CMBS Article
Here is an article (subscription required unless you email it to yourself) from today's Wall Street Journal on the CMBS market.  Commercial mortgage default rates, defined as more than 60 days past due, for mortgages in CMBS are now at 7%, and are expected to reach 11% by year-end.  This article confirms what I have been hearing, in that special servicers, the firms tasked with handling defaulted mortgages, are getting more creative in restructuring mortgages.  Until recently, the special servicers only real options were to extend a mortgage for a short period or give a break on interest rates, as their sole goal was to protect CMBS investors from losses.  This task is getting untenable as the scale of defaults and pending maturities are changing CMBS dynamics.  Here is a long quote from the article:

Servicers have restructured about $13.7 billion of those loans, according to estimates by analysts at Deutsche Bank. Such restructurings, which include extending loan maturities and reducing interest rates, could help bondholders and borrowers avoid bigger losses as the economy recovers. But some borrowers still wind up defaulting.

Such firms—including LNR Property Corp., owned by private-equity firm Cerberus Capital Management LP, and CW Capital, majority-owned by Canadian pension manager Caisse de Dépôt et Placement du Québec—are "going to trot out the entire playbook" used during the real-estate crash of the early 1990s, said Mark Warner, a managing director at BlackRock Inc.

One emerging restructuring strategy involves cutting mortgages into good and bad pieces. For example, Grossman Company Properties was in danger about a year ago of defaulting on the $190 million mortgage for its Arizona Grand Resort in Phoenix, which is suffering from a decline in business and leisure travel.

The loan, originated by Greenwich Capital, was part of the Goldman/Greenwich deal in 2006, which also includes troubled loans on an office complex in downtown Los Angels and six retail stores. Grossman is led by real-estate investor Sam Grossman, who made a name for himself by snapping up distressed assets in the early 1990s. After months of negotiations with CW Capital, Mr. Grossman's company struck a deal allowing it to keep the property in return for a $5.8 million capital infusion.

The original Grossman loan was split into two parts, with the cash flow from the 640-room resort, equipped with two golf courses and a water park, now used only to service the debt on the $100 million part of the loan, Deutsche Bank said. The second slice, totaling $90 million, will get no payments until the loan matures in 2016 and the first part of the loan gets paid off.

The net effect of this restructuring is that it allows the subordinate bondholders to avoid taking a loss before the loan matures while delaying the recoveries for senior bondholders, Deutsche Bank analysts note. Supporters of the restructuring said the move was in the best interest of all bondholders and the borrower because liquidating the property likely would have resulted in large losses.

It is my opinion that this new flexibility will help the real estate market.  I suspect it will also spur more commercial mortgage refinancings, which will also help the real estate market.

More HTA
The table below shows how Healthcare Trust of America funded its distributions in 2009 on a quarter-by-quarter basis.  The table was derived from data in a March 8-K filing by HTA.    The key to me is the second half of the year where operating cash flow is much less than in the first half of the year.

	12/31/09	9/30/09	6/30/09	3/31/09
Total Distributions	$23,900,000	$21,908,000	$18,004,000	$14,247,000
OP Cash Flow	$5,033,000	$1,718,000	$8,355,000	$5,895,000
Offering Proceeds	$18,867,000	$20,190,000	$9,649,000	$8,352,000
Dist as % Op Cash	21.06%	7.84%	46.41%	41.38%
Dist as % of Offering Proceeds	78.94%	92.16%	53.59%	58.62%

Yes, the REIT saw increased equity in the second half of the year, which would contribute to the drop in the operating cash flow-to-distribution coverage ratio discussed in the previous post, but it also saw a drop in operating cash flow over the same period.  The low operating cash flow-to-distribution coverage ratio cannot be fully explained away by problem of raising too much equity.  This ratio bears close attention in the coming quarters, especially since HTA made more than $400 million of acquisitions late in the fourth quarter, which ideally should be accretive to the REIT's current 7.25% distribution.

