Crystal River's Dividend Washing Away

Update: Crystal River provided no significant information on the conference call regarding its future. The Company was downgraded by Wachovia this morning, but at under $6/share with a potential $0.25/share dividend going forward, it's looking really cheap.

Crystal River Capital (CRZ) released first-quarter earnings after the bell Monday, and the news was worse than expected. Despite posting better than expected net investment income of $0.99/share and operating earnings of $0.81/share, Crystal River disclosed that it had sold its agency MBS portfolio during March and April -- and that the agency portfolio had been contributing half of Crystal River's REIT taxable income. Shares tumbled 11% after-hours on the expected dividend cut and dismal forecast.

Taxable income came in at just $0.63/share for the first quarter, $0.05 short of the first quarter. With the agency portfolio sold, I expect CRZ to generate just $0.30/share of quarterly taxable income going forward. I expect the Company to cut the dividend to just $0.25/share for the remainder of 2008.

Crystal River said in a press release that "[a]s a result of the challenging market conditions for structured real estate securities and financing in general, which are expected to persist for some time, Crystal River's Board has been evaluating the Company's current investment strategy."

Separately, CRZ announced that its Board of Directors had appointed William Powell as its President and Chief Executive Officer (CEO), effective Tuesday, May 13, 2008. Powell joins Crystal River from his former position as co-head of Brookfield Asset Management's Real Estate Finance Funds Group, a possible sign that Brookfield may simply fold Crystal River back into its portfolio -- much like Hypo AG did with Quadra Realty several months ago.

Curtains on Crystal River's Agency Portfolio

Crystal River Capital (CRZ) released its investor presentation for the Credit Suisse 2008 Global Real Estate Conference via this 8-K late this afternoon. As I suspected in this previous post about Crystal River, the Company is shifting its focus to Brookfield-backed funds, commercial real estate, and triple net lease buildings. During the first quarter, CRZ disclosed that the haircuts on agency portfolios financed with repo agreements surged from 3% to 7%. In response, Crystal River sold its entire agency portfolio to boost liquidity and redeploy funds to different asset classes.

I'm surprised Crystal River didn't file an 8-K to disclose the additional asset sales, but nonetheless, it's apparent that the dislocation in the agency MBS sector was swift and severe.

Mortgage REITs Manage Onwards

It was quite obvious that March came in like a lion, mauling the entire mortgage REIT sector. Even the mighty agency mREITs fell victim to fears about liquidity and forced asset sales.

At it stands now, mortgage REITs face two very difficult issues that threaten their business models. Identifying and procuring suitable investment opportunities is proving very difficult -- it's like catching a falling knife right now. The spreads are wide and no one wants to let go of their paper into a distressed market. New originations have fallen off tremendously from 2005-2006 levels, so there's very little unseasoned paper available. Secondly, even if suitable investments can be found, financing them will be a challenge. The securitization market is completely frozen and has remained so for sometime now. Repurchase agreements are becoming highly expensive and they expose the borrower to nasty margin calls.

A key point I looked for in the fourth-quarter earnings calls was how the mortgage REITs planned to manage their business going forward. Two companies really stood out to me as having a solid grasp on the challenges at hand -- Redwood Trust (RWT), which I've liked for a long time, and Crystal River Capital (CRZ), which I've worried about in the past.

In the case of Crystal River, I think the Company has matured over the last year. They are being careful about match-funding all their investments, and they've shifted their focus to the commercial market, directly owning triple-net properties instead of just buying up CMBS. I think Crystal River will benefit over time from its relationship with Brookfield Asset Managment (BAM) and that the Company will gradually shift from being a pure-play specialty finance company to a commercial real estate originator and investor.

Redwood Trust believes its competitive advantage in managing credit-enhancement securities will allow it shift through the rubble of subprime RMBS and CDOs and identify investment opportunities. Redwood plans to acquire these securities through a third-party fund vehicle, offering limiting parternship units to investors. Thus Redwood can indirectly raise capital to purchase assets. RWT plans to purchase securities through these joint ventures and hold them to maturity, so the success of the fund will depend solely upon the performance of the securities and RWT's due diligence. It's an excellent way to shift risk off-balance sheet and to also spread risk among the limited partners rather than having Redwood purchase the securities outright.

As they say, easy come, easy go. Right now, it's become pretty easy for mortgage lenders and specialty finance companies to go under. Nonetheless, I believe Redwood Trust and Crystal River Capital will be survivors.

Crystal River's CDO Could Cause Problems

Crystal River Capital (CRZ), a diversified mortgage REIT managed by Brookfield Asset Management (BAM), is a relative newcomer to the mREIT universe. The Company came public in July 2006, one of the last successful mREIT offerings before the downward credit spiral began.

However, the Company commenced operations in March 2005, and operated as a private entity for over a year before its IPO, so significant business activities took place prior to coming public. One such activity was the launch and deployment of Crystal River Capital CDO 2005-1, a diversified issuance backed by whole loans, CMBS, and RMBS. As disclosed in the third quarter 10-Q, CRZ retained "all of the non-investment grade securities, the preference shares and the common shares" related to the 2005-1 CDO.

Normally, CDO issuance is viewed positively for mREITs, since they allow for "match-funding" of assets and liabilities. That is, cash flows from the collateral pool pays the interest on the debt securities issued by the CDO. The problem arises when the collateral pool does not perform as expected and is downgraded by the rating agencies. Such a downgrade can trigger failure of overcollateralization tests and divert cash flow from subordinate holders to the senior classes. Somewhat esoteric, I know, but the bottom line is that Crystal River retained the junior classes of the 2005-1 CDO and sold the senior tranches, betting that the CDO would perform as expected.

Enter a serious problem. On January 11th, S&P cut the rating of 2005-1's investment grade tranches F,G, and H to junk, which may trigger the failure of O/C tests and certainly cuts the value of the non-investment grade tranches held by CRZ. Thus CRZ is still liable for payments on the debt securities but may not receive the corresponding cash flows from the collateral pool.

While CRZ is able to weather some failures in collateral performance, if additional senior tranches are downgraded in the future, a significant mismatch in interest income and interest expense may occur.

Crystal River Tries to Sparkle

Crystal River Capital (CRZ) reported third quarter results on Thursday, turning in good results outside of the impairment charges we've come to expect.

Net investment income was $0.91/share, operating earnings were $0.81/share, and revised REIT taxable income was $0.75/share, well ahead of the $0.68/share dividend. The company shrunk the balance sheet significantly during the quarter, unloading agency RMBS to raise cash. Such action, combined with the improvement in net investment income, is a positive for CRZ in that it was able to redeploy its capital into higher-yielding investments while maintaining REIT qualification.

Crystal River appears to have learned its lesson quickly regarding the use of repurchase agreements. 91% of CRZ's portfolio was match-funded at the end of third quarter.

Crystal River has an interesting strategy with respect to its portfolio holdings. They hold a large amount of agency RMBS on one end, but also are heavily invested in subordinate commercial real estate and other ABS.

Overall, the Company continues to comfortably cover its dividend and it has the backing of Brookfield Asset Management to help provide funding. It will be interesting to see how Crystal River defines itself going forward.

The Company is trading between its GAAP book value and its economic book value, so it appears fairly valued for now. Nonetheless, the 19% dividend yield is more than adequate compensation for investors who are waiting on Crystal River to differentiate itself.