Wednesday, 18 November 2009 05:00

Reggie Middleton Personally Contragulates Goldman, but Questions How Much More Can Be Pulled Off


The world's most handsome and charismatic blogger stands outside his beloved friends at Goldman Sachs to congratulate them on the outstanding CMBS offering made through TALF government leveraging for Developers Diversified Realty (notice the funny looks that I am getting from the women in the background, haven't they seen a handsome and charismatic blogger before??? Cool). I have a few questions about follow on offerings and what that may portend for REITs who are in a even better situation than DDR, but let's read up on why I walked past GS headquarters in the first place. After the article excerpted below, we will discuss some tidbits of data and info that neither Goldman nor the REIT prolific Merrill Lynch, or anyone within a bonus' throw or subway distance from 85 Broad will bother to tell you about the REITs, save that handsome and charismatic guy who dares poke fun at the "Almighty at 85"!


Demand is expected to be strong Monday for the first sale of commercial-mortgage-backed securities under a government rescue program designed, in part, to ease the mounting stress in the commercial-property sector.

But the strong demand is partly a reflection of the conservative underwriting of the $400 million in bonds backed by 28 Developers Diversified Realty Corp. shopping centers, in terms of the quality of the assets underlying the loan and the loan amount relative to the value of the properties. [If BoomBustBloggers remember, DDR is the company which was part and parcel of what appears to be (but only if you were to really use your imagination) a "pump'em, dump'em, double tax'em" plan with Merrill Lynch/BofA, see "Here's a Big Company Bailout by the Taxpayer That Even the Taxpayer's Missed!"] While the deal may help reopen a vital funding source for some commercial-property investors, it will likely provide little solace to owners of tens of billions of dollars of office buildings, shopping centers and other commercial real estate that are now worth less than their mortgages. [more on this in a minute]

The deal is the first issue of commercial-mortgage-backed securities under the Federal Reserve's Term Asset-Backed Securities Loan Facility, or TALF, program. Under the program, investors can borrow from the Fed as much as 85% of the CMBS bonds' value by pledging the securities as collateral...

The sale of the real-estate investment trust Developers Diversified bonds is more than three times oversubscribed, according to price talk among investors who are considering buying the paper. The healthy appetite enabled Goldman Sachs Group Inc., the underwriter of the issue, to lower the unleveraged yield of the top-tier class of the bond issue to about 4%, those investors said... [This is interesting, considering the amount of risk in the sector, but since I have not reviewed the offering maybe it might just be worth it... I do want to take this time to congratulate Goldman for this home run, though.]

"It's a great execution for the borrower," says Scott Simon, managing director and head of mortgage- and asset-backed securities portfolio manager at Pimco, a leading bond house. "If other real-estate investors can borrow money at that rate, it would be a real game changer for the commercial real-estate market that has been so devoid of financing." [With rates at effectively zero, I don't think it is the cost of the money that is the issue, it is the LTV requested by the borrower]

Mr. Simon declined to comment on whether Pimco would buy any of the Diversified Realty bonds. Bids for the securities are expected to come from many mutual funds, insurance companies and other institutional investors. Firms that are considering the deal include Babson Capital Management, the investment-management unit of Massachusetts Mutual Life Insurance Co. and Principal Financial Group, according to people familiar with the matter. Babson Capital declined to comment. A representative at Principal Financial didn't respond to requests for comment. [I had a profitable dealing with a PFG position, see the research links below]

Institutional investors are attracted to the deal because it is viewed as a low-risk investment with relatively healthy returns when compared with five-year Treasurys, which are yielding about 2%.[Isn't that what investors thought about CMBS and MBS in the 2004 through 2007 tranches just two or three years ago??? Relatively low risk as compared to what? If investors truly believe this is a low risk investment because it was written at 50 LTV, they obviously weren't paying attention to deals struck in 2007 at 50 LTV, which are anywhere from 70 to 100 LTV now. They obviously have not paid much credence to the CMBS default rates climbing, see Moody's CMBS Delinquency Tracker Hits Decade High from Zerohedge. They definitely do not subscribe to the US as Japan thesis, for if they did... I, again (I know I'm wearing this chart out, but it does tend to drive the poinnt home), refer you to the relationship between GDP and property values in Japan from the "Bad CRE, Rotten Home Loans, and the End of US Banking Prominence?" post.


