Variant Perceptions

Category: due diligence

TARP warrants: let every eye negotiate for itself and trust no agent

A secret about the TARP warrants is starting to spread.

Most have heard of the adjustment to the strike price after dividends but there is more to the anti-dilution clauses than just the adjustment to the strike price. A few months ago I decided to cryptically suggest this insight in a visited message board, where many were buying TARP warrants, to see who else had caught it.

Actually, not many. One of the few, the author of today’s post.

Over the last few months we have discussed the anti-dilution clauses. He recently decided that it was time to confirm the major insights: discussed them with a few lawyers, that did not help much, and ran the math with one of the small banks that has TARP warrants. He finally put some of the insights, but not all, in a document. It starts with a great Mark Twain quote so how could I not like it. I am thankful that he accepted to share it in this blog.

Both Bruce Berkowitz and Francis Chou mention the secret in their most recent letters. It is mentioned so cryptically as if they did not want it to be known. In the same cryptic style, the author of this post asked to remain anonymous.

There is a lot more to the anti-dilution clauses than what is being discussed in the blogs, the press, and even this post. If you are interested, I suggest you separate several hours and READ the prospectuses fine print.  Also the numbers are from a few weeks back and not all warrants mentioned in the table are from TARP or even have the same fine print. There are no shortcuts in this investment, you have to read a lot.

For more information, I first mentioned the TARP warrants almost two years ago in the following post:

Disclosure, we both are long a few of the mentioned TARP warrants



I am frequently asked, “So what is XXXX’s edge?” I think it is possible that in some cases we eliminate 80% of the competition when we start by reading the annual report. It never ceases to amaze me, how frequently we find that an investor in a particular company did not bother to read the annual report, including professional investors.

Now get ready for some tedious reading! If you do not feel like chewing leather than you are well advised when I say you should skip the following two pages.

Recently, I realized again how few investors bother to read the primary documentation, when researching the TARP warrants of US banks. I expect analysts and investors in these warrants to be do more research than the average sophisticated investor in equities due to the offbeat nature of warrants. However, it quickly became clear to me that analysts, investors and the press clearly did not bother to read the prospectuses of the warrants. Samuel Clemens (a.k.a. Mark Twain) used to say that “A person who won’t read has no advantage over one who can’t read” and that certainly rings true here.

For the benefit of those that have not heard about TARP warrants;

  • TARP- Troubled Asset Relief Program
  • Warrant- The right to purchase an equity security for a certain period at a certain price.

TARP is one of the programs that the US government created to bail out the banks. For example it allowed the US Treasury to purchase newly issued preferred equity from various banks e.g. Bank of America. The US Treasury received warrants, called TARP warrants in this case, with these shares. In time the US Treasury either sold the warrants back to the respective companies or it sold it off into the market where lesser mortals like us can now buy them.

The warrants have some important features.

  1. They are long term; 10 year warrants expiring around 2018-2021
  2. They have various anti-dilution adjustments
  3. The exercise price when compared to current tangible book value is low.

Continuing with the BAC A warrants as an example,

You can learn this by simply reading the relevant prospectus.

Technically, in the case of BAC and others, it is not the prospectus that holds the important information, it is the supplement to the prospectus. When you read the anti-dilution adjustments you note that the exercise price is adjusted downwards in some cases (e.g. when a cash dividend is declared) AND the number of warrant shares (shares/warrant) is adjusted upwards.

You can learn this by simply reading the relevant prospectus.

Last year you could purchase the BAC warrants for as little as $2.00-$3.00 with an exercise price of $13.30. Today, BAC’s book value is $21 and tangible book value is $12. We are NOT advocating that paying $2.00- $3.00 for the right to buy BAC until 2018 for around current book value is a good deal, but it is worth investigating. Particularly if there is potential for the exercise price to be reduced AND the number of warrant shares to be increased every time a dividend is declared.

You can learn this by simply reading the relevant prospectus and looking up the price.

There seems to be a general misconception in the market that the anti-dilution adjustments only apply to AIG TARP warrants, mainly because Bruce Berkowitz spoon fed the market with a statement in the press about AIG. However, these adjustments are not exclusive to AIG TARP warrants; in fact the exact opposite is true.

You can learn this by simply reading the relevant prospectuses.

In the case of BAC it also pays to read the “prospectus” for the warrent, Warren Buffett negotiated for Berkshire Hathaway in Aug 2011. Warrent, Warren. Get it? Eh, ok, I will move on.

The warrent comes with a strike price of $7.14 and 700m warrent shares (6% of BAC outstanding shares) and has the same anti-dilution adjustments as the TARP warrants. It is quite plausible for the warrent shares to increase from 700m to 1Bn AND the exercise price of $7.14 to be reduced to $5.00 over the 9 years to 2021. What can we say? The Master strikes, yet again!

You can learn this by simply reading the relevant prospectus.

Those of you that stuck with me through the section on warrants either enjoyed it or must feel like the man that tried to commit suicide by drowning himself in a puddle of water, one inch deep. The good news is, it is almost over.

When you research the various warrants you should realize that all these warrants are not created equal and we have found the most significant differences are evident when

  1. you compare the relevant company’s current tangible book value with the warrant’s exercise price and
  2. the normalized dividend per share.

In the case of b) I mentioned that the warrant shares adjust upwards AND the exercise price downwards when a dividend is paid. Technically the relevant amount is the difference between the dividend per share paid and a threshold dividend per share. This threshold was set by the last dividend per share payment at the time the warrant was issued. Most of these warrants were issued in the depth of the financial crisis, which means that in most cases the “last” dividend that was paid was at a time of peak profitability and before very substantial share dilution. Therefore, it is prudent to adjust for this and when we do so we come up with the following comparison.

We reiterate, neither are we making a case for or against buying the warrants nor are we saying this is anything more than a simplistic analysis. As always you have to do our own homework! 

We are simply saying that the relationship between the exercise price and the current book value and the relationship between the historical dividend per share and the threshold for the dividend to give you the “kicker” are very different from company to company. Therefore the investor that has that knowledge most certainly has a huge competitive advantage and in the case of the TARP warrants we believe it is a minority that understands the differences. All it takes is for the investor to read the relevant prospectuses.

Thinking about investing in US banks? a short answer to David Merkel

In the comments section to the post Three Years After Lehman I got this deceptively simple question from David Merkel, the author of the classic The Aleph Blog,

I recommend that you try to talk with M3 Partners, Chris Whalen or Hovde – if they will talk to you. They know banks far better than I do, and I am pretty certain they are bearish.

I’m no expert on banks. I only have a few question marks:

  • Exposure to Europe
  • Exposure to repo lending/borrowing
  • Lack of clarity because of illiquid assets, and lack of mark-market accounting.
  • Home equity lending
  • Over-reliance of clipping pennies from the Fed, at a time when the front end of the yield curve has collapsed.

Basically, I don’t trust the accounting. Why should I buy bank stocks when I can buy safer insurers at similar or better discounts, where I know the accounting is mostly fair, and the liability structures are stronger?



My first thought was that it was nearly impossible to answer all David’s “few” question marks in the comment section but surely I could answer his insurance versus banking question. How wrong I was. When the short answer became two pages long it was fairly obvious that it was the stuff for a post. It probably needs editing but the short answer was already taking too much time:



I am sure others do not feel as comfortable as you with insurance accounting and underwriting standards. I certainly do not and you have been my man when I want corroboration on those issues (smile)

I imagine that when you mean investing in insurance companies, you are referring to insurance companies where you personally feel comfortable with their underwriting and their history. Besides basic rules of thumb to check reserves, the accounting will not help much predicting future losses.  Also I suppose that there are some sectors that you would not trust like life insurers with large guaranteed annuities portfolios or some mortgage insurers.

