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Arbor Realty Trust, Inc. (NYSE:ABR)

Q2 2009 Earnings Call

August 7, 2009 10:00 am ET

Executives

Paul Elenio – Chief Financial Officer

Ivan Kaufman – President and Chief Executive Officer

Gene Kilgore – Senior Vice President, Structured Securitization

Analysts

David Fick – Stifel Nicolaus & Co.

Leon Cooperman – Omega Advisors

Operator

Welcome to the second quarter 2009 Arbor Realty Trust earnings conference call. (Operator instructions) I will now like to turn the presentation over to your host for today’s call, Mr. Paul Elenio, Chief Financial Officer. Please proceed.

Paul Elenio

Thank you. Good morning everyone and welcome to the quarterly earnings call for Arbor Realty Trust. This morning we will discuss the results for the quarter ended June 30, 2009. With me on the call today is Ivan Kaufman, our President and Chief Executive Officer.

Before we begin, I need to inform you that statements made in this earnings call may be deemed forward-looking statements that are subject to risk and uncertainties including information about possible or assumed future results of our business, financial condition, liquidity, results of operations, plans and objectives. These statements are based on our beliefs, assumptions and expectations of our future performance, taking into account the information currently available to us. Factors that could cause actual results to differ materially from Arbor’s expectations in these forward-looking statements are detailed in our SEC reports. Listeners are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today. Arbor undertakes no obligation to publicly update or revise these forward-looking statements to reflect events or circumstances after today, or the occurrences of unanticipated events.

Now with the Safe Harbor’s behind us, I would like to turn the call over to Arbor’s President and CEO, Ivan Kaufman.

Ivan Kaufman

Thanks to everyone for joining us on today's call. In a moment Paul will take you through the financial results for the quarter but first I would like to talk about our view of the market, strategies we are taking as well as some of our more significant accomplishments over the past months.

As we have discussed repeatedly on our earnings calls the market is severely dislocated with significant liquidity issues throughout the financial sector. The clear lack of liquidity combined with declining real estate values have posed significant challenges for companies in our space. As we said before, no one is immune to the effects of this market and we believe there will be increases in delinquencies throughout 2009 which will result in additional losses throughout our sector.

We continue to operate our business in the best possible way to successfully navigate this turbulent environment. Our total focus remains on preserving liquidity and aggressively managing our portfolio and financing sources.

Clearly the most significant accomplishment we have achieved over the last few months has been our ability to restructure all of our short-term debt. We have worked very hard and are extremely pleased with our success in this area. Just recently we have closed on restructuring $374 million of debt with Wachovia, extending these facilities for three years and virtually eliminating all mark-to-market positions while substantially reducing our financial covenants. Certainly this transaction was essential and its completion allows us great operating flexibility at a time of widespread economic weakness.

Prior to this restructuring we also continued to de-lever our balance sheet, reducing our short-term debt by $52 million through run off and by proactively moving assets into our CDO vehicles. We continued our strategy of taking advantage of the dislocated market by repurchasing our own debt at a substantial discount. We recorded a $21 million gain from these repurchases during the quarter and improved our cash flow going forward by reducing debt service payments. We will continue to evaluate similar transactions in the future based on availability, pricing and liquidity.

We were also successful during the quarter in extending two of our short-term facilities totaling $15 million until around June 2010 with a one-year extension option and satisfying the only other short-term facility we had at a discount, paying $23 million in cash to satisfy $37 million of debt. This left us with $15 million of short-term debt, $12 million of which we paid down last week resulting in a diminimous amount of only $3 million remaining.

Additionally, as I mentioned on our last call we were successful in modifying $247 million of our trust preferred securities, reducing the interest rate for three years to a fixed rate of 50 basis points and in July we restructured the remaining $20 million of trust preferred securities with the same terms. As I mentioned earlier, managing our funding sources aggressively has been critical in this environment and we are very pleased with our success in restructuring all of our non-CDO debt which has significantly improved our operating flexibility. This will allow us 100% of our time on running the business and managing our portfolio while greatly reducing our risk to financial institutions.

