Deerfield Slashes Assets, Dividend

In its recently filed 10-K, Deerfield Capital (DFR) revealed that it has suffered an "exacerbated" strain on liquidity during the first quarter of 2008 (henceforth dubbed the "UBS flu", see this article for explanation) and resulted in the "acceleration of our strategy to decrease investment in AAA-rated non-Agency RMBS and to seek to liquidate other assets to significantly reduce leverage in our balance sheet in an effort to support liquidity needs." DFR dumped $2.8 billion in agency RMBS and $1.3 billion in non-agency RMBS -- over half of its December 31 balance sheet.

Not surprisingly, the asset sales will significantly affect Deerfield's future taxable earnings. The Company warned in the 10-K that

In connection with REIT requirements, we have historically made regular quarterly distributions of all or substantially all of our REIT taxable income to holders of our common stock. As discussed, we recently sold the vast majority of our AAA-rated non-Agency RMBS portfolio and significantly reduced our Agency RMBS holdings at a significant net loss. We therefore expect our future distributions in 2008 and perhaps thereafter, to be substantially less than amounts paid in prior years. Additionally, we may pay future dividends less frequently and distribute only that amount of our taxable income required to maintain our REIT qualification. Furthermore, we may elect to make future dividends in the form of stock rather than cash. We may not have adequate liquidity to make these or any other distributions. Any future distributions we make will be at the discretion of our Board and will depend upon, among other things, our actual results of operations.

In other words, Deerfield expects to have a net operating loss carryforward from the asset sales, meaning that there is no dividend obligation and DFR may elect not to pay a dividend at all until the NOL is used up.

Ignore GAAP, It's All About the Cash

Mortgage REITs manage their businesses based on long-term opportunities to earn cash flows. Their common stock dividend distributions are driven by the REIT tax laws and their taxable income as calculated pursuant to the IRS tax code. Their reported results for GAAP purposes differ materially, however, from both their cash flows and their taxable income.

The earnings releases today highlight just how useless GAAP currently is for evaluating a mortgage REIT's financial performance. Just by adopting FAS 159 on January 1, RAIT Financial's (RAS) GAAP book value jumps from $6.78/share to $23.35/share, simply by virtue of being able to mark its CDO liabilities to market. (RAIT also benefitted from the deconsolidation of certain variable interest entities, but that's a completely separate rant.)

The write-downs, write-ups...it's sound and fury, signifying nothing for most of the mortgage REITs. I've stopped worrying about the bottom line number and turned my attention instead to the availability of liquidity in the marketplace. The lack of liquidity, as I noted in an earlier post about Newcastle Investment (NCT), is prohibiting investment growth and pressuring future taxable income.

Many of the diversified REITs have had to resort to asset sales to boost cash, including Deerfield Capital (DFR), which sold $1.5 billion in RMBS during the fourth quarter. Newcastle dumped $1.3 billion in assets during Q1 2008, and RAIT sold an undisclosed amount of RMBS during Q4 2007. Even iStar Financial (SFI) wound up selling off its investment in a timber JV.

The bigger question is from where will the financing for portfolio growth come going forward. RAIT and NorthStar Realty (NRF) both seem to be headed to the bank to seek term credit facilities. iStar is moving to encumber its net lease portfolios. Everyone is scrounging for liquidity in a post-securitization market. The survivors will be those who can adapt enough to find alternate sources of liquidity and take advantage of the less-competitive landscape going forward.

Disclosure: I'm long RAS.

Obligatory Thornburg Blurb

The mainstream media has done a pretty good job covering the Thornburg Mortgage (TMA) dust-up over margin calls related to its jumbo loan holdings. I recommend the Marketwatch piece for more information on the story.

If you ask me, Thornburg is a great buy on this dip -- as long as they face margin calls and not collateral seizures. If TMA is allowed to sell assets "selectively" (as the Company put it), they won't have to sell distressed securities and can raise cash using their more liquid MBS. If TMA gets hit with collateral seizures again, back to the 7s we go.

Newcastle's Need for Liquidity Puts the Dividend at Risk

Newcastle Investment Trust (NCT), a diversified REIT sponsored by Fortress Investment (FIG), announced dismal fourth-quarter results today, posting a GAAP quarterly loss of $2.01/share. The loss was driven by a huge $202.6 million other-than-temporary impairment charge, primarily related to NCT's portfolio of subprime RMBS and residual interests. The writedowns do not have an economic impact on NCT's business, but do give insight into the market's continued distate for subprime assets.