That reaches a central point of investing in financial firms: some leap of trust is almost always needed. For insurers you cannot know every single policy, for banks you cannot know every single loan. There are a couple of mREITs that I know all their loans but those are an exception.

There are several investment approaches to this “leap of trust” thing:

  1. Do not trust any financial firm ever: that has been the path taken by several good investors. They prefer to keep it outside their circle of competence and I will not try to convince them to change. You have to pick your spots. At the same time, there is a leap of trust in any type of investment (BP/security, NWSA/ethics, HPQ/acquisitions) even if you trust the accounting, that as we know it is not always the case. I personally have lost money investing in some simple businesses, in simple industries with lots of net cash, and instead made substantial returns in some complex distressed situations.
  2. Buy great companies with great teams: Because of some accident an investor may get to know in depth some financial sector (you insurance, me banking) and get comfortable with some teams. Good teams can avoid disasters for decades and the top of them can regularly achieve 12%+ average ROE and grow. That is a recipe for fantastic returns. I consider this approach risky. Historically many have had style drift like AIG and also be exposed to nationwide cataclysms. For example, Bank of Ireland was the best of Irish banks but that did not help much. Besides, it can nurture complacency and abdication on the part of the investor.
  3. Wait for the earthquake and look for survivors: that combined with signs of a new management team doing what is necessary (exiting marginal business, manage for capital and cash flow, reducing legacy assets significantly) can be a powerful combination. You are NOT trusting management, you are seeing it in action and following its progress.

As you have probably noticed this blog is mostly devoted to turnaround investing and that means point #3. It is a way of trying to avoid the pitfalls of #2 by waiting to see the order of magnitude of the cataclysm and watch management in action not just in words or reputation.

One key historical advantage of approach #3 for banks is that damaging credit bubbles are usually tied with real estate booms, deregulation, overvalued or even fixed exchange rates (for countries not indebted in own currency), and sustained current account deficits. Some recent examples are Latin America 82, Scandinavia 90, Mexico 94, Asia 96, Argentina 00, Subprime 08, Eastern Europe and PIGS 11. Bubbles driven by excess internal depository savings badly invested are much more rare and different in their consequences (Japan 1990s, maybe China today).  That provides several advantages to an informed investor:

  • Avoidable: Real Estate is a big proportion of banks’ balance sheet and usually with deregulation capital is lobbied to be thinned. Most crisis in other categories are usually sideshows: they are not big enough or risky enough. So by only following a couple of categories it is possible to avoid 90% of banking crisis.
  • Measurable: when the punctuation hits Real Estate, the other categories follow linear processes that can be measured and followed for a sign of a turn (with the exception of C&D, always one big if):
    1. Pricing and collateral of new loans are improved
    2. Regulators are tougher
    3. Bubble loans become a lower percentage of portfolio over time
    4. Cash and liquidity increases
  • Scope limited: wherever real estate goes (residential or commercial depending on the type of bubble) that is where the banks will go. If the government does not intervene, watch out (1932). If the government delays or avoid the devaluation of a fixed currency (Greece, Ireland, Spain today) watch out. Loans that are non-performing are difficult to hide. They will show in regulator reports, the cash flow statements or real estate industry reports.
  • Time limited: CRE and MBS from bubble times become a lower percentage of the total portfolio over time, while the new loans should be perfectly OK with the improved underwriting and pricing.
  • Hated or unloved: headlines do not help and many people were financially burned, so you can wait for confirmation before investing. People get trapped in the morality tale just when it is already in the past. Also it is not like buying the dip is a must, there may be several opportunities. The important part is to improve the probability of a hit because the upside is enormous anyway.
  • Replicable: learn one running play and play it ad infinitum. There is always a country suffering undeserved short term capital inflows, misusing them, and becoming the next candidate for a banking blow out  … with the following renaissance. Just look at Greece or Australia. There are twists here and there, like for example countries indebted in their own currency like the US, but isn’t it nice to have a perpetual compounding machine?

The funny thing is that at the moment there is not a single bank stock in my portfolio. It is circumstantial because I have had small and medium banks on and off over the last year and I think the banking sector today is fertile ground indeed.

In this blog I have tried to bounce and structure ideas on approach #3, the turnaround approach. It needs more work, pragmatism and flexibility than what is normally understood as value investing. Its success is tied to avoid investing in every single opportunity but only the high probabilities, and there must be several high probabilities in the banking sector today:

  • Good industry: there is a bank in every Western film. There is a bank branch or an ATM in every commercial location. That is how critical and entrenched are banks in a modern economy and even its history. It is oligopolistic at the local level, without technology obsolesce, and has high regulatory barriers to entry (just ask Walmart). Chris Whalen may not like the oligopolistic setup but I am not seeing many advocates of a utility model. And the alternative of too much dumb private competition was one primary reason of the mess we are in. A highly regulated and oligopolistic model has historically worked.
  • Pool of good businesses: retail banking is a local business where you want strong local market share (or a collection of strong local market shares like Bank of America and Wells Fargo). There are plenty of cheap banks with local dominance funded by long-term low-cost deposits with margin to absorb negative shocks. It is not like Bank of America is the only option, actually I think there are better risk-adjusted alternatives with similar upside.
  • Hidden downside protection: I am finding multiple cash flow positive banks that are most probably overcapitalized and over-reserved. There is some regulatory risk (pushed to dilute) but at the current prices the upside is big even with some dilution.
  • Emphasis in the core business: loose times, loose capital. Tight times, tight capital. The best example of all is Bank of America selling stakes in Canada, Europe and China (that also reduces Private Equity and Credit Card exposure) while redoubling their efforts in the good old USA. Heavy emphasis on the core business, even if it shrinks a company, is a sign of a management that gets it. It improves profitability in the long term and reduces risk.
  • The investor has time to close the loop: I usually prefer small and mediums firms because they are less followed and their turnarounds are easier. But hate can also provide time to confirm that all skeletons are out of the closet … and banking is the most hated sector today. There are still not many in the media realizing that most banks are improving. Even the smart Chris Whalen, that has been positive of medium banks, is probably missing the improvement in the Big 4 normal operations and capital ratios most probably because of too much attention to the off balance sheet putback liabilities (issue that would require a whole new post to give it justice).
  • First cash flow statement, then balance sheet, finally income statement: And the banks cash flow is at several years highs.You can distrust the balance sheet but it is much more difficult to lie with the cash flows statement. If these loans and operations are so bad, why they are so profitable? It is not like there has not been enough time for bad loans to explode.
  • Look for stable or improving earnings potential: In non-financial firms l prefer stable or growing revenues targeting a turnaround based on cost reductions. For banks I look for stable or growing assets and deposits with provisions reducing over time. Most banks’ franchises are still intact and legacy issues are getting reduced. For example, the much maligned Bank of America has been increasing total deposits and core deposits.

And as I argued in Three Years After Lehman, the sector turnaround seems to be going full speed ahead. At this speed that means most of the US banking sector legacy issues should be behind in a year or so.

Therefore, any criticism of the banks should be focused on things off-balance sheet like putbacks or new shocks like Europe. Measuring their order of magnitude should be a piece of cake but I am not seeing many doing that calculation and much less balancing it against the capital, reserves and profitability of each bank. That is the game.

I will not try to convince you David out of insurance companies especially when they are cheap and right in the middle of your circle of competence. Actually, I think it is an interesting sector to follow these days:

But if the American commercial banks are safe, they are a lot cheaper than the American insurance companies. For example, if Bank of America survives – and I am not saying it will – it generates close to $40B in pre-tax pre-provision earnings and is priced around $80B. I do not know of any such disparities in the insurance sector (maybe you do?)

Also the situation is a little different, closer to investing in insurance companies after asbestos … the shenanigans are out in the open! You are faced with the more simple task of evaluating the trustworthiness of the companies projections without short term time pressure.

