Crystal River’s Q2 Write-Downs Could Bankrupt the Company 112 comments
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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 (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]
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"Allowing an insolvent company to borrow $100 million in order to save an *illiquid* investment of about $5 million. Well you do the math."
First, the company would not need to borrow $100 million to cover the $25 million mentioned in their recent press release.
Second, the company would not be insolvent.
This is more than poor logic, it is irresponsible, self-serving gibberish posing as analysis. This is the same level of "rigor" SA apparently required in the original article.
Speaking of SA, is it not the case that by pulling the article and then reposting it, SA has implied the article meets the highest level of editorial standard claimed on its site? To pull the article and then repost it suggests the headline is well-justified based on the "rigor" SA's editorial staff requires of all articles posted on its site. In fact, it may be that SA's actions are responsible for the terrible hit the stock took today.
Oh the tangled web we weave. . .
When a stock falls in price like CRZ did today, lots of investors lose money. Typically, there are only two parties to sue.
First, if the company has been dishonest in its appraisal of its ability to remain solvent, pay a dividend, and go forward into this investment climate with the intention of increasing shareholder value, then the company is usually the target of a class action suit (as it should be).
Second, if manipulation, misrepresentation of circumstances, or the self-serving selection of facts is presented as "rigorous" research, then it would seem appropriate to file the suit against those parties that participated in such behaviors.
I do not see a third party in this instance, so I must believe either the company or Weston/SA will be named as a defendent in response to the catastrophic drop in share price we witnessed on Monday.
I guess my point is that someone is going to get sued, and from my perspective I think the company has been completely forthcoming all along.
YOU do the math!
My thoughts are those of an investor who is long the stock, and may be biased in favor of that position.
Best of luck to all who have posted here (except those who seem to have difficulty posting the whole truth - now there's a strange concept).
www.tv.com/uservideos/...
Seeking Alpha has done nothing I can see to give the article the same prominence that Mr. Weston's piece. While this is a poor substitute, there is now at least some mention of it here.
[SA Editor Mary Hunt responds: Both articles had equal "prominence" as originally posted. The reposting of Mr. Weston's article is precisely for the reason of addressing concerns such as those you raise.]
Well they might also be lower and higher, respectively. It's pretty obvious that cash is going to be higher than Q1 for example. But really we have no idea, because we don't know what has transpired in what was certainly a very busy Q2. Clearly they are keenly aware that they need to eliminate their short-term liabilities.
In April 2008 they disclosed $100M of "unencumbered" assets, $45M of net cash, and the repo lines were down to $28M, and all of the agency MBS were gone. Some of that happened after the end of Q1, so the Q1 balance sheet doesn't reflect all of this. Surely they continued the sales into Q2.
>>> 1. Do you concede that it is likely that the equity reported as of 6/30/08 will be below $100 million? <<<
Possible, but not likely, and I don't mean that as an evasive answer, really we don't have enough data. CRZ management is all too aware of the $100M equity limitation and was clearly willing and able to sell assets at a loss to preserve equity.
You're basing your book value write-downs on the movement of the indices and the assumption that they hold much the same assets at the end of Q2 as Q1. The first assumption is maybe the best thing analysts have to go on, but is nothing more than a wild-ass guess, and some liabilities will change along with the assets. For the second assumption, I would not be surprised to find that they have sold all of their non-agency RMBS and a signficant portion of their real estate loans, about 62% of which they reclassified as held-for-sale in Q1. That could represent another $100-200M of de-levering during the quarter.
To the extent that they have a strategic focus (note that I am not really that positive on the company to begin with, I mean hey, Lou Ranieri is on the board, you just gotta love that), they seem to want to focus on agency MBS, A-credit CMBS, and direct ownership of commercial property. So that clearly puts the non-agency MBS and residential loans in the jettison category.
>>> 2. Do you concede that, to the extent that Brookfield is willing to excuse a default, it will do so on terms that are in the best interest of Brookfield rather than CRZ? <<<
Of course not. BAM is going to watch out for themselves, but as long as they feel there is some long-term value in CRZ, they're going to strike a balance between all of the respective interests.
I am more familiar with BAM than CRZ and have seen the way BAM supports its distressed offspring during rough times. If you think that CRZ has been a bloodbath, I direct your attention to Fraser Papers. The losses there have truly been awe-inspiring (or perhaps awww-inspiring), yet BAM has steadfastly supported the company. Aside from backstopping a rights offering and helping them to convert debt to equity, they've lined up financing deals to help Fraser monetize some assets and gain business from other BAM affiliates. BAM has done the same with several other companies in similar situations, and certainly has the resources to help CRZ in the same way. One advantage that CRZ already has is access to BAM's deal flow, which is world-class. This is not 100% predictive of what BAM will do with CRZ, but they have long shown the willingness to support their subs and affiliates, and have plenty of motivation to do so here.