It'd Be Funny, If it Wasn't Serious
I need to stop reading public non-traded REITs' 10-Ks.  They're not good for my mental health, but reading them is like watching Kate Gosselin on Dancing With The Stars, so bad, yet you can't look away, or stop from snickering.   Healthcare Trust of America's (HTA) 2009 10-K has plenty of gems, and it may take more than this post to point some of them out.  The latest outrageous example of egregiousness is the compensation of HTA's Chief Executive Officer / President / Chairman of the Board.  This executive saw his total compensation jump from $504,753 in 2008 to $2,834,688 in 2009, the same year in which cash distributions as percentage of operating cash flow dropped to 25.5% from 66.3%.   I know HTA carried a large cash balance in 2009 as it dealt with large inflows of investor equity, and I know HTA did not acquire significant properites until late in the fourth quarter, and I have not done an analysis on the extent to which new investors may have increased the distribution pool, but a $2.3 million, or 5.6 times increase in total comp is troubling.

It is important to note that while an increase in investor equity would cause the amount of cash required to pay distributions to increase, it would not have an impact on operating cash flow.  HTA's operating cash flow increased $324,000, or 1.6% in 2009.  The properties bought late in 2009 likely did not show up in cash flow, but the properties acquired in 2008 should have, as they had a full year on the books.  Is that minuscule rise in operating cash flow worth $2.3 million?

I list below a large portion of the compensation discussion that is taken directly from HTA's 10-K:

Base Salary. Base salary provides the fixed portion of compensation for our named executive officers and is intended to reward core competence in their role relative to skill, experience and contributions to us. In connection with entering into the employment agreements, the compensation committee approved the following initial annual base salaries: Mr. Peters, $500,000; Mr. Engstrom, $275,000; and Ms. Pruitt, $180,000.  The compensation committee approved an increase to Mr. Peters’ 2008 base salary in order to more
closely align his base salary with our peers. However, due to the compensation committee’s focus on  performance-based compensation, Mr. Peters’ base salary approximates the lower end of the scale of base salaries provided by our peer companies. To emphasize performance-based compensation, the compensation committee designed Mr. Peters’ compensation package so that the majority of his cash-based compensation may be earned through an annual bonus after the compensation committee’s assessment of his performance during the year.

As discussed above, the initial base salaries for Ms. Pruitt and Mr. Engstrom were negotiated in connection with their joining our company. Also as discussed above, a key priority for us is to attract, retain and motivate a top quality management team. In order to attract a high caliber management team, the compensation packages offered must be competitive within the market, as well as reflective of the executive’s level of skill and expected contributions. These were the guiding principles followed by Mr. Peters and the compensation committee in negotiating the compensation packages with Ms. Pruitt and Mr. Engstrom.

Annual Bonus. Annual bonuses reward and recognize contributions to our financial goals and achievement of individual objectives. In 2009, we did not have a formal bonus program. Each of the named executive officers is eligible to earn an annual performance bonus in an amount determined at the sole discretion of the compensation committee for each year. Pursuant to the terms of their employment agreements, Mr. Peters’ initial maximum bonus is 200% of base salary. Mr. Engstrom’s and Ms. Pruitt’s initial target bonus is 100% and 60%, respectively, of base salary.

The compensation committee, together with Mr. Peters, developed a broad list of goals and objectives for 2009. The compensation committee awarded Mr. Peters the maximum bonus payable to him under his employment agreement based on its assessment of his performance during fiscal year 2009. In reviewing his performance, the compensation committee concluded that Mr. Peters accomplished, and in many cases, exceeded such goals and objectives, which included:

•  effectively leading the expansion of the company, including growing our portfolio through the acquisition of quality, performing assets;  
• successfully negotiating substantial and creative value-added transaction terms and conditions;    
• coordinating successful and competitive refinancing transactions during a time of significant dislocations in the credit markets;
  leading our successful transition to self-management;
• recruiting and effectively supervising our employees;  
• implementing effective risk management at all key levels of the company;
• maintaining a strong and solid balance sheet; 
• coordinating the engagement of new, competitively-priced and performance-driven property management companies for our portfolio; 
• leading the extension of our initial offering for up to 180 days, successfully transitioning the dealer manager for our initial offering to RCS and spearheading the registration of the follow-on offering; 
• establishing and enhancing our relationships with commercial and investment banks; 
• maintaining and actively enhancing our “stockholder first,” performance- driven philosophy; 
• effectively establishing our independent brand name as an asset to our company; and, 
• facilitating an open and effective dialogue with our board.

In addition to the annual bonus available under his employment agreement, after an extensive review of the peer group information and Mr. Peters’ performance in 2009, the compensation committee also awarded Mr. Peters an extraordinary bonus of $200,000. The extraordinary bonus recognizes and rewards Mr. Peters for (i) his expanded role and extraordinary efforts in providing demonstrated and effective leadership to our company, and (ii) positioning the company for continued success during recent unprecedented, difficult economic times, and in the future.

