Crystal River Capital, Inc. Q2 2008 Earnings Call Transcript

Crystal River Capital, Inc. (CRZ)

Q2 2008 Earnings Call Transcript

August 11, 2008 11:00 am ET

Executives

Bill Powell – President and CEO

Craig Laurie – CFO and Treasurer

Analysts

Jason Arnold – RBC Capital Markets

Glenn Krochmal – Weather Gauge Advisory

James Shanahan – Wachovia Securities

Tim Wengerd – Deutsche Bank

Presentation

Operator

Good day everyone, and welcome to the Crystal River Capital second quarter 2008 earnings conference call. My name is Margaret, and I will be the coordinator for today's presentation.

Before we begin, I would like to point out that some of the statements made on this conference call may be forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934 and Section 27A of the Securities Act of 1933 that involve risks, uncertainties, and assumptions with respect to Crystal River, including some statements concerning the transactions described on this conference call, future results, projected sector returns, plans, goals, credit market conditions, and other events that have not yet occurred.

For a description of factors that may cause Crystal River's actual results to differ from those expressed in these forward-looking statements, please refer to Crystal River's 2007 Form 10-K, the first-quarter 2008 Form 10-Q report, and its other reports filed with SEC, which are available on Crystal River's website, and the second quarter 2008 Form 10-Q report, which will be filed with the SEC later today.

As a reminder, this call is being recorded. With that, I will now turn the call over to Mr. Bill Powell, Crystal River's President and Chief Executive Officer. Please go ahead, sir.

Bill Powell

Good morning everyone, and thank you for joining us to review Crystal River's second quarter results. With me today are Craig Laurie, our Chief Financial Officer; and Jon Tyras, our Vice President and General Counsel.

I will begin by making a few remarks about the current market conditions and our next steps as a company before I hand the call over to Craig, who will walk you through our assets, liabilities, and financial results in more detail.

In July of last year, the Real Estate Finance sector began to show serious signs of a liquidity-related distress. This was in addition to the distress that had already begun in the securitized residential products market. Now, over one year later, the markets remain illiquid and dislocated. As we forecast earlier this year on our first quarter earnings call, the credit environment has continued to deteriorate, and market participants are now beginning to experience adverse credit events. Capital, either in the form of debt or equity, is difficult to raise.

With these market conditions as a backdrop, during the first quarter, we outlined a number of actions that we believed would enable us to successfully weather the current and future market conditions. Those actions included de-leveraging the balance sheet and reducing liquidity risk, selling our agency mortgage-backed securities portfolio and our low-yielding commercial home loan portfolio, and reducing borrowings under our funding facilities.

Thus far in 2008, we have made significant progress in these efforts. The sale of our agency mortgage-backed securities portfolio in the first quarter and the sale of our low-yielding home loan portfolio in the second quarter were important steps as these actions reduced our outstanding repurchase debt $22 million from $1.3 billion. At June 30, 2008, our short-term debt, consisting of repurchase agreement debt and debt under our secured revolving credit facility totaled approximately $60 million, which is significantly down from $457 million at March 31, 2008, and $1.3 billion at December 31, 2007. As of today, our short-term borrowings have been further reduced to approximately $53 million.

As we enter the second half of 2008, we do not expect the adverse liquidity and credit environment to improve. Evidence of an increase in adverse credit events that impair asset quality and value can be seen in the market-wide commercial mortgage-backed securities delinquency statistics, and the operating results of certain financial companies with exposure to commercial real estate loans, CMBS, and RMBS. These developments affect the marketplace and Crystal River by further reducing liquidity, cash flows, and asset values.

With respect to the residential mortgage-backed securities, we are cautiously optimistic that the recently-enacted governmental programs may have some positive impact on certain subprime loans and securitizations, including portions of the company's portfolio. However, we do not believe that the overall residential mortgage finance market will stabilize until home prices firm up and the impact of these lower home prices works its way through the various real estate financing markets.