More interestingly (at least to me), was the update that Newcastle provided for the first quarter of 2008. The Company has sold $1.3 billion of assets, about 16% of the balance sheet, since December 31. The sales resulted in a $14.2 million net loss. Of the $1.3 billion, NCT was only able to unload $45 million in junk assets, while $770 million of the assets sold were agency-backed securities. The nature of the sales suggest that NCT was a bit desperate for liquidity, and the sale of a material amount of the portfolio at a significant loss may pressure future taxable income. While Newcastle fully covered its 2007 dividends with taxable income, I would be cautious with NCT stock until the first quarter dividend is declared.

CapitalSource Can't Cover Its Dividend

Analysts may have hinted at it last week during CapitalSource's (CSE) fourth-quarter earnings call, but today the truth was confirmed -- CapitalSource is not covering its dividend with taxable income.

After the bell yesterday, CapitalSource put out a short press release announcing that the tax characteristics of its 2007 dividends were available on the Company's website. Those who've read my blog know that I track tax characteristics as a measure of a mortgage REIT's dividend health.

Despite CSE management playing up the $0.60/share quarterly dividend in its last earnings release:

Given the strength and performance of our business and, in particular, credit metrics that remain at the low end of historical ranges, we declared a $0.60 per share cash dividend for the first quarter of 2008 yesterday and we are projecting a $0.60 per share quarterly cash dividend for the balance of 2008...

The truth is that two-thirds of CapitalSource's 2007 dividends were classified as a return of capital. That's right, fully $1.60/share of the $2.38 in '07 dividends amounted to CSE shareholders being handed back their original investment. Thus, if you were invested in CapitalSource at the beginning of 2007, and you sold CapitalSource shares to harvest tax losses, well, your capital loss just got cut by $1.60/share.

In other words, CSE can't generate enough taxable income to maximize the advantages of being a REIT. Instead of owning up to this and retaining the excess capital tax-free, CSE chose to keep pumping out dividends and diluting existing shareholders through its DRIP and direct stock purchase plan -- during one of the worst credit crises in recent history. If nothing else, CapitalSource could have retained the capital and repurchased common shares as a better means of supporting shareholder value.

By their very nature, REITs maximize their value when they can fully utilize their tax-advantaged structure. CapitalSource, meanwhile, reported an effective tax rate of 33.2% for 2007. Being a mortgage REIT is not just about paying a dividend. It's about utilizing a complex structure to deliver returns on shareholder equity.

Could Carving Up CapitalSource Create More Value?

CapitalSource (CSE), a diversified REIT, reporting a disappointing $0.07/share fourth-quarter GAAP loss amidst serious derivative losses, mark-to-market losses on its MBS portfolio, and a growing provision for loan losses.

CapitalSource seemingly brushed off the actual results, focusing instead on a healthy dividend outlook and a less competitive landscape for 2008. Analysts on the call seemed a bit dazed and confused, with Moshe Orenbuch at Credit Suisse asking:

And then, I guess with respect to your thoughts on kind of the adjusted earnings level versus the dividends, someone asked a question or kind of inferred that since part of that dividend is paid at the start, is there a period of time where you are willing to under earn the dividend, how should we think about that?

Maybe you should think beyond the smoke and mirrors that CapitalSource is throwing up. The Company has a strong record of delivering on its investments, but the overall structure is suffering under management's one-stop shop attitude. CSE bills itself as a SuperREIT, a hybrid diversified vehicle that can do it all. Unfortunately, the REIT structure is not quite as accommodating as CSE would like for it to be.

CapitalSource's entire reasoning for converting to REIT structure was to enjoy significant tax advantages. However, CSE posted an "overall effective tax rate in 2007, expressed as a percentage of consolidated pre-tax GAAP net income, [of] 33.2%." Obviously, the Company is earning most of its income within its TRS subsidiaries and not with the tax-sheltered qualified REIT subsidiaries.

CSE is basically structured as conglomerate of three separate divisions: 1) a corporate finance TRS, 2) a healthcare net lease REIT, and 3) some sort of structured finance segment. It's a BDC, a healthcare triple net lease REIT, and a poorly performing mortgage REIT all in one!

Seems pretty obvious to me that CapitalSource could unlock significant value by selling off its poorly performing residential mortgage portfolio, spinning off its profitable healthcare net lease REIT as a separate entity, and restructuring its corporate loan portfolio as a BDC. The Company already operates with low leverage, and could eliminate a lot of repurchase agreements by disposing of the residential mortgage portfolio holding up its REIT status.

