NorthStar Realty Finance Corp. Q3 2008 Earnings Call Transcript

NorthStar Realty Finance Corp. (NRF)

Q3 2008 Earnings Call

November 6, 2008 10:00 am ET

Executives

Richard McCready - Executive Vice President and Chief Operating Officer

David Hamamoto - Chairman, President, and Chief Executive Officer

Andrew Richardson - Executive Vice President, Chief Financial Officer, and Treasurer

Analysts

Donald Fandetti - Citigroup

Douglas Harter - Credit Suisse

Jeff Miller - JMG Capital Management, LLC

David Fick - Stifel Nicolaus

Mark Lindy - Wachovia Securities

Harrison Rescher - AGA MSA

David Jordan - Axiom Capital Management

Robert Schwarzberg - Compass Point

Presentation

Operator

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the NorthStar Realty Finance third quarter conference call. During today’s presentation, all participants' lines will be in a listen-mode only. Following the presentation, you will be given a chance to ask your questions. (Operator Instructions) As a reminder, today’s teleconference is being recorded Thursday, November 6, 2008.

At this time, I would like to turn a presentation over to the Chief Operating Officer, Richard McCready. Please go ahead, sir.

Richard McCready

Thank you very much. Welcome to NorthStar’s third quarter 2008 earnings call. Before the call begins, I would like to remind everyone that certain statements made in the course of this call are not based on historical information and may constitute forward-looking statements.

These statements are based on management’s current expectations and beliefs and are subject to a number of trends and uncertainties that could cause actual result to differ materially from those described in the forward-looking statements. I refer you to the Company’s filings made with the SEC for a more detailed discussion of the risks and factors that could actual results to differ materially from those expressed or implied in any forward-looking statements made today.

The Company undertakes no duty to update any forward-looking statements that may be made in the course of this call. Additionally, certain non-GAAP financial measures will be discussed on this conference call. Our presentation of this information is not intended to be considered an isolation or is a substitute for the financial information presented in accordance with Generally Accepted Accounting Principles.

Reconciliations of these non-GAAP financial measures to the most comparable measures prepared in accordance with Generally Accepted Accounting Principles can be accessed through our fillings with the SEC at www.sec.gov. With that, I am now going to turn the call over to our Chairman and Chief Executive Officer, David Hamamoto. David?

David Hamamoto

Thanks Rick and thanks everyone for joining us this morning. In addition to Rick McCready, our COO, I am here today with Andy Richardson, CFO; Dan Gilbert and Dan Raffe, both EVPs, and Al Tylis, our General Counsel.

NorthStar delivered very strong third quarter result in the midst of unprecedented market disruption and a rapid deterioration and consolidation of the financial service industry. As we look to an increasingly weak economic landscape through 2009, our defensive strategy to raise capital when available, extend debt maturities and to be stingy with our liquidity continues to serve us well as each quarter since early of 2007 has brought ever increasing challenges. Our continued stubbornness to part with our cash is being rewarded.

Over the last several quarters, we have evaluated many but committed to very few investments which at the time appeared cheap but our observation of continued high financial leverage in the market, extreme volatility, and an acute lack of liquidity signaled the potential for more credits spread widening. We have also painfully observed the negative impact of these factors on NorthStar's positive capital. Consequently, as active prices continue to decline, our liquidity has increased in value.

Today more than ever, we are convinced that preserving and maintaining high cash liquidity in the Company remains our best course of action until we see meaningful evidence that government and bank financial institutions are willing to provide significantly more capital deficiencies. We support the US government's attempt to inject liquidity in the market through the TARP commercial paper funding facility and other program but the lead banks will initially use this fund to plug holes in their own balance sheet and for acquisitions.

In our view, it may take several months before business customers be in any intangible benefits from this program. What this means is that NorthStar’s return hurdle to part with liquidity are very high and in the near future, we do not expect to see a great level of new transaction closings. As we have discussed on previous calls, we continually evaluate NorthStar’s own securities for investment and I have made a few small purchases of our CDO notes but as time passes, these securities have been available at even lower prices from the distressed sellers.

Over the last several quarters, we have discussed many of the action that NorthStar implemented to position the Company for this economic environment and some of the initiatives that were repeating.

