FASB Amends Fair Market Value Accounting

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.

Fitch: RAS's Toxic Taberna CDOs Getting Even More Toxic

Taberna To Take Yet Another Hit? Maybe, But The Bad News in This Brew is Already Baked In.

Man, what I wouldn't give to be a fly on the wall at dinner time in the Cohen house. Betsy and her husband, whom I shall refer to as Laius for purposes of these frivolous first two paragraphs, were a pretty conservative couple in the City of Brotherly Love. They were content to sally forth up and down the Schuykill, closing bread and butter 80/20 real estate deals. But Daniel's Ophelia drove him into a megalomaniacal oedipus complex, and boy did it make him crazy, that Daniel. I'm just not sure if he was simply crazy, or crazy like a fox.

He founded the eponymous bank, Cohen Brothers, then started Taberna Capital, which subsequently became Taberna Realty Finance Trust, a publicly traded REIT. After three years of furiously issuing CDOs for the Cohen menagerie (RAS, Taberna, yet to be born AFN, etc.), Ophelia-crazy Daniel hired Chris Ricciardi from Merrill Lynch in 2006 (the latter day dark star CDO genius). Ricciardi was a Managing Director in Merrill's Global Structured Credit Group, and it was he and Merrill Lynch that had grown wealthy structuring, pricing and selling hundreds of billions in ultimately toxic CDOs, using Cohen Brothers to manage many of them. This also made crazy Daniel quite wealthy along the way.

I hope he didn't put it all in one account at IndyMac

Then, at the height of the bubble in 2006, the two of them cooked up an evil brew with Taberna Realty Finance as one of the main ingredients. They merged Taberna with RAS, ultimately saddling RAS with Taberna's acidic CDO equity.

Do you think they knew something we public shareholders didn't?

Taberna, which is now a rusted hulk of itself a mere two years later, continues to haunt the duo.

Assuming they have a conscience.

And undoubtedly, Betsy and Laius got the last word, or so it would seem. Unfortunately, RAS shareholders are left with the residue, after paying a 2006 premium for it.

Speculation and frivolity aside, Fitch announced last week that is had placed thirty-one classes from six Taberna collateralized debt obligations on "Rating Watch Negative". Four of the transactions -- Taberna Preferred Funding II, II, IV, and V -- are static CDOs, and the other two -- Taberna Preferred Funding VI and VII -- are managed CDOs.

The ratings action seems reasonable - maybe even overdue - given that the majority of the transactions are supported by portfolios of trust preferred securities issued to local and regional banks (see "The Trouble With TruPs"). The rest of the portfolio consists of subordinated debt issued by subsidiaries of real estate investment trusts, real estate operating companies, homebuilders, and specialty finance companies, as well as commercial mortgage-backed securities and, in a very few cases, senior debt securities or commercial real estate loans.

Fitch attributed its rating actions to "heightened concern related to continued negative portfolio credit migration, as well as additional default activity."

Earth shattering? Hardly. In fact, it barely qualifies as news and I'm practically embarrassed to post it for y'all. But Fitch did it, and now you know it. REITwrecks has your back!

Disclosure: Long RAS at the time of this writing

What's The Rub With RAS?

Things are looking up... The Wall Street Journal reported Wednesday that investors and issuers of commercial mortgage-backed securities have something to cheer about for a change: The CMBX, a two-year-old credit-market index that has been heavily influencing CMBS prices, has been on a tear since late March.

As REITwrecks wrote earlier, the index had been under the influence of short sellers and trading at levels that would imply default rates of as much as 100% of the underlying commercial mortgages. As the WSJ reiterated, this is an all-but-impossible scenario, and with the index now oversold, investors are starting to pay more attention to the fundamentals of the commercial-property market.

REITwrecks has been emphatic about this disparity between price and value: for a long time, a myopic Mr. Market simply got it very, very wrong. Superficial similarities between residential and commercial real estate just did not and do not exist, and he has discounted the instrinsic values of the cash flows associated with commercial real estate far too heavily as a consequence.