That is one huge advantage. Some time has passed and you are seeing how some of those projections have performed. Actually some competitors have gone down the drain that is also good for the survivors enjoying improving interest spreads.

With insurance companies, I personally do not know the shenanigans in this soft pricing market. Some have said that AIG was an example of a company too aggressive on pricing backed by the government but from my novice point of view they are not doing so bad in this catastrophic year. Conclusion, I do not know where are the insurance sector hidden bombs and to go by reputation and a track record is not usually my style, a style that shuns complacency.

Hope this answers your question David. Maybe next time I will post the answer to the few question marks …it is already running three pages long.

Gramercy Capital: it’s alive?

They say that the best investing is dispassionate. Fundamentals improving? buy. Fundamentals deteriorating? sell. No celebrations or funerals, just cold hard facts. I have to recognize though a sense of relief that Gramercy reached a positive settlement for Realty and will soon file its financial statements.

You might wonder why relief and not joy, was not the settlement a positive outcome?

It was. The thesis supposed a complete loss of Gramercy Realty and hinted the possibility of a legal struggle that could have taken months. Instead, the uncertainty has been completely removed with Gramercy receiving $10 million in management fees and at least $3.5 million in incentive fees for administering Realty. We do not know all the details but this is much better than getting nothing.

Even more, if you are following closely the situation you might have heard that CDO 2005 excess interest income is flowing to corporate. In case you miss that important point let me repeat it. CDO 2005 is alive and its cash flow faucet is open, Fitch broke the news a month ago.

Since last review, the CDO exited its reinvestment period. Six assets are no longer in the pool, including four CRE CDO securities sold at a loss; one mezzanine loan paid in full; and one real estate owned (REO) office property, which was exchanged for a performing office loan, as allowed under the transaction documents. While all overcollateralization tests are now passing, as of the June 2011 trustee report, the CDO was previously failing at least one test since March 2010 leading to the diversion of interest payments due on the junior classes to pay down class A-1.

But the investing emphasis in downside protection takes its toll. It’s a life of more question marks than exclamation marks and the feeling when proven right is not the joy of a Young Frankenstein surprised by his creation.

Months of checking and double checking the thesis while being patient creates anticipation with no uncertainty. Actually, the goal in investing is to avoid surprises. Good downside protection analysis should provide as much certainty as possible. And with it, it should bring the death of joy.

What do we get in return? A smirk in the face, a little gloat and relief. Being human I suppose that’s the consequence of enjoying more the process than the outcome.

Earnings Power

I have been receiving lots of questions about the consequence of the Gramercy Realty deed-in-lieu of foreclosure agreement. The following is my best guess of Gramercy’s current earnings power. Please corroborate the numbers as soon as we get the financial statements. There may have been some big changes over the last year … it has been a long time.

NII net of preferred dividends 53M – 63M
CDOs Excess Cash Flow 60M – 70M
Preferred Dividends (7M)
Fees 17M – 20M
CDOs Senior Collateral Management Fees 3.5M
Gramercy Realty Management Fees 10M
Gramercy Realty Incentive Fees 3.5M – 6.5M
SG&A (28M)
FCF pretax 42M – 55M
FCF pretax per share $0.8 – $1.1
Unrestricted Cash 150M

Using the current market multiple for Newcastle Investments NCT, that  is a very similar company to Gramercy, we arrive to a target valuation between $6.6 and $7.7 per share. And I consider NCT very cheap indeed.

Market Cap 392M 160M
Unrestricted Cash 34M 150M
FCF pretax 84M 42M – 55M
FCF multiple 4.3x 4.3x
Price Target $4.9 $6.6 – $7.7

Granted, Newcastle NCT is already paying a dividend of $0.4 per share and we are still waiting to know what Gramercy decides on this issue. At the same time, Gramercy has a better risk profile with a large percentage of its value consisting of cold hard cash and fees.

So the answer to your question readers is yes. Gramercy Capital is cheap and safe.

What’s next?

The answer is simple: here come the catalysts. And it should be an avalanche over the next few months.

  1. Financial Statements: The company already announced that we will have a 10K before the end of September. It will be time to know what has been going on the last year and to finally see the large unrestricted cash consequence of selling the Corporate New York leaseholds … if there are no other large material transaction besides the preferred buybacks and the healing of CDO 2005.
  2. Preferred Share Dividend: including the payment of 12 quarters of arrears. As you can imagine, that by itself make the preferred shares trading at par a very nice opportunity. I hope that after all the Gramercy write-ups you understand why I am looking for more by buying the common.
  3. Common Equity Dividend: Gramercy is in no hurry to reestablish them considering the recent very large accumulated loses and the large pipeline of opportunities in the CRE space. However, considering the experience of similar companies like RAIT Financial RAS and Newcastle Investments NCT, I would not be surprised with a small dividend of around $0.3 per year (30% of FCF) that would permit Gramercy to tap the capital markets in the future for the plenty of available accretive opportunities. Hey, I would not mind that FCF reinvested at 20% ROIs.
  4. Foreclosing Good Collateral:  With lots of cash, two CDOs cash flowing and management fees, there should be no worries about the future and Gramercy can be more aggressive. One way is taking control of cash flowing collateral by using the replacement strategy. Instead of continuing to extend these CDO loans why not take control of the property at great prices. Compared to banks we don’t have regulator pressure to sell them and can receive rent income instead (ie: RAIT Financial RAS). Yes, we can benefit of deed-in-lieu of foreclosures, we are not just on the receiving end.

With Gramercy Realty’s uncertainty resolved and CDO 2005 cash flowing ahead of schedule, two big mysteries were solved. But I start to wonder about the dog that has not barked … what will Gramercy do with all that unrestricted cash?

Gramercy Corporate has not been in the news in any big transaction, except for the curing of CDO 2005, and has not filed an 8K detailing one either. Without financial statements I am in the dark as everyone else but it seems Gramercy has not done much with that cash.


It is not for lack of opportunities or not enough time to close them. For example, competitors have been active over the last year. My impression is that Gramercy is preparing something big but needed to resolve Realty first before committing.

What could that be? I wish I knew but let me throw one possible scenario just for the sake of showing the range of possibilities that open up after the Realty settlement.

What if Gramercy is planning something massive like buying a large part of the dead parrot CDO 2007 bonds?

Let me repeat, this is pure speculation. But I have seen other non agency mREITs buying tranches of their non cash flowing CDOs not because they want to cure them but just because it is good allocation. When an mREIT has other sources of income, like fees and other flowing CDOs, it can take advantage of the acceleration of principal payments for the CDO senior notes.

Gramercy is both a lender and a operator of real estate, and is able to buy its debt at a discount so nothing stops it. And competitors NorthStar Financial NRF and Newcastle Investments NCT have done it too.

It might also explain why the Realty negotiations reached port so soon after a change of Roger Cozzi’s and Tim O’Connor’s incentive package that instead seemed to tip that Gramercy was preparing for a long protracted negotiation. The widening spreads of the last weeks may have provided a large buying opportunity that might have convinced Gramercy to soften a tough negotiation stand. Add that the difficult economic conditions might make difficult a turnaround of Realty … and voila?

After seeing recently buybacks of  flowing CDO bonds at 50% of par, it would not be a shock if senior CDO 2007 bonds are below 40% and that would be great. But I do not know for sure.

What can go wrong?

Gramercy has been in the news lately with the fight over two distressed loans Jameson Inns and Hilton Las Vegas. And more will probably come. However the situation is much different from 2008-2009 when delinquent loans could have compromised the viability of Gramercy. Now Gramercy can negotiate from a position of strength when the worst that can happen with a defaulting loan is a quarter or two of CDOs not cash flowing but in return Gramercy can take control of good properties at bottom prices.