We have also worked extremely hard at improving our operating cash balances and we currently have around $40 million and around $17 million of cash posted against our swaps. We also have $30 million in cash available in our CDOs for future deployment. Clearly preserving and maximizing liquidity is critical to successfully managing throughout this significant downturn and we are pleased with our progress in this area. We will continue to look for creative opportunities to improve our liquidity position including working aggressively with our borrowers to repay their loans.

In the second quarter we generated $42 million in runoff and pay down’s and refinanced and modified $375 million of loans. It will continue to be difficult to actually predict repayments in this environment but our guess is a range of around $25-50 million of runoff a quarter going forward.

Now I would like to update you on the credit status of our portfolio. As noted in our press release we recorded $23 million of loan losses during the second quarter related to 12 loans with an outstanding balance of approximately $200 million. $19 million of these reserves are on loans that we previously reported reserves on which reflects the continued decline of real estate values due to the overall weakness in the commercial real estate market.

We now have $220 million in loan loss reserve at June 30th relating to 22 loans with an outstanding balance totaling approximately $606 million. Additionally, we did record a $12 million impairment on the equity investment in the Alpine Meadows Ski Resort during the quarter. This reflects the continued decline in the values of land and pre-development deals. While we felt it was prudent given the current market conditions to record a reserve at this time, we do believe that this is a long-term project with potential upside and we will actively manage this project to maximize the value of this investment.

We also reported a $24 million loss during the quarter related to the early pay off of one loan in our portfolio. We initiated this reduced early payoff as part of a strategy to use most of the cash to retire the debt related to the asset at a discount, recording a $14 million gain from its extinguishment. This resulted in a net accounting loss of $8 million related to this transaction but created around $5 million of additional operating cash flow.

We remain extremely focused on managing our portfolio to minimize losses and monetize as many assets as we can. We will continue to be aggressive in pursuing loan monetization strategies even if it results in an accounting loss to create [pressured] liquidity and resolve any and all issues as quickly as possible.

Market conditions have also increased defaults and delinquencies in our portfolio. As I said before, this is a trend we expect to continue throughout 2009. The second quarter closed with approximately $290 million of non-performing loans, up slightly from the $285 million last quarter which continued to reduce the net interest rate on our portfolio. However, subsequent to quarter end we did restructure a $95 million non-performing loan that was in bankruptcy which has reduced our non-performing loans to approximately $195 million currently.

Clearly no one can hide from the significant issues resulting from these market conditions and we will continue to expect and prepare for the worst. Real estate values are expected to decline further and with no liquidity available to our borrowers we believe we will see ongoing stress on our portfolio resulting in additional defaults and delinquency losses. However, predicting the amount and timing of these losses will be very difficult.

In summary, these are extremely difficult times and we continue to work exceedingly hard on our core objectives which, again, are; preserving and maximizing our liquidity position and aggressively managing our portfolio. We are very pleased with our ability to restructure all of our short-term debt on what we believe are very favorable terms and significantly improving our liquidity position.

I can’t say enough about how hard our management team has worked to accomplish this significant objective. I believe our executive team has never been more focused and has the experience and discipline to face the significant challenges ahead of us. We know that success in the critical areas we spoke about is vital for us to manage through the cycle and position ourselves to take advantage of the opportunities that lay ahead.

Lastly, I would like to touch on the amendments to our management agreement which we announced recently. We believe that the new management agreement is more reflective of the current environment and the effort and costs that are associated with managing the REIT. Clearly the old management agreement was more geared towards a significant originations platform and resulted in our manager not being able to recover his costs to operate the REIT in this environment. We think the cost reimbursement concept as well as the appropriate incentive bonuses reflected in the new agreement more properly reflect the change in the market and allows our manager to more effectively manage our business in this environment.

I will now turn the call over to Paul to take you through some of the financial results.

Paul Elenio

Thank you Ivan. As noted in the press release we had a loss in the second quarter of $1.92 per share and FFO loss of $1.90 per share. We did have several large items that affected the second quarter numbers. We recorded $23 million of loan loss reserves and a $24 million early pay off of an asset. This was partially offset by our continued success in buying back some of our CDO debt and retiring one of our financing facilities at a substantial discount, recording approximately $21 million of gains during the quarter from these transactions.

Additionally, we also recorded approximately $900,000 in losses from our equity interest in the Alpine Meadows Ski Resort and recorded an impairment loss of approximately $12 million reserving against the remaining equity portion of this investment.

