Fair Value is Fair Value

"Everything secret degenerates, even the administration of justice; nothing is safe that does not show how it can bear discussion and publicity." - Lord Acton

The accounting standard known as FAS 157, otherwise known as mark-to-market accounting (see How Mark To Market Turned Mr. Market Into Mr Magoo for detail on how it works), has been criticized by some bankers, notably Blackstone Group chief Steve Schwarzman, for needlessly causing big write-downs and encouraging financial panic. It's defenders include Goldman Sachs, which pointedly left the Institute for International Finance in June, a banking lobby group, over the IIF's anti-mark-to-market stance. Last week Treasury Secretary Hank Paulson defended mark-to-market during a talk he gave at the New York Public Library (which, ironically, is now officially called The Stephen A. Schwarzman Library.)

"I believe in fair value accounting," Paulson reportedly said. Robert Teitelman writes in The Deal that Paulson offered up a spirited defense of mark-to-market accounting, also known as "fair-value accounting." Paulson made several points. First, we can't just throw "fair-value" accounting out the window because of some illiquid markets in a crisis. Second, you can't run an investment bank without mark-to-market. Third, we need to recognize the losses and move on. Fourth (Teitelman made this one up), "stop whining you damn crybabies".

Teitelman's fourth point is interesting and applicable in REIT land, and I quote liberally from his article as a result (if not already blessed with eternal life, my 6th grade writing teacher soon will be after reading this weak attribution. Apologies in advance Ms. Graham!).

Now maybe our Treasury chief is right, Teitelman writes, particularly on point four. But no one is saying -- well, hardly anyone -- that we should just toss out mark-to-market, giving the banks a fat break and move on. The question is more subtle than that: Does mark-to-market need to be applied universally, to all assets classes and financial instruments? Is the prudent duration for all assets a short-term market standard, or just for some? And do the standards or indices we now have work in illiquid markets under stress, or are they prone to failure or manipulation?

Moreover, the entire financial world does not consist of investment banks. There are insurers out there, retail banks, private equity shops, money managers. There is a whole diversity of financial providers that we are trying to jam through the keyhole of mark-to-market accounting. And, yes, given that investment banks make their money (or lose it) in short-term markets every day, it is completely appropriate to apply strict mark-to-market to them.

The fact is, mark-to-market is completely appropriate to any speculative enterprise. The spread of mark-to-market to all corners of the financial world represents not only a blurring of the once-bright line between investment and speculation, but its obliteration. Speculation has won. And the notion that the best snapshot of reality is the one hatched by the markets every day has won. And FASB 159, an extension of FAS 157, is also completely appropriate as well. Sure speculators can speculate, but others can speculate againsts those speculators (by repurchasing their own marked-down debt, for example, as NRF and GKK have done). And as a result of all this, individual investors are less susceptible to to opaque disclosures and smoky, back room deals.

For individual investors, that triumph not only brings opportunity, but also gut-wrenching, bottle-draining stress as the "daily demands of traders and activists" are digested by the second into one's individual net worth.

As Tietelman writes however, fair value, is, of course, by definition, fair. And who can argue with that?

High Yield Mortgage REITs: The Perfect Storm?

Volume of Maturing Mortgages to be Low in 2008 and 2009, Reducing Refinance Risk Even Further, but Mark to Market is Discounting REITs to the Depths of Atlantis.

After a couple of alarming headlines in Seeking Alpha related to commercial real estate, the most recent of which was "Commercial Real Estate Collapsing", REITwrecks decided to do some digging. Sherlock Holmes may have had Watson, but who better than REITwrecks to sleuth the truth in real estate?

One of the first articles appeared last week and was prompted by a study issued by the Johns Hopkins Carey School of Business on the short term future of commercial real estate markets. Despite Seeking Alpha's clumsy attempt to connect the report to potential nation-wide troubles, the report actually focused almost entirely on the the Baltimore/Washington area, and then primarily on certain development projects within that area.

It was a comprehensive report, but with such a narrow focus it hardly qualified as meaningful commentary on the market as a whole. In addition, the John's Hopkins report itself was very positive overall.