In terms of macro, a Japan type of scenario with interest rates at zero as far as the eyes can see could be positive. Banks with large concentration of CRE loans have been restricted by tough regulators of lending more to the sector, so the conditions have been fantastic for the remaining lenders with 5% plus CRE loans’ yields.

The only bad scenarios that I can foresee at the moment is a 1930s depression or a large capital misallocation. And there is no evidence that we are facing either of those.

Gramercy Capital: loose ends


The delinquent financials are hiding two big events since September 2010: a large 1 million preferred shares buyback in November 2010 (not retired yet) and the sell to SL Green SLG of several New York leaseholds owned by Gramercy Corporate including the famous Lipstick building.

I also considered that the unrestricted cash in Gramercy Realty was part of the mezzanine collateral and most probably lost in case of losing the division. This is my best estimate of the current unrestricted cash considering the lack of information since September last year.


There are two aspects to consider when valuing the preferreds:

  1. Suspended dividends accumulate: Gramercy suspended preferred dividends in December 2008 so it has accumulated 10 quarters of dividends. That is $5.07 per preferred share in arrears.
  2. December buyback: Gramercy offered to buy 4 million of the preferred shares for $15 per share. That is a 50% discount if arrears are included ($25 par + $5.07 arrears = $30.07) and 1,074,178 shares were tendered

Considering both events, this is an estimate of the new shares count and their total obligation. Let me remind you that the preferred equity is the only obligation at the corporate level.


The following is an estimate of the Gramercy CDO bonds that Corporate currently owns:


The two properties in Gramercy Corporate’s portfolio were the result of distressed transactions.  Gramercy and Lehman Brothers took ownership of Whiteface Lodge in Lake Placid on April 23, 2008 by a deed-in-lieu of foreclosure. Later on in July 2010, Gramercy acquired Lehman’s 60% equity interest financed in part with CDO proceeds. Makalei Golf and Land in Hawaii was foreclosed by two of Gramercy’s CDOs and Corporate took the opportunity and acquired it in an auction with a discounted credit bid.

Both transactions testify for the available  opportunities in distressed properties especially when you know the assets in depth.

Other mREITs are following aggressively this route and I would not be surprised that Gramercy follows that path too.  Arbor Realty Trust ABR is one lender that is taking advantage of this type of opportunities over the next quarters:

Additionally, as we mentioned in our last call, we started to acquire some of the real estate securing our loans and investment taking Type 2 properties in the first quarter totaling $132 million subject to $55 million our first lien debt. Paul will take you through the accounting related to these transactions in a moment.

Additionally, we acquired two sets of properties in the first quarter that were securing certain of our loans in the normal course of our lending operating. One of the acquisitions happened in February and was related to an $85 million performing loan secured by six resort hotels in Florida. The loan had a weighted averages interest rate of approximately $3.75% and a net carrying value of $71.6 million prior to the acquisition.

As a result, we recorded this asset on our books as real-estate owned at fair value and eliminated our loan in consolidation (RR: same thing happens with Makalei and Whiteface, you have to dig for the loan amount since it does not appear in the 10K) and we are now recording net operating income from this property including depreciation expense instead of interest income.

This is a tremendous benefit for Gramercy: it is both a lender and operator of real estate assets. Compared to banks, Gramercy can take control of properties in foreclosure and not be forced to sell to comply with regulatory guidelines. While compared to an average developer, Gramercy has long-term low-cost financing to finance the transaction with CDO 2007 still in its reinvestment period. Even when the reinvestment period ends, the replacement strategy can still be used for some financial wizardry.


Some CDO experts may wonder why I did not mention the interest coverage test; the other important test that can redirect cash flow. The reason is that it does not matter much in the current low interest rate environment.

The IC test is the ratio of the CDO interest cash flows against the interest payments due to the CDO bondholders. Its goal is to make sure that there is enough cushion to ensure interest payment to bondholders. However, with CDO 2005 and 2006 being variable rate instruments and a FED’s zero interest rate policy, the denominator is very low. The IC tests pass easily.

There are other portfolio requirements to ensure basic geography diversification and avoid concentration in exotic or risky real estate instruments. Both CDO 2005 and CDO 2006 pass them and any short term failure can be cured with a replacement strategy.


One concern that I have heard in similar situations is that debt discounts signal significant problems for the equity. Well, a good margin safety especially outside the CDOs, as in this case, should be enough to dispel this concern. Even more, I think sometimes discounts do not signal anything about the underlying assets.

To understand what is going on, it is good to remember that senior CDO bonds were AAA securities with very low interest rates when issued despite being non-recourse, non-marked to market, and long term financing. A very good deal to the borrower if you ask me.

Let’s move forward in time. Having gone through one of the worst financial crisis ever, CDO bonds liquidity is much lower, despite being marketable securities, and their AAA has gone away. Actually, there has been no CRE CDO bonds issuance since the start of the crisis. Most financial institutions are faced with regulatory restrictions on what securities can be used for repos and CDO bonds are not being used for that purpose any more. Also critical stakeholders, burned by other CDOs, just want to leave this episode in the past.

So you have a double whammy where institutions that bought these bonds very expensive are willing to sell them back to Gramercy for reasons beyond the current quality of the security. The compounded effect is a large discount to par just at the precise moment that Gramercy and other mREITs would like to buy them. And Gramercy does not need to buy 100% of those bonds, it just needs a small number of institutions under these very common set of circumstances.

In other words, there is not much demand beyond Gramercy’s own and there is supply. It is not like retail investors can or want to buy CDO bonds.

Also Gramercy has perfect information of what is inside the CDOs. Not many people can or want to do a detail analysis of the assets inside them. Despite CDO 2005 and 2006 demonstrating through out the crisis a good performance compared to other types of CDOs, panicky bondholders can have other reasons not to buy.

Concluding, Gramercy sold its lenders the CDO bonds at the equivalent of Florida real estate prices in 2007 and is buying them back at 2011 prices.


This potential risk was mentioned in the “Risks” section but it might be important to discuss it in a little more depth.Despite he mezzanine loan being non-recourse a foreclosure could still carry costs. Exceptionally these procedures can get messy specially if the borrower, in this case Gramercy Realty, decides to fight the foreclosure. The reason is that the threat of a messy foreclosure procedure is their negotiation card while discussing the terms of a died-in-lieu of foreclosure.

None of the parties would want a messy outcome. But still, if the negotiations break down, because of either party overplaying their cards, Gramercy might be pushed to start a legal fight. The lenders in turn would probably sue under the bad boy provisions or a possible fraudulent conveyance even if these have no merit. See for example the legal fight that iStar Financial is enduring with Rittenhouse.

This sounds worse than it really is and the legal costs should be more than affordable with the current cash hoard. But still, the legal costs can make some some dent on the margin of safety. My comfort is that I do not see Gramercy following this route if they think it could compromise the viability of the company.

Long GKK


CDO 2007

CDO 2006

CDO 2005

Gramercy Capital: management team

With respect to CDO buybacks, a wise man once told me that when you can buy your debt back cheap buy it because you understand your debt better than anybody else – Michael Ashner, Winthrop Realty Trust


It seems that every time someone analyzes management teams it ends up being a pedigree review. I prefer instead to review track records and paper trails because they give a closer understanding of the players’ capabilities and motivations.

Not that Gramercy’s management does not have credentials. Just as an example, CEO Roger Cozzi was the former iStar Financial SFI chief investment officer, a Fortress Investment Group FIG managing director and a Goldman Sachs GS alumni.

However, a closer view of Gramercy’s actions shows survival skills that have been nothing short of amazing. Under the watch of the new management team that took over in October 2008, including among others CFO Jon Clark and President Tim O’Connor former COO of iStar Financial SFI, Gramercy promptly made several right moves. These actions preserved capital and reduced several hundred millions of recourse obligations and tens of millions of expenses while playing near the eye of the credit hurricane.