In addition, the second quarter included an $8.7 million expense related to the termination of interest rate swaps associated with the restructuring of our trust preferred securities. Although the termination of these swaps resulted in a large one-time charge, we will recover a majority of this amount over time through the reduced interest expense as these swaps are no longer necessary because we restructured our trust preferreds to a fixed rate of 50 basis points for three years.

We also had a $2.6 million increase in interest expense for a change in the market value of certain interest rate swaps which GAAP requires us to flow through earnings during the quarter compared to approximately $750,000 increase in interest expense in the first quarter. These swaps effectively swap out assets in our CDOs which pay based on one-month LIBOR and our CDO debt which is based on three-month LIBOR. The value of these swaps will eventually return to par at the maturity of the trades but if the market outlook for rates and spreads continues to fluctuate greatly these trades could produce significant changes in value which would increase or decrease our earnings going forward.

As Ivan mentioned, we amended the management agreement with our external manager going to a cost reimbursement base management fee retroactive back to January 1, 2009. We also agreed to pay a $3 million one-time fee to partially reimburse the manager for unreimbursed costs and other services associated with the 2008 calendar year. This resulted in an increase to the management fee expense line item of approximately $5.5 million during the second quarter. As we mentioned in our press release we estimate the base management fee to be around $8-9 million for 2009 or $2-2.5 million per quarter for the remainder of the year.

Our adjusted core EPS would have been around $0.28 per share for the second quarter compared to around $0.38 per share for the first quarter adjusting for non-recurring items and loan loss reserves. This decrease was primarily due to reduced rates on our refinanced and modified loans as well as the impact of our non-performing loans in the second quarter.

I will now take you through the rest of the results for the quarter. Our average balance in core investments declined by about $53 million from last quarter mainly due to run off and pay downs from the first and second quarter. The yields for the quarter on these core investments was around 5.40% compared to 5.12% for the prior quarter.

Without some non-recurring items related to non-performing and restructured loans as well as the acceleration of fees, the yield on these core assets was around 5.40% for the second quarter and around 5.90% for the first quarter. This decrease was primarily due to reduced rates on refinanced and modified loans as well as the impact of our non-performing loans in the second quarter.

Additionally, the weighted average all-in yield on our portfolio was around 5.35% at June 30, 2009 compared to 5.82% at March 31, 2009. Again this decrease was due to lower rates on refinanced and modified loans and a slight increase in non-performing loans during the second quarter.

The average balance on our debt facilities decreased by around $72 million from last quarter which was more than the decrease in our core investments. This was primarily due to continued reduction of our short-term debt by moving loans out of our warehouse and term debt facilities into our CDO vehicles. The average cost of funds in our debt facilities was around 4.45% for the second quarter compared to 3.94% for the first quarter. Excluding the unusual impact on interest expense from our swaps our average cost of funds was approximately 3.90% for the second quarter compared to around 3.78% for the first quarter. This increase was primarily due to the cost of some of our interest rate swaps combined with the greater impact on the average rate of financing fees due to the decline in the average debt balance during the quarter.

In addition, our estimated all-in debt cost was around 3.50% at June 30, 2009 compared to 4% at March 31, 2009. However, at July 31, 2009 our estimated all-in debt cost was around 4%. This was due to the impact of the new pricing of the Wachovia deal offset by the benefit of unwinding several interest rate swaps associated with our trust preferred securities which have been converted to a fixed rate.

So overall, normalized net interest spreads on our core assets decreased to approximately 1.50% this quarter from 2.12% last quarter due to lower rates on refinanced and modified loans, the impact of our non-performing loans and additional costs related to our interest rate swaps. As we said earlier we are expecting additional defaults and delinquencies for the remainder of 2009 which would reduce our net interest spread going forward.

Next, our average leverage ratios were around 69% on our core assets and around 81% including the trust preferred debt for the second quarter, down from 71% and 82% for the first quarter. This reflects the continued de-levering of our balance sheet through run off and removing assets to our CDOs. Our overall leverage ratios on a spot basis were also down slightly to around 3.0 to 1 for the second quarter from 3.1 to 1 for the first quarter.