CapitalSource can perform from an operations standpoint. I wish they'd give themselves the opportunity to do so.

FBR Framing Future

Friedman Billings Ramsey (FBR) has done a nice job winning me over ever since I questioned their use of the REIT structure a couple months ago. At that time, I wondered if FBR might be considering a partnership conversion. After reading through the Q407 earnings call transcript, I think FBR is back on track to succeeding as a REIT.

FBR has done an excellent job of restructuring its balance sheet, dumping the riskiest assets and eliminating commercial paper as a source of funding. The company has deployed the capital freed from asset sales into the purchase of agency-backed securities, a return to FBR's "core business, the conservative substantially hedged agency mortgage backed security strategy."

Most importantly, FBR has set itself up to generate qualified REIT income through its mortgage management segment, which may help FBR to monetize its $372 million of net operating loss carry-forwards and $268 million of capital loss carry-forwards. At a minimum, the NOLs will allow FBR to retain tax-free earnings at the REIT and shield the Company from a dividend obligation. It may choose to repurchase shares, since FBR is trading once again below economic book value of $3.10/share (including the expected FNLC recovery).

FBR very nearly destroyed itself by trying to do too much within the REIT umbrella, as active mREITs and those with numerous nonqualified activities can quickly stretch themselves too thin.

Mortgage REIT Roundup - February 15th

Just a few odds and ends here that merited a quick note...

Dynex Capital (DX) reported fourth-quarter earnings of $0.05/share and a GAAP book value of $8.22/share. The Company also declared a $0.10/share common stock dividend despite having continued net operating loss carryforwards (and therefore no taxable income). Dynex is optimistic about its future prospects, electing to pursue an agency MBS strategy in addition to its previously announced efforts in CMBS. Dynex stock was up on the earnings news and the future outlook.

MFA Mortgage (MFA) shares sank despite reporting $0.16/share in fourth-quarter earnings and improving its net interest margin by 29 basis points versus the prior quarter. Book value, however, was just $6.76/share, which may have prompted the pullback in the share price from a 1.6x book valuation to just 1.4x book value.

New York Mortgage Trust (NMTR.OB) announced that it had privately placed 15 million shares at $4.00.share. The $57 million in expected net proceeds is expected to be used to purchase agency MBS. NMTR continues to seek strategies to produce taxable income that can be used to offset their sizable deferred tax asset.

Mortgage REITs Rise From Ashes

It's hard to believe, but one of the hottest sectors in the market right now is in the center of credit crisis gripping the capital markets. Mortgage REITs, which were all but left for dead in early 2007, have exploded on the scene as the Fed has lowered interest rates and more investors have dared to call a bottom in the lending market.

On Tuesday, business development company bellwether American Capital Strategies (ACAS) decided to throw its hat in the ring, filing a $400 million IPO for American Capital Agency Corporation, a newly-formed REIT focused on agency-guaranteed residential mortgage backed securities. American Capital's decision to enter the arena is hardly surprising given the 53% year-over-year gain for the stock of established agency mREIT Annaly Capital Management (NLY) and the astonishing 122% year-over-year return by Capstead Mortgage (CMO). Although ACAS has no experience operating a REIT, it does have considerable experience meeting the onerous qualifications of being a BDC and it has hired talented and knowledgeable personnel. With the temporary expansion in conforming loan limits, there may well be a greater supply of agency-backed RMBS available to American Capital.

Meanwhile, the existing agency mREITs are busy exploring new territory themselves. Following the success of Annaly's launch of Chimera Investment Corporation (CIM), which is trading some 25% above its November IPO price of $15, MFA Mortgage (MFA) has also filed its own $250 million IPO for MFResidential Investments, Inc. (proposed ticker: MFR). Much like Chimera, MFR will focus on investing in investment-grade non-agency RMBS. In the prospectus, MFR's management cites

[c]oncerns about increased mortgage delinquencies, declining home prices and rising unsold home inventory have caused many investors to question the underlying risk and value of mortgage assets across the ratings spectrum. Many traditional mortgage investors have suffered losses in their residential mortgage portfolio, resulting in a decline in the availability of capital to fund the purchase of mortgage assets. These factors have resulted in mortgage assets trading at lower prices and higher yields, creating attractive spread investment opportunities for us.