  • Suspended dividends: for both the common and preferreds. Having just closed the AFR transaction it was tough and crashed the stock price. Painful but it was the right move and shows a team willing to face reality.
  • Exchanged trust preferreds: Gramercy somehow persuaded the holders to exchange their shares for junior notes bearing 0.25% interest. Then came back to them in 2010 for a par-for-par exchange for CDO bonds that Gramercy had repurchased that were trading at 50% of par. The whole transaction saved at least $75 million in recourse obligations.
  • KeyBank facility: Convinced a group of hedge funds which had partnered with KeyBank to accept accelerated repayment of just $60 million on a $175 million facility, for savings of at least $115 million. This was one of the most outstanding negotiations I saw during the crisis.
  • Wachovia facility: First Gramercy managed to extend it to 2011 with covenants and recourse obligations waived. Then they paid it only half in cash and the rest in a mezzanine loan participation for a profit. Nice.
  • JP Morgan facility: Taking advantage of the crisis, Gramercy negotiated with JPM to retire a $9 million facility for $2 million
  • Eliminated management fees: As part of the disentanglement of the relation with SL Green SLG, Gramercy completed its formal management spinoff saving $15 million per year in fees. Most other comparable REITs like Newcastle Investments NCT, Arbor Realty Trust ABR and RAIT Financial RAS still have outside managers siphoning fees.
  • Achieved SG&A reduction goals: The management team had a target of reducing corporate SG&A to $28 million and achieved it. This gives me confidence that they will do what is necessary if they lose Realty.
  • Repurchased preferred shares: Tendered more that 20% of the preferred shares at a 50% discount to par value plus accumulated dividends at the end of 2010 saving $15 million in recourse obligations.
  • Sold joint ventures at book value: Sold at book value several leaseholds to SL Green at book value, generating $89 million in Corporate unrestricted cash. Cash that can take Gramercy very far in the current CRE environment.
  • Bought discounted AAA CMBS: One of the reasons that CDOs 2005 and 2006 were well defended, while being in the center of the hurricane, was the fantastic reinvestment in 2008 and 2009 of close to 15% of their assets in CMBSs, rated AAA at their origination, at very high discounts to par to improve the OC/par test. Those CMBSs price have recovered strongly recently.
  • Bought back CDO bonds at large discounts: Most buybacks were closed by previous CEO Marc Holliday: $128 million par buybacks with the bulk of it in 2008 at 30 cents on the dollar. But the new team did his share of repurchases, under severe liquidity limitations, buying $61 million par at 45 cents on the dollar and was instrumental in using them used to eliminate the junior bonds.

Financial Alchemy indeed.

However we reach a point of contention: the AFR acquisition of 2008. It is very easy now to dismiss it as hubris; it drained cash and saddled Gramercy with debt at a critical point. But let’s consider a couple of things:

  • Negotiated and closed by previous team: The AFR deal was announced in the fourth quarter of 2007 and closed mid 2008. Roger Cozzi became CEO in October of 2008 with the cards already dealt for him while Marc Holliday retrenched to his concurrent job as CEO of SL Green SLG.
  • Partially paid in stock: and not only that, Gramercy’s stock at the time was a very overpriced stock at around 13-15x free cash flow. Valuable currency.
  • Good price: and the price was very good. Bought at a discount to book value and a very reasonable to the buyer 8% cap rates. If not for the credit crisis they surely would had a chance to keep this stable income stream.
  • Provided some cash flow: also the deal was closed with some downside protection since Realty generated more than to $200 million in cash flow to Corporate coffers during the last three years.
  • Depreciation preserved capital: This is an important point. To preserve REIT status Gramercy has to pay in dividends a substantial part of its taxable income. Without Realty’s depreciation, Gramercy would have struggled to preserve capital while delevering the recourse obligations. Other REITs preferred to lose their status or find loopholes by paying dividends in stock. Gramercy chose differently, keeping the benefits of its REIT status and avoiding controversial legal issues.
  • Not the end of the story just yet: while the whole investment thesis is based on the margin of safety provided by the non-Realty assets while planning for the worst outcome, the result of the Realty negotiations is still uncertain.

The transaction was badly timed and had bad consequences. Though, it had some redeeming factors and we have to balance it against the new team’s vindicating deal streak.

Gramercy also managed to preserve cash, cash that they are now ready to invest. There is a future for Gramercy without the Realty division, and maybe even prosperity, if they manage to protect the Finance Division and its CDOs.


If Gramercy loses Realty, management’s time will probably be stretched along three main goals. First, to invest its large unrestricted ($196M) and restricted ($141M) cash hoard. Second, to find alternative funding sources to rebuild the REIT. And third, closely related to the reinvestment of the cash hoard, to protect CDO 2006 and heal CDO 2005.

This last goal is crucial in assessing Gramercy’s margin of safety. Failure of an overcollateralization test can cause “phantom income” problems when cash that constitutes income is diverted to pay down debt instead of being distributed to Corporate.

Without being completely exhaustive, since I imagine management is considering other options too, I put forward three ways to protect CDO 2006 and heal CDO 2005.

Reinvestment Strategy

With CDO 2006 getting to the end of its reinvestment period but with $141 million in restricted cash one option is to invest it to improve the OC test.

So far the best way to improve collateral has been to buy CMBS at a discount. In other words, buy $100M CMBS face value for $70M and you increase the collateral by $30M. CMBSs have recovered in price, the discount decreased, and the collateral positive effect diminished … but there are still opportunities.

Another way is for CDO 2006 to repurchase its own bonds at a discount with its restricted cash. Buying discount CDO bonds would have the same effect as buying discount CMBS; it would increase the par value collateral used in the test.

There are limits to how much CDO 2006 can buy in CDO bonds and CDO 2007 is a dead parrot despite its lighter covenants on this issue. However, there are no restrictions for Corporate’s unrestricted cash.

Redemption Strategy

Gramercy Corporate, among several other mREITs, has chosen to buy back previously sold CDO tranches for cents on the dollar. It makes a lot of sense just as good capital allocation if management is confident in the collateral,.

The math is simple. The average duration of CDOs is like 6-8 years. Let’s suppose it is 7 years and the CDO bonds were repurchased at 50% of par. Using the Rule of 72, that is a 10% annual return plus interests.

And those are unlevered returns! If for example they finance the buyback with a repurchase agreement (repo) backed by the CDO bonds, like Newcastle Investments NCT did last year, those returns can be multiplied by two or three times depending on the repo haircut.

That is jolly good but the repurchase of senior CDO bonds is even more effective for REITs struggling with their OC tests. Along with the outstanding returns and accounting gain, the repurchase can help to recapture diverted cash flows if they cancel enough of those bonds.
This is the redemption strategy, the buyback and cancellation of CDO bonds to reduce the denominator of the OC test.

The redemption strategy is controversial because it is not specifically allowed in the indentures. At the same time, it is not specifically prohibited.

Some senior CDO bondholders liked their accelerated payment of principal so they protested their trustees. Since trustees have many masters to please they kicked the issue to the courts where the Delaware Supreme Court finally upheld the redemption strategy.

Concord (Winthrop Realty Trust) vs Bank of America

I am not going to pretend to be a legal expert and say that this is the last word. What I do know is that, despite fits and starts, cancellations have continued. Maybe not at the brisk pace of 2008 and 2009, where ridiculous CDO bond discounts and some REITs desperation pushed the limits, but still good enough to cure borderline CDOs.

Concluding, the redemption strategy might be controversial and CDO 2006 might be at the end of the reinvestment strategy, but we have seen that they are still useful and powerful. But for the still somewhat concerned, there is a third option.

