Macklowe Mess Manhandles Capital Trust

When UBS downgraded Capital Trust (CT) five weeks ago, citing the company’s low reserve levels and its belief that CT will have to take meaningful reserve charges in future quarters, analyst Tayo Okusanya couldn't have known how right he would be. Capital Trust recently posted an unexpected loss of $1.59/share for the second quarter and adjusted income of $0.73/share, well short of the $0.84/share earnings consensus.

CT's shocking loss came courtesy of a net $50 million exposure to mezzanine loans secured by Harry Macklowe-owned office buildings in Manhattan. To be fair, Capital Trust did mention this exposure in its first quarter conference call, noting that "Our Macklowe exposure is $50 million on the balance sheet...recent comps in the market support our position in the capital structure and we continue to believe that our investment is money good."

Oops. According to the second-quarter press release, "subsequent to quarter-end, the Company made the decision to record a $50 million reserve against this [Macklowe] loan based upon management's assessment of the probability of recovery." Whether it was really Capital Trust management that suddenly discovered the need for a full reserve or the urging of auditors Ernst & Young, we'll never know. What we do know, however, is that in addition to this quarter's $50 million probable loan loss, Capital Trust also owns a $12 million pari-passu participation in a first mortgage on a Southern California multifamily project that did not make its contractual interest payment during the first quarter. However, despite commencing foreclosure procedures, CT did not record a reserve against this loan "given its expectation for a full recovery of principal."

Right. And I bet they have an office building in Manhattan to sell me as well. In any case, Capital Trust's reluctance to recognize its losses leaves its stock on shaky ground. Shares were off 9% after hours in light trade.

The New Mortgage REIT Magic

The origination market for the battered mortgage REIT sector has all but dried up, with few new loans being made. Many borrowers, even large commercial tenants, are simply trying to extend or modify existing loans. Even the few new borrowers in the market no longer meet most underwriting standards now that the securitization market is dead and the credit risk can't be offloaded. However, for those mortgage REITs who are largely match-funded with existing CDO liabilities and don't have immediate liquidity concerns, there is a question of how to best deploy loan repayments (and prepayments).

Enter a rather clever solution. Perhaps best thought of as an extension of marking CDO liabilities to market under FAS 159, a few mortgage REITs have chosen to begin buying back previously sold CDO tranches for cents on the dollar. The buy back of the CDO debt has many positive accounting implications. Assuming the CDO is consolidated and accounted for as a financing for GAAP purposes, the repurchase of the CDO debt allows the original issuer to extinguish the CDO liability on its books, reducing leverage ratios and more importantly, generating a gain on the extinguishment of debt. This gain is also a source of taxable income, allowing mortgage REITs who are facing realized tax losses from foreclosures to offset these losses and potentially support their existing dividend payouts. Gramercy Capital (GKK), for example, utilized this model during its second quarter, repurchasing $37.8 million of BBB to A+ rated CRE CDO bonds previously issued by Gramercy’s CDOs, generating gains of $17.6 million. These gains partially offset Gramercy's additional $23.2 million in loan loss provisions and allowed the Company to maintain funds from operations just above its dividend payout.

The purchase of the senior CDO debt would be even more effective for those REITs struggling with qualification issues. In addition to the positive accounting effects noted previously, the senior note holders have control over whether a CDO is liquidated once an event of default is declared. The repurchase of the senior CDO debt would allow the issuing REIT to recapture the diverted cash flow and allow the REIT to prevent the liquidation of the CDO and thus preserve the recognition of qualifying REIT income. Of course, the issuing REIT would have to proactively seek to repurchase the senior CDO debt before it becomes obvious that the CDO is in trouble.

Mortgage REITs may be up against a wall when it comes to originating attractive new investments, but they shouldn't forget about the magic that can be made by rediscovering old ones.

iStar Continues to Flame Out

iStar Financial’s (SFI) woes continued to mount this week after last week’s ominous pre-announcement warning. Fitch downgraded iStar’s debt ratings to BBB- and placed the Company on Ratings Watch Negative. iStar is now at the very bottom of the investment grade ranks, which is key to being able to issue unsecured debt into the marketplace. Unsecured debt is iStar’s primary form of financing and is significant to the Company’s overall capital management. Fitch cited concerns over the Company’s ratio of EBITDA to fixed charges and the increased in secured debt, despite iStar’s move to increase liquidity through asset sales. Shares of iStar plummeted further this week; the stock has shed nearly two-thirds of its value since mid-May.

Disclosure: Author is long SFI at time of posting.

Gramercy's Tardy Tell-All

No wonder Gramercy Capital (GKK) waited so late to release its second-quarter earnings - I'm sure they hope investors don't read the release. FFO for the quarter barely covered the dividend, and analysts are certain to question Gramercy's revised FFO guidance. The Company now sees full-year FFO of just $2.20 to $2.45 for fiscal year 2008 - despite already earning $1.32/share in the first six months of 2008 alone. GKK blamed the diminished expectations on an increase in non-performing loans and provisions for possible loan losses prompted by challenging economic conditions, severe illiquidity in the capital markets, and a difficult operating environment.

Gramercy's jump in its loan loss provisions was shocking. The Company's allowance nearly tripled after the Company recorded an additional $23.2 million in expected future losses. The hit to earnings would have been even more severe had it not been masked by the repurchase of $37.8 million of BBB to A+ rated CRE CDO bonds previously issued by Gramercy’s CDOs, which generated gains of $17.6 million.

Clearly, Gramercy's fundamentals are rapidly deteriorating, validating the stock's sharp fall during the past six weeks. Analysts will be quick to suggest the possibility of a dividend cut within the next two quarters, as Gramercy's $2.52/share annual dividend is no longer supported by the FFO outlook. While FFO is not equal to taxable income, it still remains an important bellweather for judging the health of the dividend. Given Gramercy's disclosures, it's difficult to tell if the Company had any spillover TI from 2007 that could possibly support a continuation of the $0.63/share dividend through the rest of 2008.