First, on the investment side when capital was cheap and the market extremely competitive, we emphasized direct origination with borrowers rather than the acquisition of prepackaged Wall Street product. We, fundamentally, believe we can get more control by originating the entire debt security and structure better credit protection by working directly with the borrower rather than buying a prestructured piece of a much larger financing created by a bank that had no intention of holding the risk. This means we did not participate in the top of the market large headline transaction, many of which are having significant issues.

Second, we aggressively issued long term cheap and flexible liabilities and turnout short-term debt to minimize liquidity risk. We now have no significant debt maturities until the second half of 2010.

Third, we sharply curtailed investment volumes and increased return hurdles beginning in the second half of 2007 when we saw cracks in the residential mortgage markets begin to spread in the other market.

Fourth, in 2008, we raised capital at an attractive spot by monetizing portions of our net lease portfolio.

And finally, we invested in portfolio management resource prior to the market difficulty enabling us to be proactive and aggressive in getting in front of the types of credit issues and before they become problems jeopardizing our shareholders’ capital. The result of these strategies at the end of the third quarter includes $280 million of available liquidity, no nonperforming assets and no delinquencies of contractual interest or principle payments.

Looking forward to the remainder of 2008 and 2009, we believe that macroeconomic condition will deteriorate further as market illiquidity continue to decline in housing prices and rising unemployment will put enough enormous pressure on business to the many sectors. These factors will continue to pressure commercial real estate and NorthStar’s assets will not be immune from this condition. Because of this outlook, each member of our senior management team spends a majority of their time on liquidity and risk management.

Positive news is that unlike what has happened in the residential sector, new commercial real estate fly during this cycle was moderate. The situation is much different from the late 80s when the US economy ended a recession with a massive oversupply of real estate. All these events create challenges. They also generate great opportunities for those few companies like NorthStar who have proactively managed their balance sheet and credit.

We are seeing the pressure building and distressed assets sales in other market that have not yet seen massive direct selling pressure and credit issues in commercial real estate. We are consciously willing to endure earning solution in the near term caused by holding high cash balances in order to have illiquidity to take advantage of this exceptional future opportunity.

Earning to the third quarter, we conservatively deployed approximately $68 million of equity capital. This capital was invested early in the quarter and the transactions were largely opportunistic. Our only new loan origination was the $30 million, $41% loan-to-cost subordinate first mortgage at an all-in-rate of approximately LIBOR plus 25%. Borrower was under time pressure to complete the transaction and we were able to charge with that response of the survey.

We also funded approximately $43 million related to prior period loan commitments. Repayments were a strong at $130 million during the quarter representing approximately $28 million of equity capital. Of note, several of our borrowers were able to refinance their properties for the existing banking relationship, so there was a capital still available but it was more expensive and scarce.

During the third quarter, we also continued to see opportunities in buying securities at deep discounts from motivated sellers. We acquired $33 million of highly rated investment rate security issued by own CDOs at an average discount in par of 50%. This represents some of the most senior securities in NorthStar’s capital structure.

Last month, our board of directors authorized the common stock repurchase plan. We now also have the flexibility to acquire our securities up and down the capital structure. When and if we do acquire other NorthStar’s security, we expect them to be quiet and opportunistic purchases and such acquisitions will be made with careful considerations to market condition and the impact on our cash liquidity.

Market conditions have also made raising private capital much more difficult. Many sources of this capital are having their own issues with redemption, large net asset value decline from poor performance and a virtual standstill in liquidity realization from asset sales. As to those sources of capital that can make commitment, we will continue to be selective and only engage in transactions where we are appropriately contemplated for our franchised value and the expertise that NorthStar brings in the table.

Next, we will pay the previously declared 36% dividend on our common stock. From a tax perspective, we preliminary expect that 2008 dividend payment will approximate our taxable income, although estimates of taxable income are difficult due to the complexity of our structure.

Going forward in 2009, dividends will continue to be evaluated based upon consideration of several factors including our view of taxable income, company liquidity, availability of capital in the market, and investment opportunity.

To summarize, we believe NorthStar has established itself as a best in class commercial finance company with its earning, credit, and liquidity management track record during this long and difficult period. We are not immune to market conditions but we have a franchise that we believe can successfully manage through this period and take advantage of the exceptional opportunities which arise during this time.

Now, let us turn the call over to Andy who will review our results for the third quarter. Andy.

Andy Richardson

Thanks, David. I will first review our third quarter earnings result then discuss credit and liquidity before we open the call up for questions.

