Alesco Declares Dividend, Doubt

The good news: Alesco Financial (AFN) maintained its dividend at $0.25/share for the second quarter.

The bad news: How more dividends will be declared if Alesco terminates its REIT status?

Alesco announced today that it was declaring a Q2 dividend of $0.25 per common share. However, James McEntee, President and CEO of Alesco Financial, cautioned, "Our REIT taxable income to date supports the payment of a $0.25 dividend per share for the quarter. AFN is continuing to review strategic alternatives for the company, including whether to continue to maintain its REIT qualification. Any change in strategy or operating results could impact the level of future dividend payments."

With the Kleros CDOs moving closer and closer to liquidation, it is likely that Alesco will remain a REIT for 2008, but will convert to a publicly-traded partnership (PTP) for 2009 and beyond. Alesco's money-making bank and insurance TruPS portfolios are not qualifying REIT assets, and with the lowered spread available on RMBS (limited repo lines available makes it difficult to lever up RMBS to profitability), it makes sense that the Company will end its run as a REIT.

Alesco Slammed on IndyMac Deferral

Alesco Financial's (AFN) CDO woes never seem to end. Today's blowup comes courtesy of ailing Alt-A lender IndyMac Bancorp (IMB), which announced (in addition to a worse-than-expected quarterly loss) that it would defer the interest payment on its trust preferred securities. AFN holds a portion of the equity interests in eight CDOs that include trust preferred securities issued by IMB.

The disclosure sent Alesco shares reeling and prompted the Company to issue a statement quantifying the impact of the IMB non-payment. AFN admitted that that IMB's deferral will trigger the over-collateralization tests in five of the eight CDOs for a period of time. Failing the O/C tests will cut Alesco off from the cash flow from these CDOs, although AFN will still record the interest income (as it is doing with the Kleros CDOs).

AFN claims it could maintain its current dividend stream despite the O/C test failures, but cautions that "[the Company] is reviewing a number of strategies for the company, including whether to continue to maintain its REIT qualification. Any change in strategy could impact the level of future dividend payments."

Perhaps Alesco can withstand one deferral, but if another IndyMac situation arises (and one has to believe it will), Alesco's CDO machine will overheat and crash.

How Much Longer Will Alesco Financial Remain a REIT?

Alesco Financial's (AFN) conference call was dominated by questions about the Company's structure going forward, particularly after AFN disclosed that it may struggle to remain a REIT if two or more of its Kleros CDOs are forced into liquidation. I first wondered about this issue back in November, but since then, the issue has heated up further.

Alesco's qualifying real estate investments are mostly tied up in their consolidated Kleros CDOs, which have all failed overcollateralization tests and are no longer pumping cash flow into Alesco. However, AFN is still allowed to recognize qualifying REIT income from these CDOs despite the events of default that have diverted cash flow. Because of AFN's heavy investment in non-qualifying REIT assets, it just narrowly satisfies the REIT qualification tests each quarter.

Five of Alesco's Kleros CDOs have actually technically experienced an event of default (per S&P), so the CDO noteholders have the option to liquidate these transactions. However, Alesco only consolidates Kleros I, II, III, and IV. Although liquidations are only opted for about 25% of the time, just two liquidations could cause Alesco could fail its REIT asset tests at the end of this quarter.

Alesco's Results Have Familiar Theme

Update: I read through Alesco's conference call transcript, and management confirmed that they don't envision any trouble satisfying the REIT qualification tests, although they are continuing to consider voluntary conversion to a partnership structure. Alesco also guided to a $0.31/share dividend.

Alesco Financial (AFN) reported results after the bell today, and much like RAIT and Redwood, Alesco posted a significant GAAP loss but fared well on a taxable income basis.

Alesco's third-quarter loss was $8.36/share, driven by a $521.3 million loss on the Kleros Real Estate CDOs. On an adjusted basis, after adding back the valuation adjustments, Alesco earned $0.31/share in taxable earnings, equal to the third quarter dividend. AFN estimates that its adjusted book value is $5.62/share.

While Alesco's results are similar to its peers in terms of heavy valuation losses, Alesco has more risk in that the continued downgrades of the Kleros CDOs are reducing the value of qualified REIT assets, thus putting Alesco at risk for failing REIT asset and income tests. Alesco admitted that "As of November 1, 2007, none of the Kleros Real Estate CDOs are making cash distributions to AFN. The Kleros Real Estate CDOs have all failed overcollateralization tests as a result of significant ratings agency downgrade activity."

Although Alesco continues to generate taxable income from other investments, I hope management will add some color on the upcoming conference call as to whether there will be enough qualified REIT income to maintain Alesco's status as a REIT.