To look at it another way, what does BAM have to gain by foreclosing? They would go from being the senior lender secured by a bunch of squishy assets to the direct owners of the same. Is their exposure diminished or accounting treatment any better after foreclosing? No. They are not dumb enough to foreclose and then try to liquidate the assets into a terrible market, and the ~$50M of debt is not meaningful to their ~$100B asset base. More likely they'll convert their debt to equity ownership so they reduce their downside risk and increase their share of the upside if and when things turn.
It is telling that CRZ has chosen to pay off the repo lines with BAM's line of credit, instead of the other way around -- clearly they believe that BAM is a friendlier party than their repo lenders.
>>> In the past, when companies with toxic real estate debt have sought to go to capital markets, the results have been horrible for common shareholders. cf TMA and BKUNA. <<<
Yes but TMA and BKUNA did not have well-heeled parent companies, nor did Homebanc, New Century, Delta Financial, or the whole host of other blow-ups. A few billion of liquidity in the hands of a friendly party can go a long way during rough times.
>>> Since you are the only person commenting here who has made any intelligent bullish comments, I'd love to also hear your general case for this stock. <<<
Well really I am neither long nor short, but I've been following cRZ pretty closely for about 4-6 quarters looking for an oppotunity to go long. When the fit first hit the shan, they had a fair amount of "dry powder" in the form of agency securities that I thought could be sold and redeployed into higher yielding assets, but that didn't really pan out so well, because agencies didn't hold up as well as anyone thought they would. Then things really started to go pear-shaped, and they started to sell agencies for survival rather than redeployment.
However, the market should be rife with opportunities for those with capital to deploy, and many participants are talking about mid-teen unlevered yields in A or higher rated securities. Of course an A or even AAA rating doesn't mean what it used to, and maybe it's all crap at this point.
Generally, I don't like MREIT's of any type or variety because they don't have any balance sheet to them, and generally don't add any economic value -- they are just a passive portfolio. I prefer REITs that are direct owners and operators and those that add value through expertise and redevelopment. Even moreso, I like property management companies that are not obligated to pay out all of their income as a dividend so they have more balance sheet and liquidity (examples are BPO and FCE). So, in light of all that, I'm never going to get excited about going long CRZ unless the situation is more stable than this one is, though the discount is starting to look pretty compelling. I'll definitely wait for the Q2 report to come out before making any calls.
Uncle
The line of credit and the repos default if the company's equity goes below 100M. Remember a lot of the prices CRZ reports for its assets are theoretical values that are probably above the price they would fetch if actually sold.
Further, if the pace of write-downs continues at the Q1 and my predicted Q2 rate (which are about the same), the company will have negative book value fairly soon. You could argue things are going to get better later this year, but I don't think this will happen, in fact I think commercial RE in particular is going to get much worse in Q3 and Q4.
It would be naive to think that they took these actions without consultation with Credit Suisse, but that seems to be a base assumption of this article.
The whole REIT industry is down. You know that. In many cases it has nothing to do with quality of management or portfolios. Management doesn't control that stock price (and can't without violating the law and risking stockholder lawsuits). They can recognize the state of the market and the position there company is in relative to the market and take steps to prevent things from getting worse. That is what "getting ahead of the curve" is all about: taking actions that you'd prefer not to take before you are forced to take them.
That won't stop "analysts" like yourself from ignoring the action and its implications, assuming the worst based on numbers taken out of context, and broadcasting a general feeding signal to shorts. Neither will it prevent you from being investigated as per www.marketwatch.com/ne...
The speculation among the longs is that BAM will waive the terms of the credit line in order to save its $5 million or so investment in CRZ.
The problem with this argument is (1) If you investment relies on a bank waiving terms on a loan in default, it probably isn't a good investment (2) It is illogical for a company to extend $100 million in credit to protect an _illiquid_ investment of about $5 million.
I made my short call at 3.50, and the stock is now around 50 cents, down 85% in less than 5 months.
I made over $12,000 in 8 months by being long RZ (Now CYRV) from the bottom to the crest for the rebound.
Mr. Weston, perhaps you made as much being short?
On 2008 Dec 01 09:54 PM Greg Weston wrote:
> CRZ announced today they will be delisted.
>
> I made my short call at 3.50, and the stock is now around 50 cents,
> down 85% in less than 5 months.
On Sep 01 02:17 AM Ernesto Gomez III wrote:
> And I bought several thousand shares under .55 each in Nov-Dec 2008,
> then sold them in August 2009 in the $2 range.
>
> I made over $12,000 in 8 months by being long RZ (Now CYRV) from
> the bottom to the crest for the rebound.
>
> Mr. Weston, perhaps you made as much being short?