I like that extraordinary bonus of $200,000.  I wonder whether it was for ""facilitating an open and effective dialogue with the board," or "leading the extension of the Company's initial offering for up to 180 days."  How is the nearly six times jump in CEO pay putting "stockholder first," unless that stockholder is the CEO.  To me, the bonus targets are too subjective and several sound like normal tasks that are part of any CEO/President/Chairman job duties, and not factors that should be included in a bonus determination.   I examined a few other REITs' executive compensation plans, and all were quantitative in the metrics that their executives needed to achieve, not subjective goals like HTA.

As you read further, the data gets more interesting.  The increase in CEO's total compensation is disturbing, but his termination clause is hard to believe.  I list the description of HTA's senior executive termination clauses listed in the 10-K below:

Termination without Cause; Resignation for Good Reason. If we terminate the executive’s employment without Cause, or he or she resigns for Good Reason (as such terms are defined in the employment agreement), the executive will be entitled to the following benefits:

 • in the case of Mr. Peters, a lump sum severance payment equal to (a) the sum of (1) three times his then-current base salary plus (2) an amount equal to the average of the annual bonuses earned prior to the termination date (if termination occurs in the first year, the bonus will be calculated at $1,000,000), multiplied by (b) (1) if the date of termination occurs during the initial term, the greater of one, or the number of full calendar months remaining in the initial term, divided by 12, or (2) if the date of
termination occurs during a renewal term after December 31, 2013, 1; provided that in no event may the severance benefit be less than $3,000,000; 
• in the case of Mr. Engstrom and Ms. Pruitt, a lump sum severance payment equal to two times his or her then-current base salary;
• continued health care coverage under COBRA for 18 months, in the case of Mr. Peters, or six months, in the case of Mr. Engstrom and Ms. Pruitt, with all premiums paid by us; and
• immediate vesting of Mr. Peters’ shares of restricted stock and restricted cash award(s) and Mr. Engstrom’s and Ms. Pruitt’s restricted stock units.

“Cause,” as defined in the employment agreements, generally means: (i) the executive’s conviction of or entering into a plea of guilty or no contest to a felony or a crime involving moral turpitude or the intentional commission of any other act or omission involving dishonesty or fraud that is materially injurious to us; (ii) the executive’s substantial and repeated failure to perform his or her duties; (iii) with respect to Ms. Pruitt and Mr. Engstrom, gross negligence or willful misconduct in the performance of the executive’s duties which materially injures us or our reputation; or (iv) with respect to Ms. Pruitt and Mr. Engstrom, the executive’s willful breach of the material covenants of his or her employment agreement.

“Good Reason,” as defined in Mr. Peters’ employment agreement generally means, in the absence of his written consent: (i) a material diminution in his authority, duties or responsibilities; (ii) a material diminution in the his base salary; (iii) relocation more than 35 miles from Scottsdale, Arizona; or (iv) a material diminution in the authority, duties, or responsibilities of the supervisor to whom he is required to report, including a requirement that he report to a corporate officer or employee instead of reporting directly to the Board. “Good Reason” as defined in Ms. Pruitt’s and Mr. Engstrom’s employment agreements, generally means, in the absence of a written consent of the executive: (i) except for executive nonperformance, a material diminution in the executive’s authority, duties or responsibilities (provided that this provision will not apply if executive’s then-current base salary is kept in place) or (ii) except in connection with a material decrease in our business, a diminution in the executive’s base salary in excess of 30%.

I like the "Good Reason" clause that states that if HTA's offices are moved more than thirty-five miles from Scottsdale it is reason enough to trigger the CEO's termination clause.   HTA's 10-K states that the termination amount at the end of 2009 for the CEO / President/ Chairman of the board would have been $11,037,118.   If moving the office more than thirty-five miles is worth $11million, what's it worth if the printer runs out of toner?  $500,000?  What a crazy clause.  This REIT's board needs to get its act together and straighten out this compensation.  If the CEO saw a nearly six times leap in salary for lackluster financial performance, it's hard to imagine what's he going to want in compensation if performance improves for real.