For the third quarter, our GAAP net income inclusive of FAS 159 adjustments was $233.5 million or $3.70 per share. AFFO for the quarter was $26.6 million or $0.38 per share inclusive of a $1.6 million or $0.02 cents per share write off of cash collateral belonging to the Securities Fund and held by a bankrupt Lehman Brothers entity.

We invested approximately $68 million of equity capital during the third quarter and received approximately $28 million of equity capital from loan repayment. We delivered a 14.7% return on average GAAP equity for the third quarter excluding G&A. A net interest income which is interest rental and advisory fee revenue plus interest extent property operating cost and asset management fees was $35.7 million, down $4.5 million from $40.2 million in the second quarter.

Second quarter net interest income included approximately $4.8 million of earnings relating to the sales to the Securities Fund of a majority of the management fees relating to a CDO that is owned by the fund. Prepayment penalties and other income totaled about $9.5 million under the third quarter, approximately $5.5 million higher than the second quarter. The increase was principally due to a $9 million lease termination fee relating to our Reading, Pennsylvania distribution property partially offset by $3.6 million sale of participation by us in the second quarter.

General and administrative expenses excluding non cash stock-based compensation decreased approximately $530,000 from the second quarter to $8.2 million. Accounting and auditing fees were nearly $300,000 lower than the second quarter and our third quarter G&A also include approximately $650,000 write off of previously capitalized funds relating to our private capital fund raising effort. Our first and second quarter auditing fees are traditionally higher in other quarters due to the preparation of our annual audited financial statement.

During the quarter, net mark-to-market adjustments increased NorthStar’s book value by approximately $253 million. The increase was principally driven by a $251 million decreased in value of our issued CDO note and recently observed trading levels validate the deeply discounted prices at which sellers are transacting.

Our GAAP book value as of September 30th was $15.59 per share. The earnings released contained a detailed reconciliation between our second and third quarter book value. If all mark-to-market adjustments and accumulated depreciation were excluded, book value would be $8.69 per share at September 30th.

As David mentioned, we continued to opportunistically acquire notes in our CDO at discounted prices. During the third quarter, we invested approximately $16 million of equity capital and acquired $33 million paid amount of our issued CDO note and in credit rating ranging from AAA to BBB flat and an average 50% discount to pay. The purchase price also represents the $7 million discount to our carrying value of this debt at the beginning of the year so we recognize the net realized gain for that amount. We owned the underlining collateral on these transactions so the investment is very efficient in terms of underwriting resources deployed.

During the third quarter, we committed to and funded a $30 million junior first mortgage loan and made an $11 million equity investment into the LandCap venture. We made no new net lease investments during the quarter.

NorthStar has no nonperforming assets or delinquencies of contractual interest or principal payment across its commercial real estate lending through its portfolio as of September 30th. On the net leased front, we have approximately $1.3 billion of real estate assets based on undepreciated book value that are subject to long-term net leases having a weighted average remaining term of the 8.7 years as of September 30th. Of the 1.3 billion, 747 million represent healthcare-related assets which are fully leased as of September 30th. The remaining 549 millions of assets are office, industrial, and retail net leased properties.

During the third quarter, we agreed to a lease termination requested by our tenant, Cott Beverage, on a distribution facility in Reading, Pennsylvania the Cott was not using. Cott agreed to pay Norhtstar’s $9 million in lease termination payment and we are actively working to retenant the facility. Also during the quarter, JPMorgan Chase acquired from the FDIC the assets and substantially all the liabilities of WaMu Bank, our tenant in three adjacent office building in Chatsworth, California. JPMorgan is within the 90-day period to accept or reject the leave and their intention is unclear at this time. All rent payments have been made today. For details on these facilities including related non recourse debt financing, please see the payables in the back of this quarter’s earning release.

Moving over to security, we managed approximately $2.2 billion space of commercial real estate securities for the REIT of which $638 million are consolidated and $1.5 billion are accounted for an off balance sheet financing. Many are seasoned with 82% of our CMDF portfolio issued in 2005 or prior and the entire portfolio has an average investment great credit rating of BBB flat.

All of the securities are current and paying according to our contractual term. Delinquencies remain low by historical standard with September 2008 delinquency statistics coming in around 45 basis points of outstanding. Weighted average credit support through our CMBS investment is 9.2%, 20 times since September of 2008 delinquency rate.

