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There was a development this week in the land of the high-yielding mortgage REITs.  Wealthy and income oriented investors have been flocking to these for years because of their high dividends which are often up in the double digits as these entities are forced to pay out almost all of their income as a dividend to be taxed at the investor level.  With low taxes on dividends and with a promise from Ben Bernanke to keep rates exceptionally low out to mid-2013, the path was set for clear skies ahead.  Until this last week…

On Friday came a sector downgrade from Bank of America’s Merrill Lynch.  This might have been considered a valuation call or that the dividends were unsustainable if you just looked at the summary.  It is worse.

Mortgage REITs underperformed the market this week because of the possible impact of changes in how the Securities Exchange Commission interprets mortgage REITs and their exemption from the Investment Company Act.  The only potential saving grace is this: “The SEC has not made formal recommendations, so any specific outcome is unclear at this time.”

BofA/Merrill Lynch downgraded 6 of the 12 mortgage REIT stocks in its coverage universe to Neutral from Buy, and the research calls with the implied dividends are below:

Annaly Capital Management, Inc. (NYSE: NLY) was downgraded from Buy to Neutral; indicated yield is 15%. American Capital Agency Corp. (NASDAQ: AGNC) was downgraded from Buy to Neutral; indicated yield is 20.5%. Hatteras Financial Corp (NYSE: HTS) was downgraded from Buy to Neutral; indicated yield is 15.3%.  Chimera Investment Corporation (NYSE: CIM) was downgraded from Buy to Neutral; indicated yield is 18%. Invesco Mortgage Capital Inc. (NYSE: IVR) was downgraded from Buy to Neutral; indicated yield is 23%.

Redwood Trust Inc. (NYSE: RWT) was maintained as Underperform; indicated yield is 8.3%.

PennyMac Mortgage Investment Trust (NYSE: PMT) was maintained Buy; indicated yield is 12.1%.  Dynex Capital Inc. (NYSE: DX) was downgraded from Buy to Neutral; indicated yield is almost 13%.  Apollo Commercial Real Estate Finance, Inc. (NYSE: ARI) maintained Buy; indicated yield is 11.1%.  Starwood Property Trust, Inc. (NYSE: STWD) maintained Buy; indicated yield is 10%. Colony Financial, Inc. (NYSE: CLNY) maintained Buy; indicated yield is almost 8.5%. CreXus Investment Corporation (NYSE: CXS) maintained Buy; indicated yield is about 11%.

The newly launched Market Vectors Mortgage REIT Income ETF (NYSE: MORT) fell almost 2% Friday to $23.26 after having been around $24.50 on Wednesday.

The Bloomberg Mortgage REIT index fell 1.7% on the week.  BofA/Merrill Lynch noted another form of caution even if the SEC action dies out, “The weak employment markets are consistent with our view that many mortgage borrowers will continue to struggle to qualify for refinances barring additional government intervention.”

BofA’s belief is that now these shares will be tied to fair value movements in the underlying asset classes.  The net effect of the SEC consideration and speculation that the government could intervene in mortgage markets only add to the issue.  As a result, Merrill Lynch’s call is that some of these stocks may reflect a discount to book value now.

Here is where this gets very interesting.  You know now that BofA has had enough with its mortgage losses that it is exiting the sector just about entirely.  Bye-bye Countrywide.  The problem is that the bank is under fire from more states, pensions, and agencies for misrepresentation and losses tied to mortgages.  It is endless.  Our take is that Merrill Lynch might know even a bit more here about what could happen to some of the mortgage-backed securities out there that are being held by these REITs.  That sounds a bit like a conspiracy theory, admittedly, but think about it for a bit…

JON C. OGG

Apollo Commercial Real Estate (NYSE: ARI) Started as Overweight at Barclays; Started as Hold at Citigroup.
Canadian Solar (NASDAQ: CSIQ) Raised to Equal Weight at Barclays.
CSX Corp. (NYSE: CSX) Raised to Buy at Stifel Nicolaus.
Diedrich Coffee (NASDAQ: DDRX) Cut to Hold at Roth Capital.
Ener1 (NASDAQ: HEV) Started as Buy at Deutsche Bank.
Intel Corp. (NASDAQ: INTC) Cut to Equal Weight at Morgan Stanley.
Nvidia (NASDAQ: NVDA) Cut to Underweight at Morgan Stanley.
Valueclick (NASDAQ: VCLK) Raised to Hold at Citigroup.
Vitacost.com (NASDAQ: VITC) Started as Buy at Needham; Started as Buy at Jefferies; Started as Outperform at Oppenheimer.

You can join our open email distribution list to get updates on top analyst upgrades and downgrades, top day trader alerts, IPO’s, secondary offerings, Warren Buffett and other guru activity, M&A and more.

JON C. OGG

Mistra Group (NYSE: MG) priced its offering at $12.50 on October 7.  While it traded as low as $12.17, it has escaped the hangman’s file of ‘busted deals’ as it is now a $13.51 stock.  The one thing that may have helped was that it priced under an initial range of $14 to $16 per share.  Talecris Biotherapeutics Holdings Corp. (NASDAQ: TLCR) also went into the busted category temporarily after hitting a low of $18.01 after a $19.00 pricing.  Fortunately, it is up at $19.97 so is also now out of the hangman’s eyes.  Still, an 8% gain and a 5% gain in this market might leave some investors feeling lonely.  Banco Santander Brasil S.A. (NYSE: BSBR) was a very large IPO of over 500 million shares at an implied $13.40, and this one got out of the “busted IPO” dungeon on Thursday and closed at $13.51 on Friday.  Before Thursday it had spent its 6 prior trading sessions as a busted IPO.