Can't Fix Stupid
AIG looks to sue Goldman Sachs over losses in mortgage-backed securities that AIG insured, and then on which AIG had to pay claims when the insured securities failed.  (I think the taxpayers, via AIG's bailout, played a large role in paying AIG's claims).  AIG reminds me of a fat guy trying to hustle Michael Jordan in a game of H-O-R-S-E because he has one trick shot, and then claiming Jordan cheated after he gets beat and loses all his money.  Goldman, other Wall Street firms and hedge funds took advantage of AIG's dimwitted, short-term thinking, where AIG collected premiums for insurance it did not reserve against because it was unregulated (and therefore AIG was under no legal obligation to reserve against it), and that it never expected it'd have to honor.   The explosion in credit default swap demand should have alerted AIG to the huge problems in the mortgage market, but AIG thought it had created a new way to mint money.  The guys from State College should not play financial H-O-R-S-E with the guys from Harvard and Stanford.

Smoking Gun?
Here is an article from yesterday's New York Times about the involvement of Goldman Sach's senior management in decisions relating to the mortgage market.  I don't see a smoking gun here, I read just the opposite, that Goldman's senior management was actively engaged in what the firm's mortgage traders were doing.  This is the type of engagement that shareholders should expect from top management, especially in a line of business that had seen dramatic growth in a relatively short period of time.  It's the type of engagement that taxpayers would have liked to have seen at AIG, as a once small division (Financial Products) became huge in very short time writing un-reserved insurance policies against newly created securities that never been exposed to a full market cycle.

The article details Goldman Sach's internal debate over the housing market and how the bears prevailed in late 2006.  This was before the early-2007 collapse of the two Bear Stearns' funds that started the subprime mortgage implosion.  Goldman made a lot of money when the crap mortgage securities began to decline in value.  Here is a long quote from the article:

Goldman’s top ranks changed its stance on housing in December 2006. In a meeting in a windowless conference room on the executive floor, Mr. Viniar, the chief financial officer, and Mr. Cohn, the president, gathered about 10 executives for a briefing. Mr. Sparks, the head of the mortgage unit, walked them through the numbers. The group was unanimous: Goldman had to reduce its exposure to the increasingly troubled mortgage market

A few months later, in February 2007, senior executives began turning up on the trading floor. The message, one former employee said, was clear: management was watching.

“They basically said, ‘What does this department do? Tell us everything about mortgages,’ ” this person said.
The executives told Mr. Sparks to tell his traders to sell Goldman’s positive bets on housing. The traders’ short positions — that is, negative bets, mostly used to hedge other investments — were placed in a central trading account.

Not everyone was happy about it. One trader leaving the firm wrote the mortgage unit a one-word e-mail message: “goodbye.”

Goldman turned over all these negative positions to Mr. Swenson and Mr. Birnbaum, the traders who had previously been positive on the market. Along with Mr. Sparks, they have been credited for managing the short position that yielded a $4 billion profit for Goldman in 2007. Mr. Sparks retired in 2008. Mr. Birnbaum also left in 2008, to start his own hedge fund.

But former Goldman employees said those traders benefited from the short positions that were given to them. And their trading was tightly overseen by senior executives.

At one point in the summer of 2007, for instance, Mr. Birnbaum made a case to Mr. Cohn that some mortgage assets were cheap and that Goldman should let him add $10 billion in positive bets. Mr. Cohn said no.

Goldman / Paulson's Magnetar Trade

My last post linked to an article that detailed how a hedge fund helped create CDOs and then bet against those CDOs.  Today, the SEC charged Goldman Sachs with doing nearly the same thing.  Goldman, according to the civil suit filed today, allowed hedge fund manager Paulson & Co to select mortgages for inclusion into CDOs.  Paulson selected the mortgages it felt had the most default risk.  Goldman then sold the CDO to institutional investors while Paulson bought a credit default swap (insurance) that paid off when the CDO defaulted.  Here is an explanation from the New York Times:

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst. 

Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds. 

But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.

I like this paragraph near the end of the article.  Our old friends at AIG, of course, provided the insurance through the credit default swaps that made Paulson so much money:

In seven of Goldman’s Abacus deals, the bank went to the American International Group for insurance on the bonds. Those deals have led to billions of dollars in losses at A.I.G., which was the subject of an $180 billion taxpayer rescue. The Abacus deal in the S.E.C. complaint was not one of them.

