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.

RSO Dividend Going the Way of the Snail Darter?

SNAIL DARTER
(Percina (Imostoma) tanasi)

FAMILY: Percidae

STATUS: On October 9, 1975, this species was officially classified in the Federal Register as endangered.

Resource Capital Corp reported yesterday. Ominously, REIT taxable income for the quarter was less than its declared dividend, and RSO reduced future dividend guidance to .37-.39/quarter. Still, RSO year-to-date earnings are ahead of its year-to-date declared dividends, so it may be too early to sound the red alarm. On the surface, RSO's earnings were not too disimilar to Northstar's (NRF), which last quarter also reported AFFO that was just below its dividend (Northstar reports Q2 earnings on Thursday, August 7th).

The similarities end there, however. Northstar is an internally managed REIT that focuses on one thing: commercial real estate. RSO is externally managed and has a "diverse" - real estate being the largest component - portfolio of cats and dogs that includes everything from equipment leases to real estate loans, bank loans and even REIT TruPs. I love the fact that RSO has both issued TruPs (as a borrower) and invested in them (as a lender).

Regrettably, RSO also commenced operations in 2005, which meant that they faced intense competition for quality assets amidst a frenzy for yield. As a result perhaps, some of their "bank" loans (but not all) carry spreads of up to 6.75 over LIBOR, which indicates a pretty frightening borrower risk profile.

So it shouldn't be surprising that RSO's earnings pressure came partly as a result of both specific loan loss reserves and charge offs, and an increase in general reserves, as well as a huge miss on loan exit fees and loan repayments. Even clumsy IStar (SFI) didn't have such a bad showing on forecast repayments. Unfortunately, this means that RSO's IRR-driven borrowers have been unable to execute their exit strategies with either (1) asset sales or (2) refinancings. In contrast, Northstar's earnings pressure came simply from the fact that they were sitting on a big pile of uninvested cash. Like RSO however, Northstar management believes that "best investment opportunities we have seen in years will occur later this year."

I also loved the juicy RSO conference call. The CRE portfolio manager spent the bulk of his time detailing events around one defaulted mezzanine loan with an underwritten debt coverage ratio of 1.18% and a coupon of treasuries plus 765 yikes! but management curiously spent almost no time explaining why they had increased general reserves on the rest of the portfolio, which includes those other "bank" loans at LIBOR plus 675 yikes again!

The "inside" story:

The best part of the call was the characterization of the mezzanine borrower as "disengaged" and the collateral as a case of "good property gone bad" malls gone wild! with "sudden vacancy issues". Truthfully, and in all fairness to RSO, these particular malls may have been good properties when they first opened. But that was back in 1969, a few years after sputnik.

Now, almost four decades hence, both were Brady-Bunch era relics having a difficult time competing with the brand new "lifestyle" shopping centers that had just opened down the street. Suddenly, treasuries plus 7.65 is looking cheap! quick, where do I sign? These new shopping destinations siphoned off tenants from the old fallout shelters malls securing the RSO loans, including the anchors, which led to the "sudden" vacancy issues they referred to in the conference call. Going in, everybody knew about the lifestyle centers....but that was then and we all know about then now.

As for the disengaged borrower, this is a guy who started out twenty years ago with a couple of brownstones in Brooklyn, I jest not, and by 2005 he had grown his company into one of the largest privately held owners of real estate in the country by using you guessed it! OPM. That led to his nearly $8 billion purchase of the "limited service hotel chain" from Blackstone AT THE PEAK!, and the now "distressed" multi-billion dollar loan related to it.

The Usual: Delay of Game

How disengaged was he? Well, first of all it wasn't his money, so the term implies he was really engaged in the first place. That aside, he was pretty disengaged. At the end of March, he had been saying for weeks that he was close to reaching a deal on $31 million in defaulted unsecured corporate bonds related to the hotel deal (he defaulted on March 15).

Then, he said it was really just a matter of a simple family vacation. "My luck -- the guy who is in charge of it [the workout], he called me and said, 'Look this is not very important to us and I'm on spring break with my kids. And let's just finish it when we get back.' "

This is the same guy who was negotiating a work out stuff job with RSO. S&P was not fooled, amazingly enough, and placed the senior bonds (CMBS) secured by the malls on negative watch at the same time (March). In response, the borrower offhandedly said that the mall loans "likely will be worked out".