Replacement Strategy

Even if a CDO is outside its reinvestment period or the CDO bonds cannot be bought at a sufficient discount (or faces legal opposition to cancel them) all is not lost. Gramercy can voluntarily exchange defaulted loans/securities/properties inside the CDO for loans/securities/properties that are current. These new loans/securities should be of an amount at least equal to the defaulted loan/security/property par value plus unpaid interests. The valuation difference is at the expense of Gramercy Corporate.

The math is very favorable because only a couple of quarters of CDOs cash flow can be sufficient to pay for any difference in valuation. And in addition, Gramercy would be taking control of the defaulted loan/security/property.

This strategy is specifically contemplated in the indenture of all CDOs (section 12.1) and it is not limited by the reinvestment period.

Notwithstanding the foregoing, the Collateral Manager (at its option and at any time) shall be permitted to effect a sale of a Credit Risk Security or a Defaulted Security hereunder by purchasing (or causing its Affiliate to purchase) such Defaulted Security or Credit Risk Security from the Issuer for a cash purchase price that shall be equal to the sum of (i) the Aggregate Principal Balance thereof plus (ii) all accrued and unpaid interest (or, in the case of a Preferred Equity Security, all accrued and unpaid dividends or other distributions not attributable to the return of capital by its governing documents) thereon. Notwithstanding anything to the contrary set forth herein, no Advisory Committee consent shall be required in connection with such cash purchase (the “Credit Risk/Defaulted Security Cash Purchase”).

In addition and notwithstanding anything to the contrary set forth herein (and provided that no Event of Default has occurred and is continuing), the Collateral Manager (at its option but only upon disclosure to, and with the prior consent of, the Advisory Committee) shall be permitted to effect a sale of a Defaulted Security or a Credit Risk Security hereunder by directing the Issuer to exchange such Defaulted Security or Credit Risk Security for (i) a Substitute Collateral Debt Security (that is not a Defaulted Security or a Credit Risk Security) owned by an Affiliate of the Collateral Manager (such Substitute Collateral Debt Security, the “Exchange Security”) or (ii) a combination of an Exchange Security and cash, provided that:

(i) (A) the sum of (1) the Principal Balance of such Exchange Security plus (2) all accrued and unpaid interest (or, in the case of a Preferred Equity Security, all accrued and unpaid dividends or other distributions not attributable to the return of capital by its governing documents) thereon plus (3) the cash amount (if any) to be paid to the Issuer in respect of such exchange by such Affiliate of the Collateral Manager, shall be equal to or greater than (B) the sum of (1) the Principal Balance of such Defaulted Security or Credit Risk Security sought to be substituted plus (2) all accrued and unpaid interest (or, in the case of a Preferred Equity Security, all accrued and unpaid dividends or other distributions not attributable to the return of capital by its governing documents) thereon;

(ii) the Eligibility Criteria and the Reinvestment Criteria shall be satisfied immediately after such exchange; and

(iii) the Aggregate Principal Balance of the Defaulted Securities and Credit Risk Securities so exchanged shall not exceed 10% of the Aggregate Collateral Balance as of the Closing (such limitation, the “10% Limit”).

The restrictions to the replacement strategy are standard. The Eligibility Criteria and Reinvestment Criteria are the same as for any acquisition of any loan or security for a CDO. And regarding the Advisory Committee, despite working by unanimity, it does not include representatives of the bondholders just one independent member.


Gramercy Capital is a cash flow positive Graham stock with a dividend trigger event, a good management team to invest the cash, and several other assets to boot, that should provide a good margin of safety and several low-cost options for profit.

Long GKK

PS: There is going to be a part 4 with some loose ends and exhibits

Munger on key success factors

You need a different checklist and different mental models for different companies. I can never make it easy by saying, ‘Here are three things.’ You have to derive it yourself to ingrain it in your head for the rest of your life – Wesco meeting 2002


I am having the fun of a lifetime with the BBC Sherlock, so my apologies if you do not like the arrogant and obnoxious new header of the blog. It will stay there for a couple of weeks as an experiment. And any suggestion that this show inspired the most recent banking post is probably right.

PS: I am on the fence on the Asperger or Sociopath debate, it is just a good show

Fortress International Group: fortitude is a virtue

Micro caps are a nice hunting ground because they are under the radar of most investment firms. For the same reason I do not usually talk much about micro caps because I like to have the time to increase my position and do a little trading to reduce the average cost taking advantage of the low liquidity and large bid/ask spreads.

However it seems that the cat is out of the bag and the positive characteristics of Fortress International Group (FIGI) have been discovered after the recent fourth quarter 2009 conference call. The market reaction to a barely negative earnings result may be a surprise until you realize that this is a company in a cyclical industry with positive trends.

FIGI’s Management defines its industry as mission-critical IT solutions market but in layman terms what they do is construction management, consulting, and facility management for datacenters. This industry is fragmented and probably the only competitive advantage is deep relationships based on a history of giving results. Some of their competitors are Washington Group International, Dycom Industries, Mastec, Hill International, Hewlett Packard, Holder Construction, Nova Construction, Syska Hennesey, Whiting Turner and Clark Construction. The traditional competitors were engineers and contractors, but they are being displaced by these more specialized firms.

I am not very good in the timing of macro calls, and probably many investors are selective in their good memories when they think they do. However, I also think that there is no evil that lasts a hundred years. Hey, the Great Depression lasted barely a decade. So what I look for in any cyclical is the ability to grind it out. So here is what I like about FIGI:

  1. Downside Protection: the cost structure is mostly variable and they have managed to stop burning cash the last two quarters when revenues basically dried up. It has some cash, low debt and sort term maturities have been renegotiated
  2. Good Economics: There is specialized expertise and long term relationships, so even though the industry is fragmented the pool of players is stable. The pent-up demand is substantial and a bottleneck is expected
  3. Secular Growth: Datacenter needs are growing with the increasing internet traffic. Clients revenues and capital expenditures are expected to grow double digits for the foreseeable future

Over the last four years FIGI managed to transform itself from a government dependant company to a national organization with several private clients. FIGI’s customers include data center real estate developers, co-location providers, managed hosting companies as well as customers that have traditionally owned their own data center space. The following slide from Equinix (the largest colocation player) shows some examples of potential clients, not exactly FIGI’s.

Datacenters supply picked up very slowly after the 2000 internet bust given the massive overcapacity. This provided the side benefit of a more concentrated client base and more rational capital expenditures. So for the most part, there is no significant overcapacity today and it might be argued that there are bottlenecks. To give you a flavor of the favorable economics on the client’s side, this is the stock performance of REITs in this space: they include some of the greatest under reported opportunities in late 2008: Digital Realty Trust, Switch & Data Facilities, Equinix, DuPont Fabros Technology

And what are the clients looking for in companies like FIGI besides ways of reducing capex? First and foremost, expertise in ways to reduce energy costs. And this is where FIGI becomes important because technology and innovation are central.

There are three elements that provide a margin of safety for this investment

  • Variable Cost Structure: Most of its costs are consultant salaries, which can be reduced to adjust to revenues. The elements that were no variable, like NASDAQ listing costs, board size and G&A have been significantly reduced or negotiated to a variable structure
  • Low Debt: while the cost cutting measures started taking effect in Q3 2009, FIGI has some cash to navigate the issues and the $2.2 million debt maturities were successfully renegotiated.
  • Some Recurring Revenue: the facility management division has recurring revenues that while small ($5 million approximately), is growing and provided a buffer over the last year
  • Stopped Burning Cash: FIGI has been almost cash flow positive the last quarters despite depression like revenues. FIGI demonstrated its ability to survive.