Hard to believe that just two years ago, MFA was trading at just $6/share, while subprime lender New Century Financial (NEWCQ.PK) was trading north of $38/share. Such is life in the mREIT jungle. It will be interesting to see how this new cycle of mortgage REITs fare.

Why Arbor Realty's Chasing CBRE Realty Finance

I wasn't really sure why Arbor Realty Trust (ABR) was pursuing CBRE Realty Finance (CBF) until I read through the transcript of Arbor's conference call earlier today. As a bit of an aside, Arbor hit another home run on earnings, delivering full-year earnings of $4.44/share, yet creating enough tax deferment in the gains on their equity kickers to limit the 2007 special dividend obligation to just $0.15 - $0.20/share. It's precisely this sort of shrewd forward-looking business decisions that has differentiated Arbor from its peers and limited ABR's exposure during the credit crunch.

So the question again, why go after CBRE Realty Finance? I suspect Arbor is seeking to expand its origination platform -- and they have the opportunity to exploit (if somewhat begrudgingly)CBF's relationship with CBRE/Melody, the mortgage origination and servicing subsidiary of CBRE.

On Arbor's 4Q call, David Choksi at Lehman Brothers really surfaced the most serious issue at Arbor -- "And then, Ivan in your comments, you sounded somewhat of a cautious tone, given the prepayments you have upcoming, you are just seeing liquidity. What’s kind of the timing to redeploy those proceeds?"

Indeed, Arbor originated five new loans and investments totaling $116 million during the quarter, but seven loans paid off with an outstanding balance of approximately $138 million. Ivan Kaufman, Arbor's CEO, tapdanced around the answer, citing liquidity needs, etc.

Choksi pressed on, asking "And then, one final question. Ivan, you mentioned that you were looking at JV opportunities. Can you elaborate on some of the things that you are looking at?"

Kaufman appeared very interested in this possibility, replying "And clearly, if we could utilize other people’s capital and just a little bit of our capital and enhance our returns through promotes, that would be an attractive structure for us and we’ve been evaluating those options."

CBF has $76.8 million invested in joint venture equity investments, but it is looking to exit these investments quickly for liquidity purposes. Arbor, on the other hand, has the ability to take a longer-term view of these JV investments and monetize them at attractive times.

In short, Arbor's talent for managing investments is becoming constrained by its access to opportunities. Arbor has recognized an avenue to access more originations through a (forced) partnership with CBRE and has recognized that CBF does not have the ability and experience to run a commercial REIT. Perhaps CBF's shareholders will agree.

Earnings Roundup - Thursday Edition

Chimera Investment Corp (CIM) reported core earnings for the period commencing November 21 and ending December 31, 2007 of $1.3 million or $0.03 per average share. The Company reported a GAAP loss for the period commencing November 21 and ending December 31, 2007 of $2.9 million or $0.08 per average share. The difference between the Company’s Core Earnings and GAAP results is related to the Company’s unrealized losses on interest rate swaps at December 31, 2007 - meaning the Company is not designating its hedges under FAS 133.

Capstead Mortgage (CMO) reported net income of $15,860,000 for the quarter ended December 31, 2007 compared to net income of $2,350,000 for the fourth quarter of 2006. After considering preferred share dividends, the Company earned $0.31 per diluted common share for the fourth quarter of 2007 compared to a loss of $0.14 per diluted common share for the fourth quarter of 2006. Not surprisingly, Capstead's results benefitted from several accretive equity raises and aggressive Fed rate cuts.

BRT Realty Trust (BRT) announced its results of operations for the first quarter of its fiscal year. For the three months ended December 31, 2007, BRT reported total revenues of $7,508,000 and net income of $3,230,000, or $.28 per share on a diluted basis. For the three months ended December 31, 2006, total revenues, net income and net income per share on a diluted basis were $12,745,000, $8,289,000 and $.95 per share, respectively. BRT's results suffered as a result of a decrease in interest and fee income on outstanding loans. The decrease in interest on loans was due to (i) a decline in the average balance of loans outstanding, (ii) the increase in non-earning loans, and (iii) a decline in the rate earned on the portfolio. During the quarter ended December 31, 2007 two loans, aggregating $18,700,000, became non-earning.