Earnings Releases: Just Whenever

Just a quick rant to complain about the sputtering start of the Q2 mREIT earnings season. Dynex Capital (DX) had to replace its earnings release; book value and portfolio duration were misstated in the original version. At least Dynex got it done in a timely fashion -- FBR Group (FBR), which has a 9:00 am ET Thursday conference call, just released (it's after 10 pm Wednesday now) its second-quarter earnings. I skimmed the release; no serious accounting issues or any particular reason that FBR's earnings should have been delayed so long after the bell. Maybe I should just be happy to see a release -- Gramercy Capital (GKK) has yet to produce anything despite its 2pm ET conference call tomorrow.


Maybe I'm just cranky; maybe it's just a coincidence. In any case, it's an ominous start to the Q2 2008 earnings season.

Alesco Agony Reaches a Crisis Point

With the seizure of Indymac Bancorp (IDMC.PK), Alesco Financial's (AFN) CDO agony has reached a crisis point. Alesco reported that the seizure of IndyMac will cause AFN to record a realized tax loss of approximately $86 million. The realized tax loss is expected to significantly offset AFN's expected 2008 taxable income including the non-cash income relating to the CDOs that are failing overcollateralization tests as of June 30, 2008.

In addition, subsequent to the original IndyMac deferral, four additional banks elected to defer interest payments on their trust preferred securities, which has resulted in the failure of overcollateralization tests in two additional CDOs in which Alesco holds equity interests.

Without taxable income, Alesco can remain a REIT for the remainder of 2008 without a dividend obligation. However, as its portfolio of CDOs continue to crumble, one has to wonder if Alesco's business model can remain viable.

CapitalSource Spins Off Healthcare Unit

As CapitalSource (CSE) management described on the first quarter conference call, CSE is indeed spinning off its healthcare net lease unit. In a press release after the bell today, CapitalSource announced that its subsidiary, CapitalSource Healthcare REIT, would file an S-11 to register an IPO of the subsidiary. The IPO of common shares in CapitalSource Healthcare REIT is expected to raise at least $300 million for CapitalSource.

CapitalSource will continue to own the majority of CapitalSource Healthcare REIT following the IPO. CapitalSource Healthcare REIT will invest in income producing healthcare-related facilities, principally long-term skilled nursing facilities, through triple-net lease structures.

It remains to be seen how CapitalSource will satisfy the REIT requirements for the remainder for 2008.

Double-Digit Disaster

This afternoon's deep dive on Dow plunged several mREITs into in a pool of double-digit percentage losses. These five mREITs also all notched 52-week lows. These shares have been steadily on the decline, so you know the shorts are going after them hard:

1. Chimera Investment (CIM), down 16% to $5.95
2. CBRE Realty Finance (CBF), off 22% to $2.17
3. Newcastle Investment (NCT), off 16% to $4.54
4. Resource Capital (RSO), off 10% to $1.66
5. Gramercy Capital (GKK), off 10% to $8.50

The forward annual yields on these fateful five stocks, based on today's closing prices, are as follows:

1. Chimera Investment, 10.7%
2. CBRE Realty Finance, 18.4%
3. Newcastle Investment, 22.0%
4. Resource Capital, 29.0%
5. Gramercy Capital, 29.6%

Says quite a lot, doesn't it?

Weekend Filings

Just an update on a few late Friday afternoon filings...

Thornburg Mortgage (TMA) entered into a consent with the majority participants in the Override Agreement to change the requirement that a successful tender offer for the preferred stock from at least 90% to 66 2/3% of the Company's outstanding preferred stock. Thornburg has until September 30, 2008 to convince two-thirds of preferred shareholders to tender their shares in return for $5.00/share and 3.5 common shares.

Impac Mortgage (IMH) received a second notice from NYSE Regulation Inc. that the Company was not in compliance with NYSE continued listing standards relating to maintaining a consecutive thirty day average closing stock price of over $1.00 per common share. The Company has notified NYSE Regulation that it intends to submit plans within the required 10 day period to address the price deficiency. NYSE Regulation will consider the Company's plans as part of its continued listing assessment and make a determination regarding the expected course of action, which may include truncating the procedures applicable in cases of share price non-compliance or immediately initiating suspension and delisting procedures.

Luminent Mortgage Capital (LUMC.OB) noted that Arco, Luminent's primary repurchase agreement lender, declared an event of default after Luminent failed to meet a margin call. Arco is demanding immediate payment by the Company of the aggregate repurchase price of $182.6 million. While not included in the filing, Luminent is likely to seek Chapter 11 protection as a result of multiple debt defaults.

Agency mREITs Aching Over Fannie, Freddie Flu

Persistent commentary about the potential insolvency of Fannie Mae (FNM) and Freddie Mac (FRE) pounded shares of agency mREITs today, as investors worried that the liquidity of this group holdings would dry up. Until recently, mortgage REITs investing in agency-backed MBS had enjoyed relative strength compared to non-agency peers because of the liquidity provided by the implicit government backing of the MBS holdings.

However, with spreads widening considerably on Fannie and Freddie debt, investors worry that the holdings of groups like Annaly Capital (NLY), Capstead Mortgage (CMO), Anworth Mortgage (ANH), and MFA Mortgage (MFA) will lose their liquidity privilege in the marketplace and lose their value, forcing painful margin calls and perhaps requiring significant asset sales.

Keep an eye on the Fannie and Freddie news in the coming days to see if agency mREIT shares can regain their liquidity privileges and recover share value.