If we are entering a lost decade, 50 LTV can become 110 LTV faster than you think. Ask the guys who thought they were being conservative just two years ago... I'm not saying this is a bad deal, but I wouldn't harp on how safe and relatively risk free it is for a mere 4% yield, either. Then again, I'm not getting paid to underwrite and hawk the securities, now am I?]

The deal reflects the high bar the Fed has set for loans eligible for TALF financing. The 28 shopping centers in 19 states securing the bonds have stable cash flow because they often are occupied by discount retailers that tend to attract business even in a recession. For instance, one of the properties is Hamilton Marketplace, near Princeton, N.J., a 957,000-square-foot property whose tenants include Wal-Mart Stores, Lowe's, BJ's Wholesale Club and supermarket ShopRite. According to Fitch Ratings, the property has maintained an average occupancy of 96.7% since 2006 and is 95.1% occupied. [Uhmm, if we are currently below the three year average occupancy level, doesn't that mean we are trending down by over 150 basis points?! Hey, it must be me...]

The $400 million loan represents about half of the value of the underlying properties. [Let''s keep that figure in our head as we move on - 50% LTV is currently what the market will bite, and according to the WSJ, bite with gusto] By comparison, in the years before the financial crisis erupted in 2007, banks were willing to lend more than 70% of a property's value because the debt could be easily sold as CMBS. [Yes, some deals were offered as high as 75 LTV at the height of the bubble.] Even under a "stress" scenario, according to Fitch, the Developers Diversified properties would produce a cash flow of about 1.44 times what is required to service the debt. Back when credit was easy, the ratio for stress scenarios would even fall below one [cashflow to debt service coverage, but does that make sense? Wouldn't practically guarantee a default unless you KNEW cash flows would increase???] for many CMBS offerings. [No disrespect intended to Fitch and the rating agency cabal, et. al., but isn't this the same crew that preached perpetual HPA just a couple of years ago. For those that don't know, perpetual HPA = perpetual home price appreciation. Their AAA RMBS ratings were based on the assumption that housing prices would appreciate,,. FOREVER!!!!! I'm dead serious. By extension, all derivative products based upon those RMBS were also equally as flawed. Investors should take past performance and some common damn sense into consideration when ingesting rating agency fodder! Let's peruse an excerpt from the always entertaining Mish Shedlock's blog:

Fitch Discloses Its Fatally Flawed Rating Model...

What follows are excerpts from Absence of Fear, an excellent article written by Robert L. Rodriguez at First Pacific Advisors.

We were on the March 22 call with Fitch regarding the sub-prime securitization market’s difficulties. In their talk, they were highly confident regarding their models and their ratings. My associate asked several questions.

FPA: “What are the key drivers of your rating model?”
Fitch: They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past 50 years.

FPA: “What if HPA was flat for an extended period of time?”
Fitch: They responded that their model would start to break down.

FPA: “What if HPA were to decline 1% to 2% for an extended period of time?
Fitch: They responded that their models would break down completely.

FPA: “With 2% depreciation, how far up the rating’s scale would it harm?
Fitch: They responded that it might go as high as the AA or AAA tranches.

Okay boys and girls, this is a graph of what the actual home price appreciation looked like over the last few years...


If Fitch's models would break down and invalidate AA and AAA ratings with an extended period of 1% to 2% home price depreciation, what in the world would happen with an extended period of 20% to 50% price depreciation. Essentially, no one will know whether these tranches are AAA or junk! I really wonder if better due diligence was actually performed for these CMBS investments. After all, I would think it is safe to assume that Goldman has a tight relationship with Fitch, and Goldman really wanted that deal done, right??!!!

