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[Editor: Following review, we are republishing this article with two editor's notes and one clarification to the author's positions in stocks mentioned. Readers with differing opinions on this topic are invited to submit an article for publication.]

Crystal River Capital, Inc. (CRZ) is a leveraged financial entity structured as a Real Estate Investment Trust. I think that the company - within two to six months - will be insolvent and its stock worthless (and trade like other worthless REITS such as Thornburg Mortgage (TMA) for under 30 cents a share for awhile as it awaits delisting).

You might chide me for being Captain Obvious now for not speaking up about CRZ sooner. Predicting the demise of CRZ is not too bold a move, considering that its stock has plummeted over the past year, from about $25.50 to about $3.50. Nonetheless, one can still profit from buying puts on the stock as it falls to zero. The values of CRZ’s assets have fallen dramatically, but these declines are not reflected in its overpriced stock. Nor is the risk that the company could be suddenly wiped out by an inability to pay margin calls or meet its credit default swap obligations.

That swing has already happened, or very nearly so. I do not even think the company will be able to pay its next quarterly dividend [Editor's note: The author refers to the September 2008 dividend]. The market largely agrees, which is why stated dividend, if paid, would result in the stock having a yield of 34%. If the company does not announce that it is suspending its next dividend, its creditors will probably either issue margin calls or file a suit against the company to enjoin the dividend payment.

Balance Sheet Review

First, the company’s largest asset is available for sale securities, which it values at $271 million. The company took a big write-down on this part of its portfolio last quarter. I expect another large one when the company reports Q2 earnings and values as of 6/30/08.

Using the same method I used to estimate the write-downs in Redwood Trust's (NYSE:RWT) portfolio, namely comparing similarly-rated segments of the CMBX to the securities in CRZ’s portfolio, I see CRZ’s CMBS portfolio decreasing in value from $271 million to $242 million. This is a somewhat larger percentage write-off than I am estimating for the CMBS portfolio of RWT. This is because RWT’s slightly older vintages of CMBS faired a bit better than CRZ’s newer CMBS.

Next is the company’s holdings of non-agency RMBS. Here, I estimate the company will report a $42 million write-down, again based on declines in the comparable ABX indices. While the CMBX and ABX are not perfect proxies of the value of CRZ’s MBS portfolio, many companies explicitly have disclosed that they rely on these indices in valuing their Level III assets, and in past quarters declines in these indices have closely mirrored the write-downs actually reported by CRZ and other public companies with these assets.

CRZ no longer owns agency MBS. These were once the largest part of the company’s portfolio, and its most stable liquid asset, which it was forced to sell in the first quarter.

In total, I predict a write-down of available for sale securities of $71 million. This is only slightly higher than the company’s first quarter writedown of these assets of $67 million.

Commercial Real Estate Loans

The company does not mark to market a portion of its commercial loan portfolio, but rather reports them at face value until it believes they are impaired. So far it has marked down the value of only one loan held at face value.  In 2005, the company issued a “mezzanine” or junior loan of $9.45 million for the construction of luxury condominiums in Portland, Oregon. A few months later, the borrower fell into financial difficulties, and CRZ threw good money after bad and loaned the project more money at 16% interest. The project has stopped paying interest on the loan. In total, because of cost overruns, the average construction price of each unit is estimated to be $849,185. Thus its “wholesale” cost of condos in Portland as the country heads into a recession is nearly a million dollars!

“We believe that it is probable that we will not recover the entire loan balance,” the company writes in its latest 10-Q. No doubt! Amazingly, sales in the project appear to be going backwards. As of 12/31/07 CRZ reported that 47 of the 70 units had been sold. Now the figure is 35 sold and 10 “under contract.” It will be interesting to see the updated figure of 6/30.

After the borrower defaulted, CRZ took a $4.5 million write-down on the loan in Q4 2007 and then another hit $2.5 million in Q1 2008. It has $6.77 million left to lose.  I expect, given the extreme weakness in residential real estate in Portland, that it will lose all of this money eventually and only the senior mortgage holder on this project will be paid from its proceeds.

Outside of this loan, CRZ has taken very little in the way of reserves for credit losses, despite the fact that these loans have a subprime average interest rate of 9.38% for junior loans and 11.98% for construction loans, showing the weak credit of the borrowers when the loans were made and/or the extreme degree of subordination of the loans.

What is the fair value for low-quality construction and junior loans made during the peak of the bubble on the open market these days? Certainly not close to the full value $50.7 million reported on CRZ’s books. $5.86 million of this is a junior loan on the Sheffield Building in Manhattan’s Hell’s Kitchen neighborhood, at 14.03% interest, and with $242.8 million in more senior debt as of 12/31/07. An article about the purchase in Real Estate Weekly, dated 1/19/05, noted that the sellers of the building were a “real estate family well known for its hesitancy to cash-out of properties” but were offered a price that was so high that it inspired “astonishment.”

The buyers won in a two-round bidding war that involved at least 15 other bidders. Unfortunately, about 11% of the units are going to have to stay “rent-stabilized” and can’t be sold until the tenants vacate, which in these types of situations doesn’t happen too often. Other troubles with the building that made news or blogs include protest marches, flooding lobbies, asbestos, and a buyer who had a “six inches in diameter and a foot high of solid concrete, [fall] directly into her tub.”