However, the SA article focused on the negative comments of several experts, who worried that the Baltimore-oriented report was overly optimistic. One of those experts was David Fick, who covers REITs for Stifel Nicholas. For that reason, the story deserved further attention, and that attention exposed some very interesting market data.

According to the story, Fick said that $236 billion in equity investments have already been written off as a result of the subprime mortgage crisis, and that "most of that investment has been in the commercial, rather than the residential, market". By the end of the credit crunch, he said he expects to see at least $400 billion in write-offs.

“The oxygen, the mother’s milk of commercial real estate, is capital,” he said in the article. “Try to get a construction loan now — it’s virtually impossible.”

In one of the more confusing paragraphs, the article quoted Fick as saying that "more 10-year, commercial mortgage-backed securities were issued in 1998 and 1999 than ever before, and that most of them would not be financed". I'm not sure what that means, but Fick went on to predict that the result would be "the demise of many of the region’s existing real estate investment trusts within the year".

Unfortunately, the author didn't attempt to clarify whether Fick meant these deals wouldn't be financed in today's market, or whether these deals wouldn't be refinanced in today's market (as the loans mature). Asserting that a development deal would be more difficult to finance today's market is not particularly insightful, nor is it relevant to a question dear to the heart of REITwrecks: what is the health of Mortgage REIT portfolios, and is the market pricing the intrinsic value of these cash flows rationally?

So I continued an investigation into refinance risks that resulted in a previous article, which disclosed that 99% of all CMBS deals maturing since the credit crunch began in August had been successfully refinanced. Thus, the supply of credit for commercial real estate appears to be holding up even in this credit-stressed environment.

Alas dear readers, that good news on supply is naturally only one side of Adam Smith's beautiful yet invisible hand, and REITwrecks unintentionally left some astute readers clinging frantically to their mousepads for even more. What about the demand side for credit in this environment? More importantly, would a huge supply of maturing paper in need of refinancing put even more pressure on the commercial real estate debt market?

I found the exact opposite to be true. According to a report issued by the Mortgage Bankers Association, the volume of maturing mortgages will be low in the coming years, which would expose few commercial loans to these refinance risks.

"There's been a general impression that a large volume of commercial/multifamily mortgages are coming due this year and next," Jamie Woodwell, MBA's senior director of commercial/multifamily research, said. "The reality is that 2008 and 2009 will see a relatively small volume of maturing mortgages, with the majority of CMBS loans not maturing until 2015 or later."

Capturing data from JPMorgan and Wachovia Capital Markets, the report found that there is more than $600 billion of outstanding loans in fixed rate commercial mortgage-backed securities (CMBS). Of this, only $16 billion is scheduled to mature in 2008 and another $19 billion in 2009.

The surge in sales, financing and refinaning volume during 2005, 2006 and 2007, coupled with the fact that CMBS loans tend to have a 10-year term, mean that the majority of CMBS loans will not mature until 2015 or later -- $98 billion of loans are scheduled to mature in 2015, $128 billion in 2016 and $127 billion in 2017.

Of the loans due in the coming years, the majority is well seasoned and have been amortizing, meaning that they now have lower loan-to-value ratios and will be more attractive to lenders. JPMorgan reports that $14 billion of the $16 billion maturing in 2008 is fully amortizing, as is $14 billion of the $19 billion coming due in 2009. According to Wachovia Capital Markets, more than two-thirds of the volume of loans coming due prior to May 2009 was originated prior to 2000.

In addition to the fixed-rate conduit deals described above, the report noted that Wachovia Capital Markets has identified $30 billion of large-loan floating-rate deals that will be coming due prior to May 2009. The maturity dates of these loans are spread throughout the period, with relatively larger volumes -- $3.5 billion and $3.3 billion, respectively -- coming due in August and October 2008.

These numbers all appear to be manageable given Fitch's report that over $21 billion in CMBS fixed rate loans had been refinanced just since August of 2007, when the credit crunch began.

The MBA report focused on maturing mortgages in the same CMBS market. Banks and thrifts will be more likely to have shorter-term and adjustable-rate loans, while life companies will tend to have longer-term fixed-rate loans, but with much lower leverage and thus easier to refinance. Each group's maturity patterns will also be affected by the ups and downs of its originations experience, but each group's originations generally fell as the CMBS market grew.

