A hedging strategy gone wrong at NovaStar Financial Corp. could have compromised its real estate investment trust status, according to company executives. This event might have had a more negative implication on the subprime lender than the income draining moves it has deployed to prevent it. If a company fails to meet the relatively rigid accounting standards required for REIT status, it would lose its loan portfolio's tax-exempt status.
NovaStar in the first quarter reported revenue that was sharply down from year-ago levels, and warned that accounting changes could lead to increased impairments within its mortgage portfolio. Meanwhile, fellow subprime lender Aames Investment Corp. on March 16 announced it would shed its REIT status, and Encore Mortgage parent company ECC Credit announced two weeks later that it was considering doing the same. Switching from a REIT to a C-Corp could help the companies improve liquidity and take advantage of net operating loss carry-overs, at least temporarily reducing taxes, according to Barclays Capital.
In the first quarter, Aames experienced higher losses than it anticipated, largely from the dwindling price investors are willing to pay for subprime and second-lien loans on the wholesale market and gain-on-sale revenue and an unanticipated loan repurchase. The lender is likely to either merge or sell itself this quarter, its Chief Executive Jay Meyerson said last week. Like ACC Capital Corp. and a number of subprime lenders, Aames has cut back on its staff, closing two wholesale operating centers and eliminating 120 positions within its company last quarter.
On March 24, NovaStar simultaneously announced the purchase of a $940 million pool of payment option adjustable rate mortgages, and plans to structure its first securitization of the year as an on-balance sheet transaction. The $1.35 billion on-balance sheet deal closed April 28, led by RBS Greenwich Capital, Deutsche Bank Securities and Wachovia Securities. Morgan Stanley was a co-manager on the deal. The lender is currently working on its next securitization, which will include the $940 million pool of option ARMs, said Greg Metz, senior vice president and chief financial officer, last week during the company's first quarter earnings call.
"As a result of rates rising 400 basis points for the last two years, we saw an increase in cash flow from our hedges, which offsets securities portfolio losses," Metz said, "But in 2006, we had too much hedging."
In addition to structuring its securitization last month as an on-balance sheet transaction and purchasing the $940 million option ARM pool, the lender has shifted hedge securities from its REIT portfolio to its taxable REIT subsidiary. The move reduces the amount of income flowing through the REIT portfolio, which carries tight restrictions, but it also increases the risk that its mortgage securities could become impaired in accordance with GAAP. "Our strategy really doesn't change the security cashflow, but here is a higher risk of getting an impairment on our mortgage-only securities," Metz said.
In on-balance sheet securitizations, which are structured as financings, mortgage loans remain on the company's balance sheet, but the ABS is recorded as debt. Alternatively, for securitizations structured as a sale, a cash gain is recorded when the deal is closed, and retained interest of the ABS replace the mortgage loans on the balance sheet. For NovaStar, the switch to on-balance sheet securitization played a big part in its substantially lower first quarter earnings of $22.4 million, or 69 cents per share, down from $33.5 million, or $1.19 a share one year ago. The lender expects its mortgage banking business to break even in 2006.
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