Why are the would-be Maklowes who bought the building so short on cash they are taking out loans at 14%? We’ll see if they default when the loan matures October of this year. In its held-for-sale real estate loan portfolio, the company took a $9 million write-down in Q1. I do not have enough information about this aspect of the company’s portfolio to venture an estimate on how it will be valued in Q2.

Commercial Real Estate

The company reports that as of 3/31/08 it values its commercial real estate portfolio at $233 million. Looking at rental revenues and related expenses, this is a reasonable - if somewhat aggressive - estimate. A better estimate of $210 million reflects the high cost of commercial real estate credit, the negative effects on rent of overbuilding office properties the past few years, and the deteriorating economic environment. I don’t know if CRZ is going to adjust the value of these assets downward, I suspect that, in line with past quarters, it won’t, except to account for depreciation. CRZ’s lenders, however, may want to consider the value of this property in determining whether to continue to loan the company money. I certainly would do so, and choose not to renew CRZ’s credit lines and issue margin calls to maximum extent the terms of the loans allow.

Going Out With a Bang or a Whimper?

CRZ reported equity of $132.6 million as of 3/31/08, or $5.33 a share. As of 6/30/08, the probable mark-to-market of the MBS securities portfolio will reduce that to $61.6 million, or $2.48/share. Another $2.5 million write-down on the defaulted condo loan in Portland would nick another 10 cents a share off book value, to $2.38/share. If the value of the CRE portfolio is just 10% lower than CRZ’s Q1 estimate, as I think it is, book value falls to a mere $1.44. Mark to market those high-risk junior loans (probably by 20% or more to reflect current conditions), and we are well under $1 a share.

The Q3 macroeconomic environment for commercial and residential real estate is looking like it will be to be much worse than Q2, which will mean additional write-downs and loan defaults. It wouldn’t take much to wipe out that last dollar of equity in the next couple months, assuming that it isn’t already already a negative figure. And with no profitable business model, a company whose stock has book value of less than 0 is worthless.

Instead of this “whimper” scenario of a relatively slow and graceful decline to below $1/share, margin calls on CRZ’s repurchase agreements or required cash payments pursuant to the terms of its credit default swaps may cause a sudden meltdown. New Century Financial, one of the first mortgage REITs to implode, closed on Friday March 2, 2007 at $14.65, but fell more than $10 a share the following Monday, closing at $4.56. Eight days later, it fell to 85 cents. Within three more weeks, the company filed for bankruptcy. Today the stock trades between 1 and 2 cents. The stories of the rapid downfalls of other mortgage REITs such as TMA, Luminent Mortgage (LUM), American Home Mortgage (AHM), NovaStar Financial (NFI), are similar, with the stocks collapsing 80% or more in a very short period of time.

Most of CRZ’s reported Q1 repurchase agreements were paid back in Q2 with the proceeds from the sale of its agency-MBS portfolio. That, however, still leaves $22 million in repo lines subject to margin calls. As the company notes:

As of March 31, 2008, our stockholders' equity was $132.6 million. If our stockholders' equity decreases below $100.0 million, we would be in default under these borrowing arrangements and … the lenders under those facilities would have the right to accelerate the maturity of the indebtedness.

My projection is that it will report soon that it is already well below $100 million. It’s possible the company will try some tricks such as writing down the value of its debt to stay above the $100 million mark, but there is only so much time to delay the inevitable. With a market cap well below $100 million, its clear that the market doesn’t think the company has that much equity. Last quarter 33% of the company’s write-downs were in securitized assets on its balance sheet, so this trick is still not enough to keep the company’s equity above $100 million given the extent of its likely writedowns.

Another problem that could suddenly bring down the company are its two remaining credit default swap [CDS] positions. The company closed out six CDS in Q1, losing $10.4 million on the transactions. The company’s exposure on these remaining defaults as of 3/31/08 appears to be $4.8 million. Losses in CDS have to be paid with cash to the counterparty, and CRZ had very little unrestricted cash as of 3/31/08. [Editor's note: See CRZ's 8K filings and Investor Presentation of April, 2008 (.pdf) for the company's statements of significant cash generated from Q1 asset sales.]

Conclusion

CRZ is going to report large write-downs when it reports Q2 earnings, which by themselves will cause it to violate minimum equity requirements on its repurchase agreements. This could cause the company’s sudden collapse. Even if this doesn’t happen, the company will have to drastically cut (for the second time) its regular dividend, if not suspend it entirely, which has also been the proximate cause of the collapse in stocks like CRZ with large MBS portfolios.

The price of CRZ stock has been rapidly falling the last few trading sessions. The time to get out of a long position, or start building a short position through the purchase of puts and the shorting of calls, is right now. At best, CRZ should be trading somewhere near an estimate of its book value, which is under $2 and dropping by the day as more and more homeowners and commercial developers default on the loans underlying CRZ’s mortgage portfolio.

Disclosure: Author is long CRZ puts, short TMA stock, short RWT stock, long RWT puts; no position in other companies mentioned.

[Editor's note: disclosure of author's RWT positions added 7/7/08]

Source: Crystal River’s Q2 Write-Downs Could Bankrupt the Company