October 6, 1998

An Investment Opinion
by Dale Wettlaufer

Asset-Backed Carnage

The carnage continues to spread in the mortgage investing sector and among companies involved in the securitization of loans. Yesterday, mortgage real estate investment trust Criimi Mae (NYSE: CMM) declared chapter 11 bankruptcy, having been caught in a severe balance sheet squeeze play. With recent conditions in the fixed income markets, many companies with low-quality credits on the balance sheet or business models that rely on low-quality credits passing through the balance sheet have been totally blown out of the water.

This isn't a new development, though. Green Tree Financial has been flailing for just about a year now, thanks to prepayments customers make on loans coming in at a more rapid rate than the company had modeled in its earnings assumptions. Again we face the fact that Generally Accepted Accounting Principles inject earnings with all sorts of assumptions as to what might likely happen. What is likely is only a strong possibility, or else it would be a certainty -- a cash stream of earnings now, today. If it's likely to happen, then there is a possibility that it won't happen. You can write some of these things off as "one-time events," but the hits to owners' equity on recording those one-time events go down to the retained earnings line, wiping out earnings that have been booked in past periods.

Cash flow statements cover this stuff well enough, though, that one can figure out what is happening on the basis of cash going in and cash going out. Criimi Mae actually had shown positive cash flow from operations through the first six months of 1998, unlike many companies involved in the subprime lending and securitization game. And its cash income wasn't that far off from its reported income. But the problem was the company's accelerating investment in loans and subordinated collateralized mortgage-backed securities this summer -- the worst time over the last five years that you could have chosen to step on the gas pedal.

Total assets on the balance sheet increased just under $1 billion through the end of the first half of the year, while total liabilities increased just over $700 million. Meanwhile, cash flow from operations declined 32% year-over-year through the first six months of the year. Here's the company's condensed cash flow statement through June:

                                1998          1997 
 Net income...............$59,239,811   $29,511,726 
 Net cash provided  
 by operating activities...16,482,103    24,168,832 
 Net cash (used in)  
 investing activities....(905,018,750)  (16,506,126) 
 Cash flows from  
 financing activities: 
 Net cash provided by  
 (used in) financing  
 activities...............906,851,021    (1,745,451)
This is a lot of cash going into the business without much coming out as a return on capital. On average assets in the neighborhood of $2.36 billion, the company's cash return on assets of 1.4% wouldn't be bad if the asset quality was there. But as we can see below, the company's asset base consisted largely of subordinated interests in mortgage securities, which like any other fixed income instruments are priced off the net present value of expected cash flows of the security. And the pricing mechanism that rules the market is the required rate of return of the buyers in the market. Confident buyers will pay up and less confident market participants won't. When the market dries up and blows away, though, there isn't anyone to fulfill the company's liquidity needs. (AOL users please expand screen to view table)
                                         June 30, 1998        Dec. 31, 1997 
 Mortgage Assets:  
 Subordinated CMBS, at fair value        $1,566,016,034       $   35,424,387 
 Subordinated CMBS, at amortized cost          --              1,079,055,459 
 Mortgage securities, insured loans, at 
  fair value                                587,031,839           18,888,883 
 Mortgage securities, insured loans, at 
  amortized cost                               --                586,224,858 
 Investment in originated loans, at  
  amortized cost                            503,643,362               -- 
 Equity Investments                          44,731,988           46,234,269 
 Receivables and other assets               120,209,124          105,368,838 
 Cash and cash equivalents                   20,423,168            2,108,794 
 Total assets                            $2,842,055,515       $1,873,305,488 
 Total shareholders' equity                 701,576,313          444,980,987 
                                           ============         ============
As far as bonds go, subordinated interests that suck up losses before senior interests are much more risky. The portfolio above isn't that different from a margin account, where the value of the liabilities is fairly constant and the equity in the account drops at a faster rate than a drop in the value of assets, depending on leverage. The more leverage, a smaller amount of an asset decline is needed to bring about an illiquidity situation. Match up the subordinated assets and their relation in value to the value of shareholders' equity and you can see how quickly things can go awry. More on that in Friday's Fool on the Hill.