Operating expenses did come in higher than the previous quarter mostly due to around $1.7 million of non-cash expense related to stock grants issued to key employees and from accelerating the vesting of all our previously issued restricted stock grants.

There are some changes in the balance sheet compared to last quarter that are worth noting. Cash and cash equivalents increased $15 million from last quarter to $30 million at June 30, 2009 largely due to cash received from an increase in the market value of our interest rate swaps. This combined with the termination of some of our interest rate swaps also accounts for a significant amount of the increase during the quarter in other assets. Notes payable and repurchase agreements decreased $101 million during the quarter primarily due to our strategy of reducing short-term debt through loan pay offs, moving assets into our CDO vehicles and from retiring some of our debt at significant discounts.

Restricted cash related to our CDOs decreased $16 million mainly due to again moving assets from our financing facilities into our CDOs. In addition, other comprehensive losses decreased by about $32 million for the quarter. This again was primarily due to a significant increase in the market value of our interest rate swaps and a change in the outlook on interest rates. This also makes up a majority of the increase during the quarter in other liabilities.

GAAP requires us to float the change in value of our interest rate swaps through our equity section and our book value per share was $10. 64 at June 30, 2009 and adding back unrealized losses on our interest rate swaps and deferred gains from our equity kickers, our adjusted book value per share was $15.18.

Lastly, our portfolio statistics as of June 30th show that about 65% of the portfolio is variable rate loans and 35% were fixed. Our product type, about 61% was bridged, 14% junior participations and 25% mezzanine and preferred equity.

By asset class, 37% is multi-family, 27% is office, 17% is hospitality, 12% land and 1% condo. Our loan-to-value was around 90% and our weighted average median dollars outstanding was 63%. Our debt service coverage ratio was around 138 this quarter and geographically we have around 38% of our portfolio concentrated in New York City.

That completes our prepared remarks for today. We would like to turn it back to the operator and answer any questions anyone has at this time.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of David Fick – Stifel Nicolaus & Co.

David Fick – Stifel Nicolaus & Co.

Can you walk us through the process for adjusting the manager’s fee? How that was negotiated and what the board’s role and involvement was?

Paul Elenio

The board assembled a special committee to evaluate the management fee and the management contract. Given the environment we are in and have been in for the last two years the management fee contract was not consistent with the work, effort and cost associated with the manager managing the business. So the special committee ran a process where they hired a financial analyst and a law firm and ran a process and had come to a decision with the manager on the revised agreement to more correctly reflect the environment that we are in and the cost and time associated with the manager’s efforts.

David Fick – Stifel Nicolaus & Co.

The retroactive fee for 2008 was something that wasn’t previously accrued or disclosed as being under discussion. How did you get to that number? Simply off the P&L at the manager level?

Paul Elenio

It was a combination. It was all part of a complete package that the board looked at. It was a combination of reimbursement of some of the costs that the manager had absorbed in 2008 that was short and the $4.2 million loan that the manager had given the REIT at the end of the year when the cash flow position of the REIT was very low. Had the manager not given that loan we could have had a margin call on certain swaps that we would have lost cash flow from.

Those two and some other items were really the considerations that went into the $3 million that was paid back for 2008.

David Fick – Stifel Nicolaus & Co.

That loan is still outstanding and will be repaid. Is that correct?

Paul Elenio

The loan has been repaid.

David Fick – Stifel Nicolaus & Co.

Was there any consideration of prior incentive fees that were paid to the manager for the transactions that are now blowing up?

Ivan Kaufman

I’m not sure I understand your question. Do you want to rephrase that?

David Fick – Stifel Nicolaus & Co.

The manager originated the portfolio that is now in distress. Naturally it did experience some losses but the losses at the shareholder level inside Arbor are much greater and there have been incentive fees paid over the years to the advisor and I’m just wondering if there should be a consideration or call back on those fees in light of the portfolio performance.

Ivan Kaufman

The only good news for the company and bad news for the manager was a significant portion of the incentive fee was paid in stock. So there is a lot of [inaudible] there.

Paul Elenio

In addition what was considered was some of what you are talking about the board did put into the new management agreement some additional hurdles on incentive fees going forward where as you saw in the release that any reversals or any reserves that were previously recorded would not be fully credited to the incentive fee calculation for the manager. The hurdle rate on the return would rise to a minimum of $10.00 per share of raised capital as opposed to now where it is just wherever the average is.