However what attracted me more about FIGI is its growth potential as the need for datacenters increases. The drivers are well known: video and graphical information is getting more pervasive with access to broadband, outsourcing based on economies of scale in managing the information, proliferation of distributed applications with distributed data (commonly known as the cloud) and the outburst of data mining applications in specific industries (financial industry and database marketing). As a result, as internet traffic doubles, the demand for conditioned space to handle it increases.

In addition, there are replacement needs in this industry. Datacenters become obsolete when they do not continue to reduce operating expenses so they need to be updated. According to a previous FIGI’s conference call:

By 2010 the same survey indicated that 50% of all the data centers will have to relocate or outsource their facilities due to changing technology trends in the cost of power. The survey also said by 2010 over 70% of all date centers will implement green computing initiatives.

Another recent article in data center knowledge stated that surveys done by both APC and Digital Realty of their customers indicated over 80% of their respondents will experience a major renovation of their space in the next 24 months and this is due to technology upgrades, green initiatives and growth.

However, the credit crunch that began in September 2008 had its effect: it reduced almost to a halt the capital expenditure in these large complexes even while the positive growth trend remained intact. The reason for the recent slowdown is that the client’s business is a very capital intensive. Building a datacenter costs around $1,000/sqft, check the following slide from DuPont Fabros :Also, some of the large clients are REITs that distribute a large percentage of their earnings in dividends and are dependent on the capital markets to fund their growth capex. As an example follow the DuPont Fabros (DFT) challenges last year.

The reduced client capital expending resulted in a significant decrease on FIGI’s backlog:

And cash and cash equivalents was severely impacted too

Demand for datacenters is still growing at 13% plus per year, while supply has been constrained growing single digits in 2008 and 2009. Client’s pricing continues to go up and that is huge incentive for new capital expenditures when leasing activity starts to loosen up.

The two year lead time for the construction of one of these complexes can be critical, because the whole industry can be in a rush to catch up with pent-up demand as soon as credit is available. Also, some major companies are looking for opportunities to outsource their needs in order to reduce CAPEX. The next two quarters should be crucial to FIGI.

Now that we have mentioned Equinix, it is merging with Switch and Data. It is important to note that the consolidation of large clients is probably the most important threat to FIGI. But, as usual with cyclicals, the investment time horizon is not farther than five years and the long term effects of increasing customer’s power is not even in the same order of importance as the lack of short term demand. FIGI is not your Buffett investment, but cyclicals in general are not Buffet investments: the time horizon is short.

Next we will review the Spartan measures taken by management to reduce their cash burn and the tactical issues of where to find the idea and when to buy a cyclical.


Maguire Properties, Liabilities (Part II)

Good liabilities are an asset – Bill Ackman

Note: this article was written for the Complete Growth Investor a couple of weeks ago. The preferreds and common had a fantastic ride since it was written. So I would recommend some caution with the margin of safety of both the common and the preferreds and please adjust the reference prices and target returns. Note also the intro written two weeks ago.

The thesis has two parts. First, to prove that MPG has a margin of safety and its liability structure will protect it from Chapter 11. If that is true, it will come perfectly clear that the unencumbered and non recourse properties should provide plenty of assets and cash flow to pay the cumulative preferreds in a year or two.

The preferreds have accumulated already $1.9 per share and will keep accumulating $1.9 per year. And there are only 10 million preferred shares with a $25 liquidation preference trading at $9 per share. I think it is safe to say we are looking to a potential 3x in two years with a clear catalyst (dividend reestablishment) and downside protection (properties with non recourse mortgages and unencumbered assets). And every quarter we wait at least we are accruing more dividends.

The second part is trickier because it is no only about showing that the common is undervalued. But more important, that it has more upside than our opportunity cost: the potential 3x of the preferreds and its higher preference in the capital structure. And there is a real possibility that I may fail to convince you given that an important part of the value in the equity is intangible optionality.

So let’s start. “Good liabilities are an asset” is a very counterintuitive thought. However, when credit is limited long term maturities and non recourse gives management options in his negotiation with lenders:

The post is dry, so I hope this chart will make things easier. The top right quadrant (Type 1) is the type of debt that you want to have, the type of debt that gives you options. In particular, if you have to refinance an unprofitable mortgage it will be in your terms because you have time (LT maturities) and you carry a stick (non recourse). It is much more difficult if you are in the bottom left corner (Type 4). The obligatory maturity payment gives the lender the upper hand. Even a profitable property in this situation, like Lantana, could be a problem. And that is the reason that its sale for a profit is such good news.

For the most part, MPG has good liabilities (Type 1 in green). However, even some of these good mortgages, the ones highlighted in red, have some recourse obligations. One is Lantana that was sold in November last year, so problem solved, and the other one is Griffin Towers recently mentioned in a WSJ article, with a $23 million recourse repo facility.

Also from the good mortgages (type 1) you have probably noticed that several are in default. Those are the ones jingled mailed (OC strategy) that I mentioned in Part 1 of the series:

I’d like to begin my comments this morning with a brief background on the assets involved in our plan announced today. All seven of these assets were acquired by the company after the initial public offering of Maguire in June 2003.Four were part of the acquisition of 24 EOP/Blackstone assets in April 2007. One was part of the acquisition of the common wealth portfolio in March of 2005 and Park Place I and Park Place II were acquired in 2004. The borrower for each of these loans secured by these assets is a special purpose entity formed for the purpose of owning and operating and individual property. Prior short falls in monthly debt service and leasing costs have been mostly satisfied through property level reserves. These reserves were funded at acquisitions with mortgage proceeds. As these reserves are exhausted, capital of contributions to these special purpose entities will be required.

Six of these assets included in the plan are encumbered by CMBS mortgage loans. The master servicers of the mortgage loans in cumber in these properties have been advised that the future operating and debt service requirements for the property will rely only on property generated revenues and as a result, the borrower expects an imminent default under the loan. (CC Q3 2009)

And what is the beauty of this? Well all these properties have a combination of large vacancies, high interest rate, or both. In other words, they were burning needed cash.

Projected cash flow savings for the next 18 months from the disposition of these seven assets are anticipated to be approximately $30 million. Then in addition for this group of asset, the cash burn associated with this group of assets during the quarter was approximately $6 million so as you can see once these assets are dispose we’re still slightly negative primarily due to capital expenditure but again we are still utilizing restricted cash on our balance to fund the majority of our leasing cost, those are funds that will be defeated overtime and need to replace but from a near term liquidity perspective , that’s a major source of cash that we have to lease of our portfolio. (CC Q3 2009)

Cash Flow Savings = $30 million / 18 * 12 = $20 million per year

Reduced Cash Burn = $6 million * 4 = $24 million per year

Increased Cash Flow = $44 million per year

For MPG, that has only recently achieved cash flow breakeven, this is nothing to sneeze about and should help the company navigate the recourse debt left. And also, it could easily sustain the dividends for the preferreds if the core Los Angeles CBD properties do not deteriorate.

But that is not the end of the story, since they are carrying a big stick and there is no incentive for the lenders to foreclose. I do not want push this point too far given that to renegotiate commercial mortgage-backed securities (CMBS) is difficult given the fragmented nature of its ownership (ie: Stuveysant). But, if MPG, that does this for a living, is not able to lease these properties up to profitable levels, who else?

Regarding the recourse short maturity portfolio (type 4), most of it is related to constructions loans

Each of our construction loans is subject to a partial or total guarantee by our Operating Partnership. The amounts guaranteed at any point in time are based on the stage of the development cycle that the project is in and are subject to reduction if and when certain financial ratios have been met. These repayment guarantees expire if and when the underlying loans have been fully repaid.

The terms of our Lantana Media Campus construction loan and Plaza Las Fuentes mortgage require our Operating Partnership to comply with financial ratios relating to minimum amounts of tangible net worth, interest coverage, fixed charge coverage and liquidity. Certain of our other construction loans require our Operating Partnership to comply with minimum amounts of tangible net worth and liquidity. We were in compliance with such covenants as of September 30, 2009.

