Crystal River Capital (CRZ), a diversified mortgage REIT managed by Brookfield Asset Management (NYSE: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 D-1, D-2, and E 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.