According to the RSO conference call, the senior lenders took a "significant hit" to principle when they finally foreclosed on the malls. This was no surprise, and it flicked RSO's junior mezz loan into the bin as a result. Given that the senior underwriting probably anticipated debt service coverage of at least 1.30% (and look what happened!), how unreal do you think RSO's pro forma junior 1.18% was??

It's just another reminder not to eagerly swallow every morsel offered up by management Let's face it: the collateral here is older than the CEO. Everybody is struggling to get it right, but in this environment getting it right is just about impossible. If RSO's borrowers are currently unable to sell or refinance, it means that those deals are not working as planned either, and that could lead to even more reserves and charge-offs down the road.

MANAGEMENT AND PROTECTION: The Snail Darter Recovery Team recommends that there should be at least five separate viable populations to eliminate the threat of extinction.

Disclosure: At the time of this writing, long NRF, none for RSO or SFI

The Trouble With TruPs

After looking at some potential apartment acquisitions in Ohio last week, American Airlines flew me back home through the lively metropolis of St. Louis. During the layover, I had a chance to read the St. Louis Business Journal, which featured on its front page a story about bad loans and their effect on local banks. It was entitled "Bad Loans Intensify Bank's Pain." Lively indeed!

First Bank, a firm headquartered in St. Louis, sounds like a real basket case: loan charge offs in the latest quarter were up 202% and profits were down 90%, to just $2.5 million from $25 million a year earlier. Its parent, First Banks, Inc., also disclosed that profits were overstated by $11.1 million over three years due to irregularities in its mortgage division.

Non-peforming loans were so common that 25 banks chartered in the region and surveyed by the Business Times reported that cumulative increases in NPLs were up 165% vs the year prior and profits were down more than 35%.

According the the Business Times, bankers there expect it to get worse before it gets better. "I expect the first quarter trend showing greater charge offs to continue through most of 2008", said Mike Flavin, President if the Business Bank of St. Louis.

Falling home prices remain at the center of the problem as these regional banks, which were basically forced out of big real estate and corporate loan syndicates by the ravenous and much cheaper CDO, CLO and CMBS markets, wound up heavily exposed to local housing markets with risky loans to small, local developers.

Not only have these banks been getting burned by loans to developers, but high yielding small loans to rehabbers have also turned south. "The rehabbing business has been difficult," said Rick Bagy, President of the First National Bank of St. Louis. "Everyone went into the rehab business in the last 10 years - doctors, lawyers, housewives - because it was easy money."

And punctuating that point was still another article relating the story of Triad Bank, yet another local lender, that was foreclosing on a local rehabber and seeking up to $1 million in the foreclosure suit. These are big numbers for small local banks and one of the major reasons why the FDIC, OCC and other regulators are stepping up their supervision of local and regional banks and their lending practices.

Forget worrying only about commercial mortgages, there are a number of Mortgage REITs out there, as many of you know, that bought and originated Trust Preferred's as a way of diversifying out of real estate. Many of these TruPs were covenant-lite and therefore poster children of the credit bubble: easy money just didn't get any easier. This was because these particular REITs were turning around and issuing CDOs secured by the TruPs, which was the ultimate OPM game. For those of you who don't know what OPM is, there is a book entitled OPM that was written about a leasing company of the same name. It is great reading, and illustrative of what happens when a lender's interests and a borrower's interests are no longer aligned.

No earnings after issuance? No problem! Busted tangible net worth covenants? Why bother to calculate it, pay that mob of lawyers to get it right in the docs and then monitor it all for compliance? Let's just leave that pesky provision out of the deal, shall we? After all, it's not our money, hey? We're just in it to collect management fees, so it's really no problem if you don't pay us back.

Among the many concerns now facing the banks that coughed up TruPs as fast as the lawyers could replace the ink cartridges on their printers are strong recessionary pressures within the US economy, outsized exposure to residential construction loans and home equity loans, and reduced short-term profitability. Significantly, these are not isolated problems at one or two thrifts, or just one or two wayward mortgage lenders (e.g., IMB). It is spread throughout the country, and it is particularly bad in the Southeast and West, two of the hottest housing markets in 2005 and 2006.