Can Alesco Remain a REIT?

Last week, I blogged about the latest downgrades to affect Alesco Financial's (AFN) portfolio of CDOs. Both Kleros I and Kleros II, Alesco's MBS-related CDOs, contained tranches that were downgraded significantly.

Looking back to AFN's 2006 10-K, I noted the following ominous warnings:

Our investments in TruPS, RMBS and leveraged loans or in corporate entities, such as CDOs and CLOs, that hold TruPS, RMBS and leveraged loans, are subject to limitations because we conduct our business so as to qualify as a REIT and not be required to register as an investment company under the Investment Company Act of 1940. TruPS, leveraged loans and equity in corporate entities, such as CDO and CLO entities, created to hold TruPS, RMBS and leveraged loans, do not qualify as real estate assets for purposes of the REIT asset tests.

A substantial portion of our borrowings are in the form of collateralized borrowings. If the value of the assets pledged to secure our borrowings were to decline, we would be required to post additional collateral, reduce the amount borrowed or suffer forced sales of the collateral. If sales were made at prices lower than the carrying value of the collateral, we would experience additional losses. If we are forced to liquidate qualified REIT real estate assets to repay borrowings, we may not be able to maintain compliance with the REIT provisions of the Internal Revenue Code regarding asset and source of income requirements. If we are unable to maintain our qualification as a REIT, our distributions will not be deductible by us, and our income will be subject to U.S. federal income taxation, reducing our earnings available for distribution.

Alesco has acknowledged that it is evaluating the risks and benefits of converting its structure from a publicly-traded corporation, that has elected to qualify as a REIT, to a publicly-traded limited liability company, or LLC, that intends to qualify as a partnership for U.S. federal income tax purposes. Such a move would be similar to the conversion undertaken by KKR Financial Holdings (KFN) earlier this year and would allow Alesco to add higher-yielding leveraged loan and equity tranches to its portfolio. Conversely, the conversion may also allow Alesco to retain more mezzanine and equity paper, which it cannot sell in the current credit environment anyway. In any case, Alesco needs to make the decision quickly, or continued downgrades of Kleros CDOs may make the decision for them.

More CDO Woe for Alesco

Two of Alesco Financial's (AFN) CDOs, Kleros Real Estate CDO I and Kleros Real Estate CDO II, were gouged by Moody's today. The downgrade affected $64.7 million of Kleros I tranches and $219.7 million of Kleros II tranches.

Alesco had previously warned in a September 4, 2007 8-K that these two CDOs had failed overcollateralization tests, thus AFN would no longer receive cash flow from the retained mezzanine and equity tranches. Nonetheless, Moody's cut previously AAA-rated tranches in both CDOs, damaging Alesco's reputation in the collateralized debt obligation market and making potential buyers think twice about purchasing from Alesco.

Shares of Alesco were under pressure today, down over 3% at last glance.

Did Merrill's CDO Contagion Spread to Cohen?

An interesting (and free) article from the Wall Street Journal reveals that Merrill's whopping $7.9 billion write-down might have had its seeds sown as early as 2003 -- and a familiar name in the mortgage REIT world, Cohen & Company, might have been its victim.

The article reveals that:

In the 18 months after his [Chris Ricciardi's] early 2006 arrival [from Merrill], Cohen's assets under management swelled to more than $40 billion from $10 billion. Mostly in conjunction with Merrill as underwriter, Cohen formed 25 new CDOs valued at $23 billion, most of which contained subprime mortgages.

Many of these CDOs were issued through Cohen & Company's managed REIT - Alesco Financial (AFN). In addition, a large number of CDOs were also issued through another Cohen-controlled entity, Taberna Realty Finance. Late in 2006, however, as the cracks in the mortgage finance indsutry became much more visible, Cohen & Co. transferred its Taberna investment to another publicly-traded entity, RAIT Financial Trust (RAS) - a company that conveniently happens to be run by Betsy Cohen.

The Cohen CDO machine hit a wall earlier in the summer. The Taberna CDOs acquired by RAIT have been downgraded and produced at least one default -- when American Home Mortgage's (AHMIQ.PK) bankruptcy wiped away the value of RAIT's investment in American Home's trust preferred securities. The default amounted to net equity exposure approximately $95 million, or $1.56 per share of book value. Meanwhile, Alesco admitted in September that two of its CDO issuances were failing overcollateralization tests, which meant that cash flow to the subordinated tranches held by Alesco would be cut off.

Shares of RAIT Financial Trust have fallen 76% since hitting a high of $38.25 in February. Shares of Alesco Financial have fallen 62.5% in the same time frame.

Disclosure: I have a small long position in shares of RAIT Financial Trust.