AMAC's Advisor Provides Repo Refuge

It didn't require Scooby and the Mystery Machine to decipher American Mortgage Acceptance's (AMC) oddball Friday 8-K. The 8-K disclosed a hasty written consent to amend AMC's bylaws regarding affiliate transactions -- specifically, to allow for a majority vote of the Board to sell property to AMC's sponsor, Centerline Holding (CHC). Why was AMC in such a hurry to amend its bylaws when the Board would surely be meeting in a couple of weeks to review fourth-quarter results?

A good memory and a terrible nerdy habit of devouring SEC filings reminded me of this disclosure from the third-quarter 10-Q:

[I]n October 2007, we decided not to pursue a second CDO securitization. In connection with that determination, we entered into an agreement that will terminate our Citigroup repurchase facility on February 28, 2008....

We also plan to sell all of the first mortgages pledged as collateral for the Citigroup line to a third party and recognized an impairment loss of $1.3 million as of September 30, 2007, reflecting the market value of the loans as of that date….

To the extent that any of these assets remain on the facility after February 1, 2008, the rate will increase to a range from LIBOR plus 0.95% to LIBOR plus 1.60%.

Is it possible that AMC was in a big hurry to unload mortgages financed by the Citi line? Decide for yourself, but the issue seemed pretty clear-cut for me when I saw this Tuesday afternoon 8-K disclosure:

On January 30, 2008, the Registrant sold four first mortgage loans to an affiliate of Centerline. This sale resulted in sales proceeds of $23.3 million, of which $16.5 million was used to repay principal amounts on a repurchase facility collateralized by these investments. Based on the amortized cost of $24.6 million prior to the sale, the transaction resulted in a realized loss of $1.3 million.

American Mortgage shares closed Tuesday at $2.08/share, down 88% from its 52-week high.

Arbor Realty Again Ups the Ante

As I guessed last week, Arbor Realty Trust (ABR) is taking its pursuit of CBRE Realty Finance (CBF) to a proxy fight. You can review Arbor's proposed slate of directors in this SC 13D/A. The filing states that "...the Nominees, if elected, intend to evaluate all strategic alternatives to enhance and maximize, stockholder value, including, but not limited to: (i) seeking a business combination or sale of the Company; (ii) reviewing the performance of CBRE Realty Finance Management, LLC, the manager of the Issuer (the "Manager"); (iii) replacing the Manager; and (iv) seeking the reimbursement of fees previously paid to the Manager, if warranted."

As a side note, Arbor apparently didn't submit its alternate slate in time, so they filed suit to prevent CBF from rejecting their slate.

For its part, CBF issued an acidic press release in response, saying "Our board of directors decided we have better things to do with our Company's money and resources than litigating something like this...We will take Arbor at its word that it misread our bylaws, and move on. Our Board of Directors is dedicated to maximizing stockholder value and will look forward with interest to hearing what the members of Arbor's dissident slate have to say."

Earnings Roundup - Monday Edition

Editor's note: This week will be very heavy with earnings announcements in the mREIT universe. Each day this week, I plan to do an earnings roundup to at least provide some coverage for each company reporting.

Thornburg Mortgage (TMA) reported fourth-quarter GAAP diluted EPS of $0.33, well above the consensus estimates of $0.27. Thornburg has completed a restructuring of its balance sheet and expects to be able to begin growing and financing the portfolio in 2008. The Company saw significant improvement in net interest margins and spoke positively of being able to create agency securities if the conforming loan limits are raised.

Annaly Capital (NLY) reported fourth-quarter "core" EPS of $0.37, in-line with the consensus estimates of $0.37. Annaly benefited from gains on MBS sales during the period, from net interest margin expansion, and from continuing with its accretive equity offerings.

Alt-A Investors Mount a Comeback

Maybe it was just the rate cuts, maybe it was talk of a bailout for insurers, but money has been flowing into the Alt-A investors over the past two weeks.

Redwood Trust (RWT), which closed at $33.41 on January 22, has risen 34.5% since to close at $44.94 today. Likewise, Impac Mortgage (IMH), which I had admittedly left for dead, has climbed from $0.75/share to $1.71/share in the same time frame - a stunning 128% gain. Even Luminent Mortgage (LUM) has rallied 57%, moving up from $0.56/share to $0.88/share. Both stocks have a chance of regaining compliance with the NYSE listing requirements if the trend continues.

Of the three, I am of course the most interested in RWT. Although it's still well off its mid-60s highs, RWT has weathered this storm much better than most companies. Even so, it's not yet clear sailing for Redwood. Earlier this week, S&P put several classes of its Acacia CDOs on creditwatch negative.