So what we appear to have is the equivalent of a hurricane hitting during a spring tide. The storm's turbulence is no less intense, but the extremely low tide is preventing the storm waters from getting anywhere near the beach.

Nevertheless, the market is pricing a force 5 hurricane hitting during a full moon flood tide, and it is conspiring with mark to market accounting to discount prices by Poseidon-like proportions. The resulting price dislocation is almost unprecedented, and for long-term, opportunistic investors it really is the perfect storm.

How Markit Turned Mr. Market Into Mr. Magoo

In order to understand the answer to this question, it helps to first ask another: How could a Commercial Mortgage REIT, with absolutely no credit losses and no non-performing assets across its entire $7.4 billion portfolio, be forced to take a $180 million loss?

Part of the answer lies in an earlier post I wrote about Mr. Market, an imaginary man who has helped created the buying opportunity of a lifetime in many REIT stocks. According to Ben Graham, the legendary value investor who imagined him, Mr. Market appears daily without fail to name a price at which he would either buy your assets or sell you his.

At times Mr. Market feels euphoric. When in that mood, he sets a very high price for your assets because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead. On these occasions he will set a very low price for your assets, since he is terrified that you will try to unload your interests on him, bringing him immediate losses.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. Consequently, Graham said you must heed one warning: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.

While we are free to determine the merits of Mr. Market’s wisdom on a daily basis, the accounting profession is entrusted with no such discretion. They are collectively the Joe Friday’s of the investing world: “Sorry m’aam, just the market value.”

Believe it or not, accounting rules require most Mortgage REITs to value the vast majority of their investment portfolios at whatever value Mr. Market thinks they are worth, no matter what mood he’s in, as if they were going to sell 100% of their assets - all at once - at whatever price the market would bear on any given day. This is what “mark to market” accounting means, and that is essentially how it works.

But what if these were not normal times, and Mr. Market was almost completely out of action, frozen by fear? What if Mr. Market were so completely incapacitated that he could not even quote a price, never mind buy or sell?

This is exactly what has happened, and the accountants are left with nothing but the Markit Group’s CMBX index to value many tranches of CMBS. The CMBX is partly what scared Mr. Market half to death in the first place, and it has drawn scrutiny for its lack of transparency and limited disclosure.

If Mr. Market was near sighted before, the Markit Group has helped turn him into Mr. Magoo, the very caricature of myopia.

While the dust-up between the the Markit Group and its critics will be fun to watch, here is the important part for REIT investors: Mr Market’s Markit driven myopia results in accounting losses that are mostly temporary, non-permanent, and non-cash. Not only have these huge GAAP losses created frightening headlines, they have contributed to a great deal of confusion over the real valuation of financials. This confusion, and the fear related to it, has created a huge window of opportunity in certain REITs and financial stocks that simply will not last.

Here’s how it works: Because the securities being valued aren’t actually being sold, GAAP allows management some discretion in determining whether impairments can be considered temporary or permanent. If cash flows have actually declined and the asset is not performing as expected, management must classify the asset as permanently impaired. Permanent impairments flow through the income statement and drive taxable income lower. This is bad, because taxable income is what drives dividends. If taxable income declines, so do dividends.

However, if cash flow hasn’t declined and management determines that fair value will recover in a reasonable amount of time, they are given the discretion to classify those market value “losses” as temporary. Temporary impairments do not affect taxable income. They run through a balance sheet account known as Other Comprehensive Income, or Other Comprehensive Income (Loss), depending on who is doing the reporting, and they are reflected on the balance sheet as a reduction of stockholders' equity. This only affects GAAP book value, not taxable income.

Making the determination is a three step process, and it goes like this:

(Diagram courtesy of Redwood Trust 2007 10K)

Because temporary impairments adjust a balance sheet account (stockholder’s equity), not an income statement account, temporary impairments are non-cash. Consequently, they have no real effect on income. They do not impact cash flow, taxable income or dividends, and no money is lost until the securities are actually sold – if they are ever sold. As long as the assets continue to perform as expected, your dividends will not be cut. Furthermore, any increase in Mr. Market’s myopic view of market value will cause those write downs to be written right back up.