David Fick – Stifel Nicolaus & Co.

I guess now that this fee is in place there is a known run rate. What should we model going forward?

Paul Elenio

We are estimating 2009 to be $8-9 million in the base fee. Obviously the incentive fee is still based on a hurdle rate of return which has not been hit. I would say that is the appropriate model going forward for the base fee. In addition, as you know the new management agreement lays out that origination fees up to 1% used to go to the manager and now all origination fees will be retained within the company going forward.

David Fick – Stifel Nicolaus & Co.

I understand what you did with the fee and why you did it and I don’t think anybody should have to run their business at a loss. I think you understand where I am coming from with the questions. Ivan can you review for us the status of the biggest disclosed investments that are out there that are obviously the focus of most of your time and in particular the extended stay investment?

Ivan Kaufman

The extended stay investment is currently in bankruptcy and is going through the bankruptcy process. My guess is it will be in bankruptcy for quite some time. It was filed I believe about 4-6 weeks ago and is still in the initial stages of sorting itself out. The extended stay like many of our other transactions had multiple parties. With multiple parties it just has a tremendous number of issues related to competing interests to try and get to a resolution which ends up involving a lot of time, effort and negotiations to get to the next step.

I can’t even begin to tell you how long that will take. From the senior lenders to the different groups of mezzanine lenders to the different groups within each section of those lenders, it is going to take awhile for that stuff to sort out.

David Fick – Stifel Nicolaus & Co.

Your current reserves against that investment and the book value of that investment if you could just refresh our memory?

Paul Elenio

The investment from a real state perspective is fully reserved.

Ivan Kaufman

I think we have about $16 million remaining against the investment. The rest has been fully reserved against.

Paul Elenio

So there is $16 million left from the complete investment that was originally $115 million.

David Fick – Stifel Nicolaus & Co.

What do you have left in prime retail at this point?

Ivan Kaufman

We still have a 7.5% interest remaining in prime retail.

David Fick – Stifel Nicolaus & Co.

Your counter-parties interest there was pledged under the loan facilities on extended stay. Is that correct? You don’t have an interest in their equity with respect to the extent of your extended stay investment?

Ivan Kaufman

I’m not sure exactly what the counter-party pledged but our interest is not pledged. It is all free and clear.

Operator

The next question comes from the line of Leon Cooperman – Omega Advisors.

Leon Cooperman – Omega Advisors

How do you feel about the adequacy of your loan loss reserves that is reflected in your book value? Adjacent to that question, your best judgment as you look at that business and I think you own about 20% of the equity, do you think that the GAAP book value or the adjusted book value, there is a big difference between the two obviously, in that range is a realistic reflection of the value of the business? Finally, from a cash flow standpoint do you expect to generate cash over the next 12 months that will come into the till net of expenses?

Ivan Kaufman

I will take your last question first. We significantly increased our cash balances here. A lot of our cash flow balances are a direct result of the distributions that come out of our CDOs. So far we have been fortunate to continue to get our distributions out of our CDOs. We have good cushions in our CDOs going forward. I feel we have a good likelihood next quarter of getting those distributions although I can’t give you any assurances and those distributions are in a range, I believe, somewhere between $12-15 million per quarter. With respect to the fourth quarter it is hard to look forward. It all depends on the performance of the loans that are in the portfolio.

The problem is, and I’m going to back into your last question, lots of time when loans default it is not necessarily because the loan is not performing. It could be a borrower issue. It could be issues beyond our control. It could be a mezzanine lender putting something into bankruptcy, etc. That could affect our cash flow distributions.

With respect to the adequacy of our reserves, it is clearly our intent to continue to reserve against our loans if the market declines. If the market doesn’t decline any more then our reserves are adequate but I am not optimistic that we are not going to have further declines; rent declines and occupancy declines. So I would think that third and fourth quarter will continue to show additional reserves as we see declines in the market.

I am hoping most of the damage in the market will be done in 2009 and 2010 will look a little bit better. It is hard to say. Clearly you saw the announcements today. The unemployment news was better than expected. I was a little surprised. If the market turns around we will have less reserves. If the market declines we will continue to have the kind of reserves that we have shown.