Fitch Ratings, evidencing this increasing pressure, has been notified of the deferral of TruPs payments at 11 banks and the complete default of one since September 2007. These 12 banks issued US$644.5m in aggregate TruPs and subordinated debt through 46 Fitch-rated CDOs. "Further bank deferral and default activity is likely, given current economic conditions," says Fitch senior director Nathan Flanders.

Near-term wholesale defaults appear unlikely, but the breadth of the problem is the issue, as evidenced by my anecdotal reading of just one midwestern business journal on my way through an airport. I'm not sure that anyone could have seen it all coming, except that the lack of covenants should have been a tip off: without covenants, there is no way to declare a technical default and get access to assets before it's too late.

As a result of the observed and expected collateral deterioration underlying bank TruPs, Fitch has revised both its rating and asset performance outlook on US bank TruPs CDOs from stable to negative. This should be no wonder, since by the time they are able to declare a monetary default, holders of the TruPs will be practically last in line for any recovery.

Fitch is also currently reviewing bank TruPs CDOs with deferral and/or default exposure or other high-risk exposure and expects to place materially affected transactions on rating watch negative in the near future. "The magnitude of underlying collateral currently in deferral or default will likely be the most significant determining factor in Fitch's analysis," adds Flanders.

Not wanting to get caught with its blinders on, Fitch says that its deliberations on ratings will also give consideration to individual exposures that Fitch believes will create increased risk, such as banks facing heightened regulatory scrutiny, banks which have recently reduced or eliminated dividends on common equity, or those with an above average level of exposure to high risk real estate. Given what's been happening in the market, this would seem to include just about everybody.

Additionally, Moody's has downgraded 53 tranches issued by 10 CDOs with significant exposure to residential mortgage REIT Trust Preferred Securities (Trups) and homebuilder securities. It said that the rating actions were prompted by continued credit deterioration and defaults in the residential mortgage REIT and homebuilder sectors.

Four of the affected CDO series include Attentus CDO (series I to III), Kodiak CDO (series I), Taberna Preferred Funding (series II to VII) and Trapeza CDO (series X). Moody's said that these CDOs have significant exposure to these sectors, ranging from approximately 25% to 50% of their aggregate portfolio balances. The rating actions also reflect uncertainties over final workout values, which are expected to be low (hence my rant on covenants before).

Not surprisingly, Moody's outlook for REIT TruP CDOs is also negative for 2008. The Taberna series were essentially issued by RAS, since it made its ill-fated purchase of Taberna and is now stuck with the mess. I don't mean to imply that a few isolated downgrades of these CDOs will be a huge problem for REITs like RAS. However, taken cumulatively with other problems, these downgrades - and the trouble they signify for the underlying TruPs collateral - could be the tipping point for those in the REIT menagerie that are struggling with a whole smorgasbord of other problems. These would include forced liquidations of assets, subsequent trouble satisfying IRS REIT income requirements and general head scratching in the board room when it comes to declaring dividends after all the defaulted scrip has been siezed or sold off.

Always looking for ways to have fun in this abysmal market, I have actually written about one such REIT in this very article. Long time readers may have noticed that having fun has not included kicking those that are down and out, but this is too important, as there is real money to be made with the survivors. Some of the more troubled REITs may also survive, but probably not as REITs, and definitely not with those head scratching dividends.

For a clue, look no further than the first letter of each paragraph.

Nuff said!

Disclosure: None

Update: Please take a look at the WSJ article which appeared today (Wednesday, June 25th) entitled "Small Banks Face a Looming Hit From Builders' Interest-Reserve Loans". The article contends that small banks are more heavily exposed to construction & development loans than bigger superregional and money center banks, and that the FDIC and OCC are examining in loans in asset-level detail to determine their performance status.

Apparently, some of these banks are using the interest reserve escrow accounts to maintain "current" status on loans secured by assets that are anything but. The article says that banking analysts worry that 150 small banks could fail in the next "few years" because of big bets on these construction loans. The FDIC has issued "cease and desist" orders to banks ranging from National City (subject of another, earlier WSJ article) to HomeTown Bank of Villa Rica, GA.

Please don't bet the "ranch" on AFN; it seems that many of their TruPs obligors may have already done so.