What about that REIT that took the $180 million GAAP loss, despite having no non-performing assets across its entire $7.4 billion portfolio? That REIT is Northstar Realty (NRF), and Northstar almost doubled net cash flow from operating activities in 2007. This increase in cash flow helped contribute to dividend growth of $.10/share during the same period. It is cash flow and taxable income that should matter to REIT investors these days, not the myopic noise coming from the shareholder’s equity account.

Given its strong operating performance and the almost pristine credit quality of its portfolio, NRF would qualify as a REIT that’s not so wrecked. Most people would consider it a good investment in almost any environment, never mind one in which a myopic Mr. Market has discounted its dividend into the high teens.

The catch? As I wrote earlier, you must be able to ignore Mr. Market while you push the button and buy from him. Unlike the accountants, you are free to let him serve you, not guide you.

For additional information on a related accounting topic (FAS 159), see Muddled Mortgage REIT Book Values Create Opportunity

Disclosure: Long NRF

Mr Market trips on Mark to Market, Gives REITs Away

In this bountiful era of REIT wreckage, with liquidity having virtually disappeared from the mortgage market, the auction rate securities market, and last week, even the municipal bond market, it is helpful to be reminded of the irrationality that can sometimes rule daily trading gyrations.

According to Warren Buffett, Ben Graham said that you should imagine market quotations as coming from a remarkably accommodating fellow named Mr. Market. Without fail, Mr. Market appears daily and names a price at which he will either buy your stock or sell you his.

At times he feels euphoric. When in that mood, he sets a very high price for your stock because he fears that you will snap up his interest and rob him of imminent gains. At other times he is depressed and can see nothing but trouble ahead. On these occasions he will set a very low price for your stock, since he is terrified that you will try to unload your stocks on him, bringing him immediate losses.

Mr. Market has another endearing characteristic: He doesn't mind being ignored. Consequently, Graham said, you must heed one warning: Mr. Market is there to serve you, not to guide you. It is his pocketbook, not his wisdom, that you will find useful.

In my opinion, Mr. Market - always fallible and never perfect - is now being blind-sided by mark to market accounting. The non-cash charges resulting from these “mark to market” write downs are causing our servant Mr. Market to see nothing but trouble ahead for business and the world. Thus, he is setting a very low price for REITs and many other financial stocks, and that is creating opportunities.

In a different post, I will add more fascinating detail on the rigors of the Other Comprehensive Income account found on the balance sheet of most Mortgage REITs. For now however, suffice it to say, this is the magic "now you see it now, you don't" account for charges not affecting the income statement, because these charges are non-cash and in many cases, NOT permanent.

Furthermore, in the absence of a market for the securities held by many Mortgage REITs, most portfolio managers must use the CMBX and ABX indices to mark their portfolios to the market. As Fitch Ratings pointed out last month, the CMBX is currently indicating a default rate that is four times anything ever seen in the history of the CMBS market. So, managers must mark their portfolios to values that do not correlate with anything even close to actual performance. Does that seem rational?

Unfortunately, for REITs that are highly leveraged, these marks can also lead to margin calls which cannot be ignored – hence the aerial somersaults being performed by the funding desk at Thornburg Mortgage this week (with a perfect triple twist).

While Thornburg may yet make it (Larry Goldstone is clearly very talented and well-regarded), there are a number of well run, slightly less risky Mortgage REITs in the REITwrecks universe that Mr. Market has put on sale.

Companies such as NRF have funded nearly all of their assets on a long-term, non-recourse basis and are not subject to margin calls. They have cash available to reinvest in a vastly improved (less competitive) lending environment. Mr. Market is literally giving these stocks away, offering yields in the high teens and low twenties. Other attractive REIT stocks include AHR, NCT and RAS.

The catch? You must be able to ignore Mr. Market while you push the button and buy from him. Let him serve you, not guide you.

Disclosure: REITwrecks owns AHR, NCT and NRF

Update: More detailed information on how the "Other Comprehensive Income" account works can be found here.