Additionally, the RMBS market is experiencing significant numbers of downgrades from the rating agencies. These downgrades impact Crystal River directly in that one of the performance triggers, one of the company's CDOs, is tied specifically to the ratings of the underlying bond. These downgrades will cause one of the performance triggers to fail, which will divert cash income that would otherwise be paid to the company to pay down the senior CDO notes that were issued into the marketplace. While this has no impact to the company from a GAAP or from a taxable income perspective, it does take what otherwise would be free cash flow and requires it to be used to pay down debt. These trigger failures have been fully incorporated into our analysis of projecting future cash flows and into our analysis of setting our current dividend level.

With respect to commercial mortgages and commercial mortgage-backed securities, we expect that loans that do not have near-term maturities and that were underwritten with the related secured properties having cash flow in place will tend to perform better during this difficult period. By contrast, loans made on traditional or value creating properties and projects that have near-term maturities will suffer the greatest. We do not believe that the overall commercial mortgage finance market will stabilize until the consequences of these near-term loan maturities are better understood. Crystal River, through its CMBS portfolio and its commercial real estate loan portfolio, has exposure to each of these loan types.

Taking into account recent loan payoffs and extensions, we only have one loan – one commercial loan with a remaining maturity in 2008. We have two loan maturities in 2009, and all other loans have long-term maturities. The company's CMBS portfolio, which is comprised solely of fixed-rate conduit deals, which generally do not have near-term maturities, will not start to have material maturities in the underlying collateral pools until 2010.

Speaking to the credit performance of our portfolio, we continue to only have one loan on nonperforming-loan status, the Cambridge Condominium Project in Portland, Oregon, which we have talked about in the past. During the quarter, we took an additional provision of $500,000 against this loan, which results in a net exposure of $6.3 million against this project.

Our CMBS portfolio has a weighted average delinquency rate of 0.64%, and the portion of our CMBS portfolio that we refer to as the CMBS primary asset has a delinquency rate of only 0.33%. Our RMBS portfolios continue to have delinquencies that track market-wide data. The delinquencies within our CMBS and RMBS portfolios are fully incorporated into our cash flow projections.

As a result of these market views and portfolio considerations, our immediate focus will be to remain cautious and conservative, and to preserve cash while proactively identifying and managing risk. We will continue to endeavor to reduce our debt balance with the ultimate goal of eliminating short-term debt altogether. Our aim is to accomplish this with the proceeds from principal repayments, excess cash flow, and asset sales. This action reflects our fundamental view that the business model has changed into a model whereby long-term assets should either be matched with long-term debt or should be owned debt-free.

In line with our efforts to preserve cash, the decision was made to reduce our third-quarter dividend from $0.30 a share to $0.10 a share. We believe this new distribution reflects an appropriate balance between the discipline of paying a dividend and allowing Crystal River to further strengthen its capital base by retaining and reinvesting any excess cash flows. As it has consistently done in the past in setting this dividend, the Board considers a number of factors and will continually reevaluate these factors when setting future dividends.

As a result of the losses realized in closing out the interest-rate swaps that hedged the repurchased debt against our agency mortgage-backed security portfolio, combined with projected declines in future cash flows on some of our assets, we currently expect to generate tax operating losses for 2008 and in the immediate future thereafter. The resulting difference between our cash earnings and our taxable income should allow us to use a portion of our cash to further reduce the company's liabilities and strengthen our capital base while still complying with the redistribution requirements.

During the first quarter conference call, we also stated we were evaluating future strategic business opportunities. At this time, we believe the right strategy for our business is consistent with the strategy we outlined then and are reiterating now, which is that we will seek to create and preserve available liquidity. In the near-term, we will continue to pay down debt. We will be proactive in identifying potential risks in the portfolio.

Longer-term, we will persistently monitor market conditions so we can evaluate positive steps and high-quality investment opportunities for the company. We believe these actions; the actions that we are taking now, will not only allow us to push through these unprecedented challenges but will also position us well for the future.

I would like to now turn it over to Craig Laurie, who will address some of the specifics of the quarter.

Craig Laurie

Thank you, Bill. I will begin with a review of our balance sheet, followed by a discussion of our earnings for the quarter.

Our total assets at the end of the second quarter totaled approximately $740 million. Included in this total is a $600 million investment portfolio with commercial real estate and direct real estate loans accounting for approximately half of the portfolio; and securities comprising the other half. About 73% of the securities portfolio is owned within our two CDO structures.