Further excerpted from Mish's interesting post:


S&P: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.

Moody's: "Moody's has no obligation to perform, and does not perform, due diligence."

'Nuff said. Let's move on to focus on the facts and the truth as Reggie sees them.

The problem with the CMBS market, or vanilla commercial mortgages for that matter, as I see it, is not availability of credit. It is the solvency of the deal and LTV needed to secure the loan. Too many players (nearly all of them) leveraged themselves at the top of a real estate bubble, and now have to roll over underpriced loans on overpriced properties. Haircuts, no not haircuts, literal scalpings have to take place in order for these deals to go through. As we have read from the WSJ article above, prudently priced deals with ample collateralization will sell. The problem is, where are the commercial REITs going to get ample collateralization from after blowing their wad during a free credit binging asset buying bubble?

I have analyzed Taubman Properties and am about to release a full forensic analysis to my blog's subscribers (hopefully available by the middle of next week, since we are are still fine tuning certain aspects). This is actually a relatively well run company (that is in comparison to some other REITs). The sell side has an average rating of hold on the stock. Luckily, I am not a sell side analyst. Here is an excerpt from Taubman's most recent 8K filing:

The Board’s decision considered that The Pier’s current cash flows, as well as estimates of future cash flows, are insufficient to cover debt service and operating costs due to economic conditions, tenant sales performance, high capital requirements to complete the property’s lease-up, high operating costs, and the anticipated refinancing shortfall at the loan’s maturity in May 2017. After recognizing the noncash impairment charge, representing the excess of book value of the investment over its estimated fair value, the consolidated joint venture’s remaining book value of the investment will be approximately $52 million. A default on this loan will not trigger any cross defaults on the Company’s lines of credit or any other indebtedness. The Company’s cash investment in The Pier is approximately $35 million.

The Company has concluded that the investment in Regency Square is also impaired based on current estimates of future cash flows and the expected holding period. After recognizing a non-cash charge in the range of approximately $55 million to $58 million, representing the excess of book value of the investment over its estimated fair value, the remaining book value of this investment is expected to be approximately $30 million. At the current level of cash flow, Regency Square intends to continue to service its non-recourse mortgage loan. This loan has a current principal balance of $74.5 million, with
$71.6 million due on this amortizing loan at its maturity in November 2011. On September 22, 2009, the Company issued a press release announcing the write down of the book value of The Pier and Regency Square to fair value.

These impairments are significant, but do they really end here? I don't think so. Recalling the financeable LTVs that the market is currently willing to swallow, we are somewhere around 50% LTV (according to the WSJ article excerpted above). This is how the Taubman porftolio breaks down from a truly fundamental investor's perspective:


Of course, the chart above is subject to change as we fine tune our models.

This is the same methodology that I used to determine the demise of GGP nearly a year ahead of Wall Street (see my work with GGP), and about a year and a half before their bankruptcy filing. Professional BoomBustBlog subscribers can download the rough draft NOI and CFAT analysis of all 26 of Taubman's properties (both fully consolidated and partially owned) here: TCO Consolidated Property Anlaysis PDF Outputs TCO Consolidated Property Analysis PDF Outputs 2009-11-17 11:49:09 2.28 Mb. Be aware that these are rough models, and we are still fine tuning some aspects. Any assumptions or roughage, has been cast considerably to the conservative side, on purpose - any variation from the finished models are not expected to break the ~17% boundary. In addition, the vacancy and credit allowances were calculated separately, thus are not explicitly outlined in the models.

We will be releasing an even more comprehensive analysis on a larger REIT the week after next, and quite possibly another two weeks after that. Stay tuned.

Relevant Research and Opinion on the companies mentioned in the WSJ article:

The venerable Goldman Sachs


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Last modified on Wednesday, 18 November 2009 05:00