Paul do you want to handle that second question?

Paul Elenio

It is hard to, as Ivan said, look to the future and try to determine what the range of book value will be. Clearly the $221 million which is a little more than 10% of the portfolio are adequate reserves today. However, if we see the market continuing to decline and we have more defaults then we will have more reserves which will shrink that book value.

However, that would be somewhat offset by the positive cash earnings we have from our core business each quarter offsetting that but it is really hard to say what the range of book value is going to be from a value standpoint until we see what the market does for the rest of the year.

Leon Cooperman – Omega Advisors

I wasn’t actually asking that question. What I was asking was you as a large owner to the equity in the business, when you look at the business you have a $2 stock price and a GAAP book value of $10 and an adjusted book value of $15. I was curious about your view of those numbers in terms of what the actual value of the business is. Obviously if we had to go into liquidation today, it is academic. We have markets for things. To the extent, in the fullness of time, the economy is bottoming out, the stock markets is suggesting that. Do you have a view of which of those two numbers is a more realistic value or is the $2 value more realistic? Just an opinion. Not a forecast.

Ivan Kaufman

Our book value is our book value. We believe if we work hard enough over time that eventually we will achieve monetization of our book value over time.

Leon Cooperman – Omega Advisors

Is the cash flow and this new value with Wachovia give you the ability to create value for the shareholders through buying back a piece of the capital structure significant discounts?

Ivan Kaufman

We certainly have that capability of doing it and that was part of our agreement to allow us to do that. So the question is, is our debt going to be available and priced at the right level to buy it back. Sometimes it is and sometimes it isn’t. We will take advantage of that opportunity when it is out there but we don’t have enough cash flow to be able to do that.

Operator

The next question comes from the line of David Fick – Stifel Nicolaus & Co.

David Fick – Stifel Nicolaus & Co.

I was just wondering, I’m sure you have looked at and are aware of the filings and sort of the next wave of commercial finance REITs that are planned. I was wondering if you could comment in two respects. First of all, how Arbor at some point might get back into sort of an offensive posture in terms of equity capital and deploying it in distressed opportunities that are at least in theory out there given what these business plans look like? Second, related to that do you think the opportunity is there or has spread compression gotten so strong that guys won’t [put up] the money for that?

Ivan Kaufman

I think that is a very good question. Clearly we have to clean things up in a significant way to be able to potentially attract new capital. That was first on our agenda. I think we have put ourselves in that position. Clearly without squaring away our short-term debt we would not be able to raise capital. We just completed that so our thoughts will be how can we raise additional capital to take advantage of potential opportunities? So I do believe that we have really cleaned up our legacy issues in a sense that most of our legacy issues are outside our current business. They are located within our non-recourse vehicle in our CDO. So it allows us to go out into the market like other people are going into the market. Even the way we structured our facility we have put in a vehicle in order to raise additional capital on a certain basis so that was factored into our line.

In terms of the opportunities that are out there I still think it is early. I still think debt is not trading at the right level. Prices have not reset. In terms of buying existing default debt I think it may be a little bit early. I also think a lot of the players who are stepping into the market may not understand the complexities that are involved in buying bad debt and the creditor agreements or have that level of expertise which clearly we do which gives us a leg up to be able to take advantage of that.

In terms of new opportunities I think the new opportunities we will see will be very similar to the opportunities we saw when we got involved in this business in 1995-2001 where stuff was done on a non-levered basis, on a highly structured basis. I think there will be significant returns for those highly structured deals. What we will look to do over time is find the right structured capital partner and joint venture partner to be able to take advantage of those opportunities. That is how we were very successful and able to develop those equity kickers and good returns.

If you go back to those times, the business was run on an unlevered basis of 12-15% providing mezzanine money. I think we are going to see a return to that. If we don’t see a return to that I don’t think it will be an overly attractive business to get into.

Operator

At this time there are no further questions in queue. I would now like to turn the call back over to Mr. Ivan Kaufman for closing remarks.

Ivan Kaufman

Thanks for your questions. We appreciate your time. Thanks for following us during this very difficult time.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect.

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Source: Arbor Realty Trust, Inc. Q2 2009 Earnings Call Transcript

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