and when it would apply/not apply, and in this regard (and perhaps others) the post was unclear.
I am mostly having fun with this site, but I do seriously struggle with the desire to balance accuracy with readability. To the extent that I occasionally sacrifice one or the other I apologize, and I am grateful that you took the time to write and clarify it. Thanks also for the kind comments on the site.
Lets say for example that at a CDO closing, all of the notes and preferred shares were purchased by investors at a discount to their collective par value of $500,000,000. The CDO priced the debt and equity at a discount sufficient to raise the respective yields to current market rates. The total purchase price discount to debt was $10,000,000 and the discount on the equity tranche was $5,000,000. There were also closing costs of approximately $2,300,000 associated with the issuance of the debt. How would the CDO account for the purchase price discounts on the notes and equity incurred at the closing of the CDO? What guidance is there on this? Are these discounts amortized?
Hypothetically, of course! In the old days, we would have convened 10 people in a room, pressed one of the unlucky 10 into drafting and redrafting a memo to the accounting policy group, which would then result in another 10 people meeting in a different room to approve, ammend and decline our original recommendation.
Your transaction fact pattern is also a little unclear to me (new assets being packaged into a new CDO, old CDO just being dumped, part of the deal being retained, still consolidated by seller as a result, if so what are FIN 46 issues, etc). That said, I decline to cop out:
I think it's pretty clear that the discounts would be accounted for as a trading loss by the seller(assuming the portfolio is classified as held for sale), and the transaction costs would be capitalized by the purchaser and then depreciated/amortized. Beyond that Cristina, if you're doing deals like this, you ought to (must?) be able to hire a qualified accountant, n'est-ce pas?
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