Despite the strong performance of commercial real estate fixed income investment, the rating agencies have been reexamining their rating model which has resulted in many downgrade actions across the sector. We have experienced and expected continuing to see net downgrade actions in our portfolio resulting from rating agency model changes. Such downgrades may not necessarily be indicative of the performance of the security. We also mark a security to market each quarter and the portfolio has decreased in value as markets credit spreads have widened. Recall that nearly all of our securities are financed to maturity and CDO term financing so we now only have the intent but also the ability to hold these assets to maturity.

Finally, we have $2 billion of commercial real estate loan portfolio comprised of 109 separate loan approximately 76% of the loan balance which directly originated by NorthStar which means that we typically have more control on credit enhancement built into these loans than what is available from Wall Street product. Approximately 42% of our loan have some sort of recourse obligations to the sponsors such as debt service reserve funding.

Funded reserves underlying our loan totaled approximately a $130 million as of September 30th. Most of our loans had extension options that typically can be exercised if the borrower meets certain hurdle. Because of these options, it is very difficult to predict prepayment activity; however, our experience has been that even in this scarce debt capital environment there remains capital available for refinancing. For example, if all extension options available through our borrowers were exercised at the beginning of 2008, our year-to-date debt maturities would have been $15 million. In fact, for the nine months at the end of September 30th, we have received $246 million of loan repayment.

Going forward, loan maturities for the fourth quarter of this year and for 2009 will be $95 million if all extension options are exercised. The markets have clearly been more difficult but we will continue to work the portfolio to maximize repayment.

The watch list this quarter increased to about $205 million. Recall that this is not an NPL list but a highly monitored asset list. Assets are put in the list because there is something going on which is requiring immediate and active attention to protect our capital. None of the assets from the watch list are delinquent on interest of principle at the end of the quarter and since 2007, we have successfully resolved $67 million of watch list assets with no losses. As one would recently expect, the list has grown as macroeconomic conditions have weakened and the capital markets remain virtually frozen. To date, all of the reserves that we have taken relate to watch list asset. During the quarter, we added three first mortgages to our highly monitored assets list totaling $79 million; one mezzanine loan totaling $21 million and our $15 million equity exposure to the WaMu net leased assets.

We took a $2.2 million net loan loss provision on a $13 million mezzanine loan backed by a multifamily asset in Atlanta. The loan was added to the watch list last quarter and the property leased as well. We also took a total of $1 million of reserves on two first mortgage loans totaling to $35 million backed by multifamily properties in the weak South Florida market. Both of these loans were on the watch list last quarter. The $3.2 million of loan loss provisions this quarter were slightly offset by the reversal of a previously recorded $750,000 reserve on a $19.5 million first mortgage loan. The loan is backed by two multifamily properties in Texas and a new equity sponsor recapitalized the asset of $2.5 million of cash equity this quarter.

On the liability side of our balance sheet, we have minimal exposure to near-term debt maturity. Last month, we completed a modification and a one year extension of the secured credit facility with JPMorgan. We have just $48 million of outstanding on the line. Our next significant final debt maturity, exclusive of this facility, does not occur until October of 2010. At September 30, we were in compliance of all the financial covenants in our debt facilities and our CDO financings were in compliance with the related interesting collateral coverage tests.

From the third quarter, we continue our track record of never receiving a ratings downgrade for debt issue by NorthStar. As I stated earlier, the rating agencies continue to adjust the ratings model by increasing the follow up and loss rate assumptions so our liability ratings could be impacted in the future even if underlying collateral continues to perform. However, rating changes of our debt will have no liquidity impact for NorthStar.

At September 30th, consolidated assets totaled to $4.1 billion, down only slightly from $4.2 billion last quarter. NorthStar’s liquidity position remains very strong. At September 30th, we had approximately of $155 million upon restricted cash and a $150 million of uninvested cash in our CDO term financing with total liquidity of $280 million. Consistent with prior quarters, future funding commitments under existing loans remains our only non-discretionary future funding obligation. Typically, borrowers must meet performance hurdles to obtain additional fund and we expect that some will not to be able to draw on these amounts in the future. All future funding and loans that are financed in our CDOs will be 100% within the CDO by revolving class of notes which means there is no cash requirement from NorthStar.

Of our $364 million of future funding requirements and as of September 30th, $196 million will be funded in our CDOs. The remaining $168 million of future funding requirement will be financed in large part under our existing credit facilities and term loans and otherwise funded from our available liquidity. We currently expect to fund approximately $74 million from available liquidity through the end of 2009.

