The origination market for the battered mortgage REIT sector has all but dried up, with few new loans being made. Many borrowers, even large commercial tenants, are simply trying to extend or modify existing loans. Even the few new borrowers in the market no longer meet most underwriting standards now that the securitization market is dead and the credit risk can't be offloaded. However, for those mortgage REITs who are largely match-funded with existing CDO liabilities and don't have immediate liquidity concerns, there is a question of how to best deploy loan repayments (and prepayments).
Enter a rather clever solution. Perhaps best thought of as an extension of marking CDO liabilities to market under FAS 159, a few mortgage REITs have chosen to begin buying back previously sold CDO tranches for cents on the dollar. The buy back of the CDO debt has many positive accounting implications. Assuming the CDO is consolidated and accounted for as a financing for GAAP purposes, the repurchase of the CDO debt allows the original issuer to extinguish the CDO liability on its books, reducing leverage ratios and more importantly, generating a gain on the extinguishment of debt. This gain is also a source of taxable income, allowing mortgage REITs who are facing realized tax losses from foreclosures to offset these losses and potentially support their existing dividend payouts.
Gramercy Capital (GKK), for example, utilized this model during its second quarter, repurchasing $37.8 million of BBB to A+ rated CRE CDO bonds previously issued by Gramercy’s CDOs, generating gains of $17.6 million. These gains partially offset Gramercy's additional $23.2 million in loan loss provisions and allowed the Company to maintain funds from operations just above its dividend payout.
The purchase of the senior CDO debt would be even more effective for those REITs struggling with qualification issues. In addition to the positive accounting effects noted previously, the senior note holders have control over whether a CDO is liquidated once an event of default is declared. The repurchase of the senior CDO debt would allow the issuing REIT to recapture the diverted cash flow and allow the REIT to prevent the liquidation of the CDO and thus preserve the recognition of qualifying REIT income. Of course, the issuing REIT would have to proactively seek to repurchase the senior CDO debt before it becomes obvious that the CDO is in trouble.
Mortgage REITs may be up against a wall when it comes to originating attractive new investments, but they shouldn't forget about the magic that can be made by rediscovering old ones.