FAS 159: More Red Flags Than a Military Base in China, or Just a Little Frost on the Windshield?

Stifel Nicholas analyst David Fick downgraded Northstar from hold to sell on Friday. Maintaining coverage at a hold is hardly table-pounding, so downgrading to sell what ev's, dude seems like a minor administrative point, especially in this market. The stock was trading ex-dividend on Friday anyway, so it was difficult to know whether the downgrade had any real effect on the price.

I have only seen excerpts of the report *because I am child-like and not to be trusted* but the main point of the report appeared to be a debunking of FAS 159's applicability to the calculation of NRF's book value. Because NRF does not apply any FAS 159 gains to taxable earnings, the only real issue here is NRF's true duh! we OWN this pos! book value. Using FAS 159, NRF calculates its book value at just over $12 per share, Fick writes that it is even less, about $5 per share, and Mr. Market simply says "Do I have to??"

The applicability of FAS 159 is definitely a case by case play. For some background on how it works, see "Muddled Mortgage REIT Book Values Create Opportunity". The argument against applying FAS 159 accounting to REITs is pretty simple. In theory, many people believe that distressed beached, sunburnt, shriveled whales Mortgage REITs will never, ever have enough cash to buy back their own debt. Furthermore, people argue, even if they did manage to come up with the cash they would have to account for the discount as an immediate taxable gain (i.e., the gain on the debt repurchase must be distributed as dividends). This presents cash-flow issues, as the required dividend would most likely exceed actual cash earnings.

But neither can FAS 159 be dismissed completely out of hand. It just doesn't make sense to penalize REITs for an amount that exceeds (in the case of a CDO) their net economic investment in a specific transaction. Moreover, FAS 159 is not just accounting theory, as evidenced by Grammercy Capital's (GKK) partial buyback of it's own CDO debt last quarter (check out "The New Mortgage REIT Magic" in The Mortgage REIT Journal for great detail on the accounting behind that deal). The GKK deal proved that FAS 159 can actually be converted to economic reality, and that even distressed beached, sunburnt, shriveled whales REITs can find a way around the frozen capital markets.

The key to GKK's deal is that they were able to shelter the gains on the debt repurchase with normal, every day depreciation losses in the portfolio of recently acquired American Financial Realty Trust. Were it not for those depreciation losses, and the fees paid to the bankers who printed the AFR trade the buyback could most likely never have been done.

A quick aside: the value of depreciation losses in relation to buying back your own highly discounted debt potentially creates a fascinating conflict: To what extent, if any, should REITS overpay for physical assets, and thus "step up" the depreciable basis of those assets, so that they can shelter even more taxable gains on repurchasing their own dodgy debt??

In NRF's case, it's a double edged sword: their CDOs are performing well so it's doubtful that FAS 159 is correcting any great accounting wrongs on NRF CDO equity valuations vis a vis the correspoding debt. It would also be difficult for NRF to take adavantage of any opportunity offered by FAS 159. They do have their net lease portfolio (which generates depreciation losses), but these are already matched against income in that portfolio, so that portfolio would not be of much use when it comes to offseting gains on the repurchase of debt. Opportunistic distressed portfolio acquisitions could incrementally create additional shelter for them, but that's unlikely to be of any great significance.

For now, I think Fick is in a dying business right to question the value of FAS 159 to NRF. For long-term investors though, this shouldn't be disappointing as the fundamental question has always been this:

how good are the assets and can management generate earnings growth?

The answer to the first question is that they are clearly very good, while the answer to the second question is a weak maybe. In this environment, NRF just can't raise accretive capital easily, but they do have some very inexpensive retained earnings/debt repayments to deploy which should help. I'm long very here, but money is fuel in this sector and right now most Mortgage REITS are simply out of gas.

But none of this FAS 159 stuff is incredibly insightful how much is Stifel paying that guy, anyway and if your investment thesis is to buy high-quality, 100% match-funded assets and ride it all out (see "High Yield Mortgage REITs, the Perfect Storm?"), that thesis is still intact with NRF. Indeed, the stock is still trading above the lows sir, your card has been declined seen in November '07 and January '08. So for now, I think it's still safe to ignore all the noise and quietly bank the 18% yield. REITwrecks is on your toes!

Disclosure: Long NRF at the time of this writing

Investing in Mortgage 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 Mortgage REITs. 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 Mortgage REIT world it will have particular relevance to CDO liabilities.

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?

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 Mortgage REITs in a more realistic manner.

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



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Disclosure: None