This concludes our prepared remarks for today. To summarize, we believed that NorthStar is well positioned from a balance sheet liquidity and credit perspective to weather the economic and capital market storm and to capitalize on the opportunities created by this market opportunity.

Now, let us open up the call for questions. Operator?

Question-and-Answer Session

Operator

Thank you, Sir. Ladies and gentlemen, at this time, we will begin the question-and-answer session. (Operator instructions)

Your first question comes from the line of Donald Fandetti - Citigroup.

Donald Fandetti - Citigroup

David, I just want to sort of get a view on how you are looking at the commercial real estate market over the next 12 months. Obviously, there is no lack of liquidity. How bad do you think for the valuation stock can get and when do you think you would expect to see a large amount of property start to change hands?

David Hamamoto

I think a big driver of that is going to be a lot of the maturities that you are seeing in CMBS that cannot get rolled over and I think $80 billion or $90 billion is coming up over the next year. The limited transactions that we have seen trade at pretty big discount to the historical prices but then where the seller is being forced to sell. And I think the drop in prices will be a result of those situations where there will be pressure on borrowers. But I think the wildcard is what happens with all of those debt maturities. And I do know that there are some efforts ongoing now in Washington with the real estate lobby to try and figure out some sort of government solution for the massive amount of CMBS coming to.

We are not counting on that but like in senses since those assets are continuing to cover most likely the loans will be extended or restructured on some basis but that being said as we said in our prepared remarks, we do accept the market to get worse and a lot of that is not just liquidity but with the recession that demand is definitely down and so rents and occupancy are an issue and I think that seeing 10% to 20% declines in commercial real estate value is certainly likely.

Donald Fandetti - Citigroup

Do you think, you had mentioned the CMBS maturity, what about the other non-CMBS debt maturities? Which one do you think is more impactful in the CMBS or the non-CMBS maturities?

David Hamamoto

I think that the issue about CMBS is, how do those loans get extended in the context of the structure that exists with the trustee and the different classes of bonds? So, I think that makes it more complicated. I think if you were just dealing with an existing structure and you have an asset that is covering, may be the borrower has to pay more, he has to make a pay down but those restructuring tend to be a little more straightforward. I think the CMBS situation will be much more complicated with the trustee.

Operator

(Operator instruction) Your next question comes from the line of Douglas Harter - Credit Suisse.

Douglas Harter – Credit Suisse

I was wondering if you could talk about whether, since you have authorized the share repurchase, whether you have used any of that.

David Hamamoto

We have not yet. We have been in a blocked out period so we have not been able to repurchase shares yet.

Douglas Harter – Credit Suisse

And I guess, can you just talk about how you will sort of balance buying back debt, making new investments and preserving liquidity? What levels of liquidity do you feel like you need to keep and how much is to use opportunistically?

David Hamamoto

Yes, I think our bias has been keep all our cash and I think that a lot of how willingly we are to part with liquidity will be driven by liquidity that we see developing in the market and how to achieve some of our corporate securities get. It is a little bit of a balancing act. I think with $280 million of liquidity, we at the Company and the Board feel comfortable that some portion of that can be used opportunistically to buy securities in our capital structure. And I think what we have found is where we have deployed the money is very much a function of the pressure on the stellar and the real opportunities are when you have somebody who have to sell particularly when you look at the complexity of our structure and the magnitude of that underwriting that needs to get done in order to buy one of our securities. The number of buyers is very limited and the information advantage that we have is huge which has enabled us, as I said, to buy a number of highly rated CDO bonds at an average discount of 50%. So, I think we will continue to be active up and down the capital structure and to date, we have seen the most pressure on some entities that are liquidating CDO bonds where we have a very strong competitive advantage but we will be opportunistic and depending on the price of any of the corporate securities that we have be willing to purchase if we feel that the value is there.

Operator

Your next question comes from the line of Jeff Miller with JMG Capital.

Jeff Miller – JMG Capital Management, LLC

Yes, I guess following on the previous question, your [29.0] unsecured converts right now are trading around 60 and that is a 25% yield to put. I guess you guys are looking at it as well. It seems like if you can retire some of your own debt at the same time, at 50% almost seems pretty compelling to me. So, I want to get your thoughts on that as well.