So selling Lantana, that was a $176 million combined debt, solved a large part of the remaining recourse issues. The rest are substantially smaller and the way they are dealing with it is through a lease up strategy to eliminate some of the recourse obligations:

If you were to look at the portfolio, basically in Orange Country, probably an asset that has got the largest cash burn would be an asset called Griffin towers. It also has associated with it a repurchase facility that is recourse to the company. So there’s a $23.2 million, I believe recourse facility. Though upon Karman Campus, which is 151,000 square foot building in Irvine, it’s a building that we constructed that’s currently empty, that’s obviously has cash burn from interest expense. Again it has a recourse obligation associated with it approximately $7 million.

Then in Central Orange, we also having that, it’s called 3800 Chapman. It’s about 63% vacant, so it is not covering debt service. However, it has a debt service guarantee until maturity for 100% of the debt service. So, our focus there is to lease-up that asset if we can achieve a one-one debt service coverage ratio for two consecutive quarters we can eliminate the recourse and that has been our strategy for that assets.

Then in San Diego, we have an asset called 2385 Northside, which was a construction asset, was 52% leased. That tenant will start paying rent later on in the year. So, it’ll make a debt into the short fall. Currently, we have no rent coming in and we are very close to signing another lease that will take that asset to 72% occupied. Our strategy there has been to focus on leasing because again, that asset has a repayment guarantee that can be eliminated, as you achieve certain debt service coverage ratio. (CC Q3 2009)

If the lease up does not work, plan B is to sell the property and pay the difference. A strategy similar to the sale of 3161 Michelson in the second quarter of 2009.

Gordon Watson – Ore Hill Partners On the construction loans you’re selling, are you anticipating at this time making any payments from unrestricted cash to get rid of those construction loans?

Nelson Rising It’s conceivable there will be some, but it’s our hope that it will be minimal. The Northside property is on the market. It’s 75% leased. It’s a good property that’s part of a four-building complex, and we are marketing all four buildings and just the newly constructed building separately if someone wants that.

And so I think that will be successful in not having any payment. The offer that we have in bottom of that for in common stock will require some payment to bring that loan to the balance. The purchase price is being offered to us under a letter of intent, not a binding agreement yet, on the 207 Goode would be the loan balance number. These are all transactions in the works. Nothing is closed, and I just don’t have an answer as to the amount that we would be forced to pay. Those loans do have guarantees.

In the case of the Glendale property we have just received a Certificate of Occupancy and as is the case of most construction loans, until you have Certificate of Occupancy 100% of the loan is guaranteed. Once the lender approves the Certificate of Occupancy, the Glendale number will be $9 million. Von Karman is about $7 million, and Northside is about $4 million. But it’s our hope that our sales prices will come close to giving us break even on this.(CC Q3 2009)

So $20 million from the construction projects plus $23 million for Griffin Towers in recourse obligations should not be the end of the world. And there are no really big short term non-recourse issues (Type 3). KPMG Tower comes due only in 2012 and it is 93% leased so it should not have a problem to renegotiate or sell. The only other issue could be Brea Corporate Place that is only 56.3% leased.

So lets consider that are some assets besides the profitable LA CBD core: cash, unencumbered land, a 20% participation in a profitable JV and a net operating loss carry forward. First cash:

$62 million in unrestricted cash and it seems that items 2, 3 and 4 are just conservative accounting. And when properties are sold some of these reserves will be released. Regarding land, I went through the 10K (Note 22), $151.6M in the books is unencumbered (Note 4 in the 10Q)

We also own undeveloped land that we believe can support up to approximately 4 million square feet of office and mixed-use development and approximately 5 million square feet of structured parking, excluding development sites that are encumbered by the mortgage loans on our Stadium Towers Plaza, 2600 Michelson and Pacific Arts Plaza properties, which are in default.

Note 4—Land Held for Development and Construction in Progress

Land held for development and construction in progress includes the following (in thousands):

MPG also owns a 20% interest and is responsible for day-to-day operations of the properties of a joint venture withan Australian firm, Macquarie Office Trust (do not confuse them). Given that they use the equity method the cash flow statement only records distributions, undervaluing the earnings power of the JV. It also receives fees for asset management, property management, leasing, construction management, acquisitions, dispositions and financing. In this JV, Quintana defaulted but all the other properties are very profitable. One California Plaza is in a bind given its short term maturity. But its equity is substantial and generates good cash flow so it is in a good position for a sell

With respect to One Cal Plaza, that’s a process that is being basically driven by Macquire. There has been a significant interest in the asset. Again, it’s under contract, and the person who has it under contract with the entity is in the process of raising, trying to put together a final financing on that property. (CC Q3 2009)

And finally, As of December 31, 2008, MPG had a net operating loss carry forward of approximately $270 million that should shield the profits when the recovery comes.

So the equation is easy: not much in recourse obligations left, the OC strategy should restart cash flow generation, and there is cash, unencumbered land, a 20% participation in a profitable JV and large NOLs to carry them through the turnaround. The preferreds must be an easy kill, is there more value left for the common?

Long MPG

Deep value shopping season Part 2

Jingle bells, jingle bells. Continuing with the tax loss selling  shopping list, here are four cyclical businesses with downside protection. These companies have hedges, long term leases, or cold hard cash that are some of the ways we can have the luxury of waiting for a recovery.

Postrock (QRCP, QELP): A very complex opportunity consequence of fraud and a liquidity crisis than I hope to analyze in more detail in the future. The fraud was more limited than initially expected and the liquidity issues should be solved by a multi-merger of all subsidiaries redirecting cash flow where is most needed: Quest Resources QRCP. Quest is the owner of 120K+ Marcellus acres drilling rights but its only source of revenue were the suspended distributions from its subsidiaries. This complex merger is still foggy but if I am right, and might well be wrong, current prices are less than 1x FCF of the consolidated entity with substantial undeveloped Marcellus acres to boot. The best place to start your reasearch is the recently amended Postrock S4.

Global Ship Lease (GSL): Friends in Twitter are becoming tired of my endless promotion of this container shipping company with long term leases (the first expiration is in 2012). Well what can I say, a company priced at 1x FCF is worth promoting. Its main issue is the dependency on CMA CGM: its single charterer. CMA CGM is breaking even the last months while its competitors are in serious problems: Hapag Lloyd and Zim were rescued by their governments, CSAV did a very diluting equity raise, Maersk, Neptune and others have reported large losses. CMA CGM just announced an agreement with the banks for a new $500 million credit line and private investors are interested in injecting capital (Cerberus and Oaktree among others).  Besides Michael Gross, the second largest shareholder and company director, has been buying GSL aggressively.

Omega Navigation (ONAV): ONAV is a product tanker company. In other words, it transports refined products in specialized ships that need special coating. Some of them are ice class so they can be used in the Arctic and Baltic. This sub-segment is beneficiary of the trends of mandatory transition to double hulk and environmental constrains to refinery expansion in developed countries. In turn, this leads to substantial expected growth over the next years that should rapidly absorb the small current overcapacity. Generating $6M of FCF last quarter and the newbuilds 75% financed, though not chartered, ONAV is navigating the rough waters of an aggressive build program. Also the Glencore counterparty risk seems under control, and even more, it is becoming a financial partner in the newbuilds program. It looks to me that the chances of a catastrophe are low given a worse case where they loose their deposits for the new vessels. And since this should not impact cash flow the current price of just 2x FCF looks like a bargain.

Travelcenters of America (TA) Where have I heard about this one before?. A Christmas surprise gift since I never expected we were going to see TA again in the mid 3s

Remember, these are just leads for further investigation and I do not own some of them.