Muddled Mortgage REIT Book Value Creates Buying Opportunity

Investing in Mortgage REITs is not for the faint of heart these days. Write-downs are easier to come by than cheap commissions, and huge losses are more common than ice cubes in a fresh cocktail. And while you may need a cocktail if you own any of these stocks, calculating GAAP book value for these REITs will definitely cause any sober accountant to reach for the liquor cabinet.

Nevertheless, it pays to understand the confusion, as there are tremendous opportunities being created by the maelstrom in Mortgage REITs. Some of the confusion is being aided and abetted by the by the Financial Accounting Standards Board, the folks who create our beloved Generally Accepted Accounting Principles [GAAP]. They recently developed FAS 159 to help reduce this confusion, and it is being implemented as of this quarter by many REITs.

FAS 159 was designed to provide a more accurate picture of the real economic value of investments in debt and equity securities, the very lifeblood of Mortgage REITs. It permits eligible entities to measure many financial instruments at fair value – not just assets but liabilities too. FAS 159 will apply to many types of liabilities, but in the Mortgage REIT world it will have particular relevance to CDO liabilities.

As every reader knows, cheap, long-term, non-recourse CDO financings were the financial equivalent of pouring gasoline onto the credit bubble inferno in the first half of this decade. As every reader also knows, investing in a CDO is now about as popular as halitosis, and CDO assets have been marked down as fast as the accountants can sharpen their pencils

However, until the implementation of FAS 159 this quarter, Mortgage REITs which had issued CDOs were required to mark down the value of the CDO assets but were unable to mark down the value of the paired liabilities. This really didn't make any sense: after all, if the assets were being marked down on one side of the balance sheet by the investors, why was the issuer still obligated to carry the paired debt obligation at full value on the other side?

FAS 159 does not provide the perfect measure of a REIT's economic book value, and not all CDOs are created equal (some have varying levels of recourse that could, in come circumstances, impair the equity interests beyond the value of the original investment), but it does address some important issues in the REIT Wrecks world.

In the case of Redwood Trust (RWT), pre FAS 159 accounting caused the REIT to report a net loss of $1.1 billion and a negative net book value of $22.18 per share as of year end. That's right, negative. A full $1 billion of the net loss was attributed to the write down of its Acadia CDO assets. Most tellingly, the net loss attributed to Acadia vastly exceeded RWT's $118 million net investment in the Acadia CDOs. This accounting convention completely distorts the real economic value of the transactions and RWT's business propositions going forward: since RWT's credit risk is limited soley to its own equity interests, it is difficult to comprehend how the REIT could lose more than its original investment.

Implementing FAS 159 at RWT results in a positive, and more accurate, book value of $23.18. This is a huge swing and illustrates not only the importance of the new accounting standard, but also the folly of relying purely on GAAP. RWT's results have been clouded by these huge GAAP write downs and net losses, which do not correlate to actual economic value. I also believe RWT is extremely well managed, and the stock deserves a close look by any investor interested in this space.

Another great example of FAS 159's impact is Alesco Financial (AFN). Upon the adoption of FAS 159, AFN expects to add approximately $2.7 billion, or $45.03 per share, to stockholders equity. Much of that comes from writing down the liabilities paired with its accident-prone Kleros CDO assets. The investors in these CDO assets have absolutely no recourse to AFN, and therefore AFN's exposure to Kleros is limited to its net investment. Consequently, the Kleros CDOs are really nothing more than a public relations problem for AFN. FAS 159 won't help that, but it will help investors assess the true economic value of AFN and many other Mortgage REITs in a more realistic manner.

Disclosure: None

Comments

[Patrick1980SC]

"Consequently, the Kleros CDOs are really nothing more than a public relations problem for AFN."

One small quibble with that -- AFN is relying on the net investment income from the Kleros CDOs to satisfy their 95% gross income test. If the holders of the Kleros CDOs move to liquidate them (as they well could, since all of them have declared an event of default), AFN could fail REIT qualification testing.

[johnthebear]

I will be very interested in an update by the author after REITs report earnings at the end of April.

Please take a look at this for me and help me understand the effect on IYR and SRS.