David Hamamoto

Yes, I think all of the securities are on the table. I think today buying those bonds at $0.60 cents is probably something that we would not do. I think we just think that the return opportunities are better than that. But I think we will explore all classes but I think 25% yield to put for that bond is there are better opportunities out there.

Jeff Miller – JMG Capital Management, LLC

You do not think that will be kind of give confidence to people? Can you address that situation in your own capital structure when your debt is currently in deep discount?

David Hamamoto

I think we, again it is a function... I think if we get more comfortable parting with more liquidity, we will be more aggressive but I think, again, we have been very focused on our liquidity and we have just seen some of the higher rated bonds with bigger discounts are available. But I guess that we would certainly look at all classes.

Jeff Miller – JMG Capital Management, LLC

I guess harping on this one more time and I apologize but do you think that when your debt and security in this deep rate discount is going to impact the ability of you to raise additional funding in the future too, correct?

David Hamamoto

Yes.

Jeff Miller – JMG Capital Management, LLC

So, I guess at some point when you want to raise additional funding that is not secured by portfolio assets, addressing your own account structure is going to be, will have to moved with front burner so to speak in terms of the interest, right?

David Hamamoto

Yes.

Jeff Miller – JMG Capital Management, LLC

Okay but at this point in time, you are seeing more compelling things elsewhere in terms of returns and you are just being extremely stingy in terms of out getting your cash and liquidity resources.

David Hamamoto

Yes and that could change throughout very quickly but, again, the way that we have been operating for the last year is really to try to do everything we can to increase liquidity as oppose to spend it. And I think to date, we have been rewarded for that and the fact that we are sitting on $280 million of liquidity makes everybody feel better from a credit perspective. And I think at some point because there is obviously significant earning solution with sitting much on that cash, we will become more aggressive in terms of putting that money to work and we do believe to the extent that the prices stay where are on our corporate securities that the best use of our capital is to buy our own corporate securities that I think, again, is going to be a function of when we really feel that we can start putting a lot more money that work comfortably.

Operator

Your next question comes from the line of David Fick with Stifel Nicolaus.

David Fick – Stifel Nicolaus

In your $9.4 million of other income, we are assuming that $5.6 million of it is the lease term fee. Can you just walk through the remainder of it?

Andy Richardson

David, $9 million of that was the lease termination fee and the other half was just points and repayment fees.

David Fick – Stifel Nicolaus

Okay. Does the EPS gain one time items affect your cash or income or any dividend ramifications?

Andy Richardson

Yes. The stocks or the bond repurchases that we have done during the year are basically cancellation of debt taxable income. So, based on where we are today, we do not think that we will be over distributed this year. In other words, our dividend is pretty close to what we think our taxable income will be.

David Fick – Stifel Nicolaus

Okay. Any impact of the changes in FAS 140, FIN 46 on you guys?

Andy Richardson

The change with FIN 46?

David Fick – Stifel Nicolaus

Yes.

Andy Richardson

No.

David Fick – Stifel Nicolaus

Or FAS 140? You do not see any impact there?

Andy Richardson

No.

David Fick – Stifel Nicolaus

Okay. If we just review the WaMu situation, I appreciate the detail you already gave. Are we correct that you got about $5.8 million annually in NOI there and that there is about $52.7 million of debt including $9.7 million of mezz that you hold? Is that statistically all correct?

Andy Richardson

Yes.

David Fick – Stifel Nicolaus

Okay. What can you tell us about the status of occupancy as opposed to, I mean, we realized the timeframe for JPMorgan decision but do you have a sense of the need for the space?

Andy Richardson

Either half, we are using half of the space right now and it is too early and I hate to say anything publicly but certainly they have people and they are going to us right now. They also have people on other facilities that are not too far away. So we do not know what their ultimate usage will be or what they want to start at this point. We are just in the early stages of that. So, unfortunately, I cannot give you more information on that at this point, David.

David Fick – Stifel Nicolaus

But theoretically that could consolidate into there or out of there at this stage?

Andy Richardson

Yes.

David Fick – Stifel Nicolaus

Okay and the timeframe is exactly what again?

Andy Richardson

We have 90 days from the date that they announced the acquisition so they have until I think December 23^rd.

Operator

Your next question comes from the line of Mark Lindy with Wachovia Securities.

Mark Lindy – Wachovia Securities

Hi, David. I wonder if you could comment on the impact of the recent volatility in LIBOR and kind of what you see going forward in terms of the impact of this in trying to return to a more normalized level.