Commercial real estate totaled $235 million at the end of the quarter and consists of three high-quality office buildings that are 100% leased on a triple-net basis to JPMorgan Chase. Real estate loans totaled $72 million at June 30, after we successfully sold the loan portfolio that we had designated as available for sale during the first quarter. The bulk of this sale totaling $78 million occurred in June, and the remaining $27 million closed July.

At the end of the second quarter, an additional $20 million in mezzanine loans were designated as held for sale. If sold, we expect to use the proceeds to further pay down our short-term debt.

The composition of our CMBS portfolio was unchanged during the quarter, but the carrying value was reduced to $242 million. There was approximately $35 million in further write-downs due to both increased spread widening in the CMBS market during the quarter, and the reduction in expected cash flows from some of the bonds within our first-loss CMBS portfolio.

The composition of the RMBS portfolio, which totals $54 million, or only 9% of the investment portfolio, with subprime accounting for less than 3%, was also largely unchanged during the quarter. However, we did receive approximately $4 million in principal pay-downs during the quarter, as well as recording further write-downs of approximately $27 million.

Turning to the liability side of the balance sheet, during the second quarter, the company continued its focus on reducing its leverage by paying down its repurchase agreement debt to $22 million at the end of the second quarter from $409 million at the end of the first quarter, and decreasing its outstanding debt under its revolving credit facility to $38 million.

At this time, the company has further reduced its outstanding repurchase-debt balance to $14 million while holding its amount drawn under the revolving credit facility at $39 million. These debt repayments were funded with the proceeds of the agency portfolio sale as well as subsequent to the second quarter the repayment at maturity of a $10 million investment in a construction loan in Florida.

The bonds within our 2005 CDO incurred substantial downgrades during the quarter, which has caused some of the performance-based triggers within the CDO's cash flow waterfall to fail. This causes a portion of the cash flow that would otherwise be paid to Crystal River to be used to pay down the senior liabilities. If the trigger remains in a fail position throughout the year, approximately $5 million of cash flow will be diverted to de-leverage the liabilities, still leaving approximately two times dividend coverage at this level.

In terms of the financial results for the second quarter of 2008, operating earnings for the second quarter totaled $16.6 million or $0.67 per share, compared to $19.5 million or $0.79 per share for the first quarter of 2008. The decrease over the prior period was primarily attributable to the lower interest income resulting from the first quarter sale of the company's Agency MBS portfolio, partially offset by lower interest expense on the company's reduced debt balance.

The GAAP net loss for the three months ended June 30, 2008, totaled $75.5 million, or $3.04 per share. Primary contributors to the second quarter 2008 net loss were impairment charges and mark-to-market adjustments totaling $87.7 million. Of the total charge, $69.4 million was attributed to impairment charges and net mark-to-market adjustments to on our assets and liabilities within our two CDOs, and $18.3 million was attributed to impairment charges and mark-to-market adjustments on our assets held directly.

That concludes my comments on the financial results. Bill and I will be happy to take any questions that you have now. Operator?

Question-and-Answer Session

Operator

(Operator instructions) And we will take our first question from Jason Arnold, RBC Capital Markets.

Jason Arnold – RBC Capital Markets

Hi, good morning, guys. I was wondering if you can offer a little bit more detail on the commercial loans sold during July, and kind of the pricing side of things.

Bill Powell

Jason, I will take this; it's Bill. The portfolio that we sold was the portfolio that was designated as for sale at the end of the first quarter. And it had two closings. The first closing was in June, and the second closing was in July. So, it's not meant to be confusing in that those were two sales. It was actually the same sale. It just had two different closing times. Unfortunately, one of the closings happened after the quarter ended. So, when you take the two sales together, I think the net proceeds for the company was within approximately 1% of what we had marked the assets to at the end of the first quarter.

Jason Arnold – RBC Capital Markets

Okay. And then, you also mentioned that you had some loans, mezz loans, that were moved to held for sale, I believe. And I guess I'm kind of curious what your thoughts are on pricing more or less on that side of things as well.