Goldman Sachs' CFO David Viniar underlined the point in a conference call with investors last month. "Many assets are being priced by the market at levels which are significantly below the levels that would stem from a fundamental valuation approach," he said, while blaming depressed prices on "technical contagion" that eventually will abate.

As if on cue, over the past several weeks, spreads between Treasury's and the AAA CMBX have tightened dramatically, which in turn has driven up the prices on actual bonds. According to the Wall Street Journal, the spread on the triple-A series 4 index, which tracks certain 2007 CMBS deals, has shrunk to less than a hundred basis points after almost reaching a 3-handle in mid-March.

"I see the rally as something that should have been expected given how far out of whack CMBX spreads had gotten versus stable commercial real-estate fundamentals," said Darrell Wheeler, global head of securitized strategy at Citigroup Inc.

In another rare sign of stability returning to the market, last week Lehman Brothers and UBS lowered some yields on $1 billion of commercial mortgage-backed securities in what may mark the first CMBS of 2008 to price at yields lower than those first pitched.

According to Reuters, Lehman and UBS lowered yields on the "AAA" rated portions by 15 basis points to 25 basis points without losing orders. Previous issues had been sweetened with additional yield to draw investors shaken by the credit crunch and concerned that commercial real estate would falter in a U.S. recession.

Signs that sentiment has begun to improve have also been seen in the secondary market for CMBS. Spreads on outstanding 10-year "AAA" bonds have dropped by 100 basis points in the past month, according to JPMorgan Chase & Co.

After spending a considerable amount of time at the bottom of the lake, even the CLO/CDO market is starting to slowly heave its chest again. Traders report an increased appetite for European CLOs in the secondary market, but that the interest remains hampered by the lack of supply - caused primarily by sellers who see value in the paper and are thus unwilling to sell at such wide spreads. Previously there had been a steady trickle of assets from credit funds, SIVs and other forced sellers, which satisfied interested buyers, but this now appears to have ended.

The groundwork is being laid for a recovery in the second half of the year, suggest structured credit analysts at JPMorgan, who contend that higher relative value now compensates for the risk of mis-timing the bottom. CLOs could actually be part of the solution, given that banks are using the vehicles to move loans off their balance sheets.

However, demand is nothing what it used to be, with two thirds of the market for CLOs, CDOs and MBS having been wiped out, and those investors that do remain have become even more sensitive to underwriting and the managers behind each deal. Track record is everything. Demand has thus not even come close to recovering from pre-crisis levels, if it ever will at all.

And this is the main Rub with RAS: even with cash flowing assets match funded with long-term, non-recourse liabilities, RAS has been cut off from the oxygen it needs to grow FFO. Thus, in one of the best markets in 20 years, RAS has very little room to maneuver for new, choice assets at these premium spreads.

Combine this with lingering doubts about the Trust Preferred portfolio, much of which is covenant-lite and exposed to less solid credits and, indirectly, even shakier markets (think Accredited Home Lenders), and you still have a lot of uncertainty. Consequently, even with Thursday's 7% jump, RAS is still trading near its credit-crisis nadir.

REITwrecks is conducting research on the Indian Ocean and will be relatively unplugged when RAS reports on May 5th, but mark-to-market is now old news. The issues to pay attention to now are the ability to fund growth (true for all REITs), and the health of the TruPs portfolio (RAS in particular).

As Lehman Brother's CFO said, "we look at the mark-to-market adjustments as more temporary in nature," the steep decline of mortgages and loans has been "driven by many technical factors, which may not reflect intrinsic value," she said.

Unfortunately, the true intrinsic value of RAS's TruPs portfolio is yet to be determined, and future value creation in this bountiful market hinges heavily on the Cohen's funding creativity. Watch for both on May 5th.

Disclosure: Long RAS

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.