David Hamamoto

Yes. As we have said before the increasing LIBOR increases our earnings because we are much funded but for the equity component of the contribution of our assets so that increases in LIBOR increase earnings and decrease earnings. We, I think, the LIBOR rate for the third quarter was pretty consistent with what it was in the second overall at about 2.6%. And we are expecting that although sticky that with said times down that LIBOR is going to continue to decline and so that will bring earnings down a little, obviously, from a credit perspective since a lot of our loans are flowing rate loans. The credit perspective on the portfolio and the interest reserves will last longer so, despite the lower earnings and lower LIBOR, it does help the credit.

Operator

Your next question comes from the line of Tim Wengerd - Deutsche Bank.

Tim Wengerd - Deutsche Bank

I was wondering if you can where you stand at the OC and IC and impacts that the downgrades had on those tests.

David Hamamoto

We are still fully covered on OC and IC test. The downgrades do not necessarily have an immediate impact on those tests. Certainly, there are more complicated than just looking at downgrades and upgrades. If securities get downgraded beyond a certain level then it starts to potentially impact the OC test but today we are fine.

Operator

(Operator Instructions) Your next question comes from the line of [Ardis Cuack] - AGA MSA.

Harrison Rescher - AGA MSA

Hi, it is actually Harrison Rescher. So, one thing I am trying to understand obviously as you guys are saying you expect the market to get worse even announced this potential share repurchase program and at least it seems like most people believe that the corporate market will probably open up before securitization market does and being a mortgagor you are somewhat capital-constrained vehicle in the long run. Do you worry about the fact that in some ways you are really by looking up to your shareholders, you are not necessarily offering your stakeholders and kind of shutting you off to other markets in the future which really that is how you end up funneling growth?

David Hamamoto

Just to be clear, we just want to understand you are asking us why we are not buying back our convertible debt at a discount to provide liquidity for those holders.

Harrison Rescher - AGA MSA

It is more than just your convertible debt, frankly, I mean it is more to the idea of buying back equity in a market where all your competitors are either issuing debt for equity swap to take out other convertible loans or buying them back themselves or issuing actual equity. It goes through a litany of other REITs. I mean just how many buying back equity as opposed to taking of the other parts of your capital structure. It is just very different than the lot of which your peers are doing which I am curious to understand why.

David Hamamoto

Yes look I think. Yes, I understand. The biggest issue for us is making sure that we have preserved the liquidity but I think one thing that all shareholders should understand is that we are going to make sure that the balance sheet is solid and that we have adequate liquidity so we never have any kind of blow up here and that has been our number one priority which I think has served us very well. As we get to $300 million in liquidity and as we the distressed dollar service in various parts of our capital structure, we believe that if we are going to put capital to work, it should be in buying back our own bonds or our equity and that is going to be a function of price. So, we are not going to favor anyone class. It will really be a function again, of being opportunistic and seeing where we can create the most value. Because you know management on over 10% of the Company, we are managing here for the long time term and for the long-term value creation and so we are going to put our liquidity where we can get the best return.

Harrison Rescher - AGA MSA

I understand and that is fair. I guess when you are managing for the long term when you have some of these bonds that are due in 2012 and then, again, more slightly after. I am curious how you weigh that versus you said the price that you talked about early on the call was not enough. What is that price and how do that factor in kind of when you looked it from a long-term view of being a shareholder?

David Hamamoto

I cannot give a specific price right now and that is something that changes really on our real time basis depending on other opportunities, liquidity, how bullish we are about to market, how soon we think the market may open up for other capital rates, how much we have in repayment. So, I mean, it is a very dynamic decision making process and I cannot give you a specific numbers today.

Harrison Rescher - AGA MSA

That is alright. You guys have done a very good job of managing your balance sheet but I just want to squeeze in this, when you have the first [inaudible] in 2012. At what point, do you start thinking about why do the due coming pretty soon. I need to refinance some. Is that a 2010 event? Is that a 2011 event or is that a 2012 event?

David Hamamoto

We, definitely, the fact that there is a hard maturity factors into its attractiveness as a buyback opportunity. So, it is not loss on us, buying back something that is a permanent life security versus something that of hard maturity that the hard maturity should get a premium because of the liquidity and that is factored into our overall model. So, we certainly would have a biased of other things being equal to buying something that has a hard maturity. And we do plan, you know, we look at 2012 and that is a factor in trying to figure out what price is okay.