Bill Powell

Generally speaking, the pricing on the single-asset mezz loan and B Note part of the commercial mortgage market for high-quality assets has held up better than other aspects of the market. It's held up much better than the CMBS market, much better than the RMBS market. So, in our efforts to create liquidity and to further de-leverage the company, two of our mezz loans we designated for sale. But this doesn't mean that we will sell them. It means that they are sale candidates that could enable us to achieve our goal of paying down our debt. I would say that the spreads behind our marking those assets to market were indicative yet conservative relative to what we're seeing in the mezz loan and B Note market.

Jason Arnold – RBC Capital Markets

Okay. Is it going to be something kind of like $0.95 on the dollar, $0.90 on the dollar? Is that more or less – or is it a bit stronger than that?

Bill Powell

No, it's less than that, and I believe – I'm not sure if it's in the earnings announcement, but there is – Craig, it's –

Craig Laurie

If you went to page 9, Jason, we have a table on our real estate loans. So, the two would be the mezzanine loan fixed-rate that have been carrying value now of 20.4 versus the original value of 26.

Jason Arnold – RBC Capital Markets

Okay. All right. And then I was wondering if you could give us I guess a little bit more color on the CDO that has the trigger. You've mentioned I think $5 million in cash flow. Was that per year? And then also, do you have a time frame for when that might cure?

Craig Laurie

Yes, the $5 million is an annual cash flow that we've – if the CDO incurred no trigger failure, we would expect to receive approximately $5 million in interest distribution. The way it works is, there's a quarterly test, and if you fail the trigger one quarter, then that has no indication as to whether you're going to fail the next quarter. So, you could – it is possible to come back into compliance.

In order for us to come back into compliance, we're going to – it could take more than one quarter, although we are endeavoring to work on that, focus on that and try to lessen the amount of time that we are in failure period. That being said, in all the cash-flow projections for the company and in the cash flows that we used in setting the dividend, we assume that we failed the triggers with the conservative view.

Jason Arnold – RBC Capital Markets

Okay. Thank you very much.

Operator

And we will go next to Glenn Krochmal with Weather Gauge Advisory.

Glenn Krochmal – Weather Gauge Advisory

Good morning, guys. I had sent Marion a list of four questions that you probably have now. Do you?

Bill Powell

Yes I do.

Glenn Krochmal – Weather Gauge Advisory

Is there any reason you shouldn't just respond to them instead of my reading them out to you?

Bill Powell

That would be fine. I will read them out for the benefit of everyone else.

Question number one, there have been almost no insider purchases for the past 11 months. It appears to be a loss of confidence by executives.

I would answer that question regarding myself. I have been in blackout period since we started closing the books towards the end of the second quarter. The blackout period will end later this week, and I do intend to purchase shares.

The second question is, is the NYSE listing in jeopardy?

I would answer that by saying that we are well aware of all the listing requirements of the NYSE, and we do not see ourselves in jeopardy at this time.

Question number three is your long-term future viable?

So I would answer that by reiterating the near-term strategy and how that sets the stage for the long-term strategy. As both myself and Craig have mentioned, we are taking steps right now that we think preserve the value of the company. Just to reiterate, those steps include reducing the dividend, and taking steps to pay down short-term liabilities. Long-term, our view is consistent with the reference I made to the current business model, which is a model of long-term assets, moderately leveraged with long-term liabilities, a model that will produce stable and consistent dividends.

So we are currently focused on the near-term steps which will provide and set the stage for the opportunity to pursue the long-term strategy. So as a long way of answering your question yes, we do see ourselves as being viable.

Glenn Krochmal – Weather Gauge Advisory

Thank you.

Bill Powell

And I actually think that answers your – I think I've kind of answered your fourth question as well.

Glenn Krochmal – Weather Gauge Advisory

You did.

Bill Powell

In that long answer for number 3, if that's okay.

Glenn Krochmal – Weather Gauge Advisory

It is. Thank you, again.

Operator

(Operator instructions) And we will go to James Shanahan with Wachovia.