Must Read
Here is a link to an incredible article about the financial crisis.  It details how one hedge fund helped prolong the credit boom.  Cracks in the system began to show in 2005 when spreads on securitized loans (CDOs) began to expand, as Wall Street became nervous about the quality of the securitized offerings.  In stepped a new hedge fund, Magnetar, which aggressively sought the riskiest pieces of new CDOs called the "equity" tranche.  Magnetar's willingness to acquire the small portion of equity, in the range of $10 million, and typically the hardest part of a CDO to sell, allowed investment banks to create CDOs in the range of $1.5 billion or more.  Magnetar even had a hand in developing the CDOs, picking actual securities that would comprise a CDO's holdings.  Magnetar wanted the riskiest loans available in the CDOs where it bought the equity.  While Magnetar was buying the equity and loading up the CDOs with as much risk as possible,  it was also buying credit default swaps, betting that its CDOs would default.  Defaults was where it made huge profits, more than offsetting the loss of the equity portion.  At one point, Magnetar was even able to package and sell some of its CDO equity portions.

Magnetar's willingness to buy high risk CDO equity sparked a resurgence in the CDO market, and therefore mortgage lending, leading to record underwriting of CDOs in 2006 and into 2007, until the whole market collapsed in the summer of 2007.  Magnetar posted huge profits in 2007 as its bets against its CDOs paid off.  This article debunks the thought that no one saw the credit crisis coming.  As early as 2005 the warning signs were apparent, but the availability of money, especially equity, caused investment banks to overlook the obvious.

Employment Figures
The economy added 162,000 net new jobs in March.  I think this is good news, even if about a quarter of the jobs are temporary Census hires.  I like the look of the chart below, stolen from FiveThirtyEight.com:

It shows employment trending in the right direction.  The unemployment rate stayed at 9.7%, reflecting in part more people who'd been out of the work force coming back looking for work.  The link above to FiveThirtyEight has more in depth analysis of today's report.

More on Non-Traded REITs 
I mentioned at the end of the last post that I'd have more to write on Behringer Harvard Multifamily REIT I (BHMF).  I think it is important that broker / dealers and investors read its 10-K.  It's complicated, but will give you a good picture of what the REIT owns.  It may surprise some broker / dealers to know that the REIT's strategy has been to acquire apartment complexes via development, and more specifically through mezzanine loans to apartment developers.  The mezzanine loans are junior to construction loans and the mezzanine loans will convert to equity when the developments are complete.  Many of the REIT's recent acquisitions have been newly constructed apartment complexes (or properties originally build as condos that are now being rented as apartment communities) that need to be leased. 

I don't have a problem with BHMF's investment strategy.  It's a perfectly fine, legitimate method of acquiring real estate.  Broker / dealers need to understand that BHMF is not simply buying cash flowing garden style apartment complexes.   BHFM's investment strategy will not allow it to pay distributions from operating cash in the near term because its properties are either under construction or in lease up.  Given the strategy, the negative Funds From Operation is not shocking or even unexpected, but it's eye-opening when you see that the REIT paid a 7% distribution to investors.   I don't have a guess when operations will fully cover the REIT's distribution, but I wouldn't expect it to cover in 2010.  Note that the BHMF had actual rental revenue in the fourth quarter.

Investors need to be compensated for the extra risk of development and acquiring properites in their lease-up phase.  This is simple investment risk/reward, where a risky investment should pay a higher return than a less risky investment.  Obviously, an investment that develops its properties should generate a higher return to its investors than an investment that acquires existing properties with established, stable income.

Sponsors of non-traded REITs get pulled by competing forces.  Broker/dealers want high distributions, but they want those distributions to be stable, low-risk and covered from operations immediately.  BHMF raised more than $40 million a month for the first two months of 2010.  I wonder how much this REIT would raise if it told broker/dealers it would only pay distributions generated from operating cash?  I don't think it would be $40 million a month.  You can't single out BHMF for "buying" its equity capital with the 7% distribution, because it is not alone in this practice, far from it.

Broker / dealers should analyze specific acquisitions made by their approved non-traded REITs that are in capital raising mode.  This eliminates the influence of excess cash waiting to be invested, and determines whether acquisitions are accretive to the REITs' expected or current distributions.  (A specific property's cash return to a REIT, based on the  REIT's investment in the property, should generate sufficient cash to support a REIT's distribution.)  If a REIT is acquiring non-accretive properites, broker / dealers better ask why, because REITs that are acquiring properties that are not accretive to their current distributions will eventually have to cut their distributions.  Broker / dealers should not feign surprise when distribution rates get cut.