Harrison Rescher - AGA MSA

I appreciate that and again, you guys have done a very good job managing your balance sheet. Congrats and it is much better than it appears. I would just like to reiterate that. You know a lot of people come to realize that if you want equity to flourish, you probably need to lookout for your lenders as well. Thank you very much.

Operator

Your next question comes from the line of David Jordan with Axiom.

David Jordan – Axiom Capital Management

David, you mentioned the near-term earnings solution in your prepared remarks and you mentioned it again when you responded to a question just a brief time ago. Could you tell us or give some insights of the near-term earnings solution, how it might impact the quarterly dividend in the next three or four quarters if that is an allowable question?

David Hamamoto

It is always a question and I am surprised that it came up so late in the conversation this quarter.

David Jordan – Axiom Capital Management

Thank you. I feel honored.

David Hamamoto

Basically, what I was referring to is the fact that since we have closed the $300 million of liquidity which is a lot more liquidity than we normally carry and given the returns on the opportunities that we see today, if we put $150 million of that to work in today's crisisthat could result in $0.13 to $0.15 cents third quarter of earning. And we basically have a sacrifice of near-term earnings for preserving the liquidity and making sure that we have a very solid balance sheet and so I think that earnings, however, is there, we just have been hesitant as I have been saying before to use that.

David Jordan – Axiom Capital Management

Okay, may be perhaps I misunderstood because I am such a novice in this area but I was concerned that going forward that the dividend that you are currently distributing will might be at risk going forward.

David Hamamoto

I think it is a complicated question and we have had other inquiries and questions and statements from shareholders about doing what other REITs are doing and cutting the dividend which we have elected not to do. As I said in the prepared remark, again, it is a complicated question and there are a lot of different considerations. For 2008, one of the considerations is taxable income because in order not to pay taxes, we have to payout our taxable income. And for 2008, the $0.36 quarterly dividend will essentially approximate taxable income so had we paid out last, we would have made the company taxable.

David Jordan – Axiom

Now, I am talking about 2009 obviously, right.

David Hamamoto

Yes and so I think, again, so for 2009 the taxable income level will be consideration in terms of what we ultimately payout, what we are actually earning and, again, the share our AFFO has covered the dividend so that was another factor and where that will change that would influence what is the dividend’s policy would be and then obviously, liquidity. So, I think it is something that we evaluate on a quarterly basis and it is complicated and it deals with earnings, taxable income as well as liquidity and cost-to-capital. I think that is about all we can say about at this point.

Operator

Your last question comes from the line of Robert Schwarzberg - Compass Point.

Robert Schwarzberg - Compass Point

I wanted to go back to the watch list a little bit. If you could talk about what, remind me again of what it was to June and may be talk a little bit more specifically about the assets that went on specifically when during the cycle they originated or if there is anything common to their characteristics that might foreshadow what else is happening with the rest of the portfolio and the watch list going forward?

Andy Richardson

Yes. There is about $91 million on the watch list at the end of the second quarter and that was net of the $20 million first mortgage that got recapitalized in August. So, the watch list just doubles a little more and I would say, basically, that we talked about the WaMu situation…

Robert Schwarzberg - Compass Point

Right.

Andy Richardson

Which is unique and the other one I would say are over half of that increase was one was the first mortgage, and one was the mezz loan or a multifamily property so again, a consistent theme of weak or slower than expected performance in those assets. And then the other two were just kind of went off first mortgage situations were again, there is no commonality except that they are being negatively impacted by economic condition and/or I would say poor sponsor performance.

Robert Schwarzberg - Compass Point

Alright, the $20.8 million mezzanine loan, what property type of loan is that?

Andy Richardson

The $20 million was the first mortgage. It was multifamily.

Robert Schwarzberg - Compass Point

Okay, I thought it. I am looking at the release, I thought it was just one mezzanine loan.

Andy Richardson

That is the multifamily as well.

Operator

Thank you. Management, if you have any further comments at this time, please feel free to make those at this moment.

David Hamamoto

We will just thank everyone for your support and we look forward to speaking in the next quarter.

Operator

Thank you, management. Ladies and gentlemen, at this time, we will conclude today’s teleconference presentation. We do thank you for your participation on the conference call. At this time, you may now disconnect and please have a pleasant rest of your day.

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