James Shanahan – Wachovia Securities

Thank you. Good morning. The commercial real estate portfolio – I just wanted to talk about that for a moment. It's $231 million at value, and I'm referring to – I just lost it, but there's a specific table in the press release that relates to that; it's on – looks like page 9. There’s $219 million in mortgage debt. What is – remind me what the weighted-average cost of funds is for that mortgage debt.

Craig Laurie

Jim, this is Craig. I think it was around 6.2. We do list in the Q the specific on each piece of debt.

James Shanahan – Wachovia Securities

I will check that when it comes out. But if I wanted to back into the earnings power of just that portfolio of assets, on the income statement the Company discloses rental income of $5.55 million; is that 100% just the earnings, or rental income, associated with these three properties on a quarterly basis?

Craig Laurie

Jim, this is Craig. The 5.5 includes the in-place rent as well as a mark-to-market, to bring the rent up to the market level. So obviously, the mark-to-market – bringing it to a mark-to-market level typically is not a cash basis. In our case, because we did have the rent enhancement which did bring it up to market, it is the cash basis. So the 5.5 does represent the cash NOI.

James Shanahan – Wachovia Securities

And the $420,000 commercial real estate expenses, are those specifically the operating expenses for these three buildings?

Craig Laurie

Yes. Those are primarily on the one parking garage.

James Shanahan – Wachovia Securities

If I wanted to back into what the earnings were, I could take rental income minus commercial real estate expenses, minus cost of funds associated with the $219 million, and I could get into a value with that? Anything else I should consider?

Craig Laurie

Yes, that's correct. And as well, in the Q that we're going to file later on today we show segment disclosure on the commercial buildings so you'll be able to see it specifically there as well. And that, after the cost – I think from memory it ended up being about the $5 million you save for revenue and about $1 million of expenses. It brings you down to $4 million of net NOI, which equals about a 7% cap rate on the buildings.

James Shanahan – Wachovia Securities

That goes to my next question, Craig. What do you think an appropriate cap rate is for these three properties?

Craig Laurie

I wouldn't really comment on cap rates. I would just mention – on the return on equity, whether or not cap rates moved or not, obviously your debt would be worth more as well. And we have not marked that to market for GAAP purposes, so I think the net equity would still be worth about the same.

James Shanahan – Wachovia Securities

Is the debt transferable in a sale?

Craig Laurie

I'd have to look at the specific terms, but I believe it is, obviously with lender approval, but it is transferable.

James Shanahan – Wachovia Securities

But you think that in the – for these three Southwest office properties, do you think the market would bear a 7% cap rate, or do you think it could be perhaps even a bit tighter than that?

Craig Laurie

I would say – again, I would say if you were selling the buildings with the debt in place, cap rates may have moved up somewhat, but as well we did not mark-to-market the debt. If I did mark-to-market this debt, which I think as I said had an average in-place – I'm just looking it up here. The commercial property debt was averaged in-place about 5.5%, so that's obviously below market, so you would mark down the debt. So I think the net equity would be right about the same.

James Shanahan – Wachovia Securities

Okay. Well, thank you.

Operator

And we will take our next set of questions from Tim Wengerd with Deutsche Bank.

Tim Wengerd – Deutsche Bank

(inaudible) one CDO. I was wondering if there are any triggers on the second CDO as well. I don't think they are rating-related, but just what the triggers are again?

Bill Powell

This is Bill. I can confirm there are no triggers in the second CDO.

Tim Wengerd – Deutsche Bank

Okay. All right. And then I was wondering if you could talk about your cash position right now and any cash needs that you have.

Craig Laurie

Sure, Tim; this is Craig. In terms of the cash – I think I've said this before on calls – we view the cash somewhat fungible with our short-term debt. So the short-term debt balance right now has been brought down to the $14 million plus the $39 million, so $53 million. We do have approximately $2 million in cash.

Bill Powell

And we have available capacity on the line. The line is still a $100 million line.

Craig Laurie

Restricted cash is still approximately $27 million.

Tim Wengerd – Deutsche Bank

Okay, great. Thank you.

Operator

And with no further questions in the queue, ladies and gentlemen, this does conclude today's conference call. We thank you for your participation. You may now disconnect.

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