'SuperREIT' CapitalSource Swoops Up Fremont's Branches

I've complained before about CapitalSource (CSE) getting too big to focus on its core competencies, but with the acquisition of the Fremont branches, CapitalSource is looking less a mortgage REIT and more like, well, Countrywide (CFC). In fact, this deal reminds me a bit of the IndyMac (IMB) restructuring from a REIT to a thrift back in 1999 after liquidity concerns forced IMB to seek new sources of funding in order to grow the business.

Scott Valentin at FBR Capital Markets asked precisely the question that concerned me the most:

Then as far as the REIT status, are there any implications in terms of trying to manage the REIT compliant assets with the bank?

CEO John Delaney poo-poohed Valentin's concerns, responding:

No, actually one thing we can probably comment on is our agency portfolio, which a lot of people know has been driving our REIT optimization -- REIT compliance. We have actually been able to downsize that because we had overinvested in that. That portfolio is probably now down to $2.5 billion. And we think it is going to go smaller because we don't need quite as many assets. So managing the REIT structure right now has not been that difficult for us. So this doesn't change any of that.

CapitalSource hasn't proven to me that it can run a mortgage REIT just yet. Now they're going to run a bank in the middle of a severe financial crisis. I guess CSE really is the SuperREIT.

Disclosure: None

Comments

[R. Richard ...:]

A good heads up!

2008 Apr 17 10:07 AM

[.crazylegs..:]

Wait a second, you've missed the point - I think your analysis stinks. They had been looking for a deposit based funding strategy PRIOR to the credit issues. Remember Tier One? I give them tons of credit NOT doing that deal as they would have ended up with a portfolio of construction loans.

Now they get to the same endpoint BUT they end up with:

1. An A participation of the loan pool that was originally sold from Fremont to iStar Financial where iStar kept a B participation. iStar is one of the best commercial RE loan operators. The CEO was recently quoted as saying he expects to earn a positive return on the investment. And Jay Sugarman is a top notch exec with an excellent reputation.

2. $3 billion cash

The A participation has an accelerated paydown as CSE gets 70% or principal payments. This is a great deal for CSE.

I would also not characterize CSE as a mortgage REIT. That would signify that they are borrowing money to purchase mortgage securities to earn a spread. They have a large direct origination platform that has a very large health care component and THEY do the underwriting. This has to be noted as a huge difference from an entity that buys other folks' underwritten products. The CSE guys are very, very good. The large investment from Farallon partners is another reason to look at this company as it does its homework very diligently before investing.

2008 Apr 17 11:12 AM

[Tack:]

On the contrary, "managing a bank" isn't a laibility in this environment; it's a huge asset, if for no other reason than it gives them direct access to Fed funds, if needed. Go ask Thornburg if they wish they'd been a bank when they got a big margin call.

Having "bank" status in a time when any large third-party borrower can be brought down by nervous lenders reduces liquidity risk, real and imagined, significantly.

2008 Apr 17 01:54 PM

[Patrick Harden:]

I suppose I was unnecessarily snarky, but my major beef with CSE is that instead of trying to run one aspect of its business well, it continues to stretch itself thinner and thinner. Now it's going to be a mortgage REIT, a BDC, a healthcare net lease REIT, and a bank?

I just wonder how efficient CSE can be running a bank and balancing the fee income versus the 95% gross income test. I guess CapitalSource just wanted access to the discount window.

2008 Apr 17 03:58 PM

[JKirk:]

CSE's competitive advantage is its focus on credit underwriting in niche businesses and with borrowers that others aren't qualified or interested in underwriting. The credits it underwrites are mostly commercial loans, M&A/bridge loans, and then some sale-leaseback transactions in the healthcare business. CSE gets premium pricing (and premium covenants, usually) for providing liquidity to people that need money fast or have complex financing situations.

It's the healthcare business that drove them to REIT status- as they can now achieve higher NPV on their healthcare loans because they have the same cost structure as the healthcare REITS they were competing against. Similarly, they've pursued deposit based funding as a diversification strategy for their own source of funds- pretty Nostradamus-like in the sense that they've been talking about this for about 2 years and we're just now seeing what happens when securitization-depende... lenders can't sell their ABS to the market.

Anyone that calls CSE a mortgage REIT doesn't understand the CSE business very well. They hold super-prime agency and high FICO Wells Fargo non-agency MBS in order to satisfy the 75% of assets REIT requirement. As their healthcare REIT grows, the need for the MBS will decrease. I think other commercial loans collaterallized by RE count too- so as those grow the need for the MBS also decreases. CSE bought ultraprime MBS, term-financed the non-agency MBS and also used hedges to reduce interest rate risk on these assets. They've done everything they could to make these assets totally unexciting- they're just there to maintain the REIT status.

If/when they secure the deposit based funding their liquidity position should be amongst the strongest in the industry. The next drop of the hat will be when inevitably they're impressively low NPAs and charge-offs mean-revert to "normal" levels. That's the next thing for CSE to focus on (they've been quite capable of protecting capital in the past) and the next barrage of criticism to follow.

2008 Apr 18 10:03 AM

[metal27:]

Are you saying the TONE acquisition, which they worked on for a year, did nothing to prepare CSE for the acquisition of FIL's 22 branches? Do you dislike the assets--$3B in cash and a loan pool administered by someone else? Earlier you were concerned about dividend coverage, and rightly so--do you not think this acquisition will help them in that regard? If you are concerned about management, have you investigated to find out how many of Fremont's employees are coming with the acquisition? Given the straits Fremont is in, I would expect nearly all want to come to CSE.

2008 Apr 19 02:42 AM

[OJO Zafado:]

CSE is a darling and recommended pick of the Motley Fool. So you will get some of their true believers criticizing your concerns. As far as doing business with I-Star the bond market is calling I-Star junk. There is a huge risk premium in I-Star. PCAP and ARCC are BDCs that have fared not much better than CSE in this credit thing. Allied Capital seems to be holding up as well as International Leasing.. I have round turn traded the CBF comercial real estate lender twice in the last year. I am out of it now despite it again comming back strong. Untill after the summer doldrum market conditions pass none of these things seem like very safe investments. The unwind of the LIBOR charade has really moved some adj preferreds. The UBS-PrD took off like a rocket last week. Many of these are still trading priced at or below their default yields (Libor + their index or say 4.5% whichever is higher), with the preferreds like BAC's FBFPrN, USBPrE , HJJ,MSJ, all still trading substantially below par. With some yielding well over 7% it seems like buying CSE for the yield is not quite the same as a combined investment in Aa1 rated HJJ and Aa1 rated FNMPrP for a combined inflation protected yield of 6.9%. All at a price substantially below par. Add in a little DXKSX as a leverage insurance and you can sit back and relax until this credit card and commercial real estate picture becomes clearer towards the end of the Summer. CSE may yet prove to be a strong company and may be a double with a very generous dividend. That is of course based on taking a lot of risk in holding or initiating a position in it.

2008 Apr 19 09:36 PM