Emdeon Inc. (NYSE: EM) had traded above $18.00 briefly after its IPO priced at $15.50 in August. But now the healthcare revenue and payment cycle management solutions provider, which is supposed to be a healthcare winner ahead, closed down at $15.35 on Friday  and had been slightly lower during the week.  This was effectively a re-IPO as Emdeon had been public before after General Atlantic Partners acquired it and it also received an investment from Hellman & Friedman. It also has ties to James Clark, the Netscape founder and was part of Healtheon.

Colony Financial Inc. (NASDAQ: CLNY) came public late in September at $20.00 per share, and it closed down at $19.69 Friday and has traded as low as $19.25.  Interestingly enough, Friday’s $19.68 close looks to be the highest price since the IPO date.   Colony is a newly formed real estate finance company (mortgage REIT) that will focus primarily on acquiring, originating and managing commercial mortgage loans, which may be performing, sub-performing or non-performing loans, other commercial real estate-related debt investments, CMBS, REO properties and other real estate-related assets.

RailAmerica Inc. (NYSE: RA) has been a busted deal after this was brought public in a re-IPO by Fortress Investment Group LLC (NYSE: FIG) after going private in February 2007.  This short line and regional freight railroad operator came public at $15.00 per share on October 12, so it hardly has much trading behind it.  But its absolute highest print this last week was $14.78 and it closed on Friday at $14.26 for a 5% loser.

Apollo Commercial Real Estate Finance, Inc. (NYSE: ARI) came public at $20.00 on September 24.  This comes out of Apollo Global Management, LLC and it intends to originate and acquire senior performing commercial real estate mortgage loans, commercial real estate corporate debt and loans and to purchase legacy and newly originated investment grade CMBS, and other performing real estate debt investments.  The highest price this one has seen since the IPO was $19.20, and it closed down at $18.57 on Friday to make the tally come to a 7% loser.

Then comes Vitacost.com Inc. (NASDAQ: VITC), which operates as an online retailer of various nutritional supplements, and health and wellness products.  Its September 24 IPO priced at $12.00 yet has been very volatile in not so much of a good way.  It has traded above the $12.00 mark at $12.25 during the first week, but then shares went as low as $9.34 and closed on Friday at $10.75 for still more than a 10% discount to its IPO price.

There are other 10% and higher losers as well.  Echo Global Logistics, Inc. (NASDAQ: ECHO), which provides business process outsourcing serving the transportation and logistics needs, came public at $14.00 on October 2, and while it did briefly hit $14.23 it closed down at $12.50 on Friday for a loss of 10.7%.

Chemspec International Limited (NYSE: CPC) was brought public in June at $9.00.  This Chinese chemical compounds company has traded as high as $10.50 and as low as $6.63.  Its closing price of $7.79 on Friday gives it a loss of over 13%.

Shanda Games Limited (NASDAQ: GAME) has all the earmarks of a forced copy-cat IPO.  Since it is out of China and a copy-cat strategy, we’ll even call it a knock-off IPO.  This was a Shanda Interactive Entertainment Ltd. (NASDAQ: SNDA) ‘spin-off’ that is technically still under control of the parent and by the IPO prospectus will remain that way.  The inspiration for this was this the successful Changyou.com  (NASDAQ: CYOU) spin-off IPO from Sohu.com (NASDAQ: SOHU), which had effectively doubled when Shanda decided a knock-off strategy.  Shanda Games came public at $12.50 on September 25 and briefly hit $13.00.  Yet it also went under $10.00 and closed Friday at $10.32 to come to a 17.4% loser.

Cumberland Pharmaceuticals, Inc. (NASDAQ: CPIX) came public at $17.00 per share and its $75.2 million was to be used for potential acquisitions, the pending launch of the Company’s Caldolor(®) product for pain and fever, expansion of the Company’s hospital sales force, product development, debt repayment and general corporate purposes.  It also markets Acetadote(®) for the treatment of acetaminophen poisoning and Kristalose(®), a prescription strength laxative.  It turns out that IPO investors felt like they got too much of that powerful laxative.  This did go as high as $17.75, but then the blow-holes opened up despite 3 broker as issuing buy ratings.  Shares have gone under $13 and closed Friday at $13.40 for a loser by over 21%.  This one has some revenues and has been profitable.

Lastly, there is Omeros Corporation (NASDAQ: OMER).  This is a biotech play as a clinical-stage company committed to discovering, developing and commercializing products focused on inflammation and disorders of the central nervous system.  It came public at $10.00, already at the bottom of the $10 to $12 per share range, and its shares closed at $6.88 Friday to account for a whopping 31.2% loss for IPO buyers.  No one who bought this has made money as its highest post-IPO price looks to be $9.49.

The Blackstone Group (NYSE: BX) is weighing as many as eight IPOs or target-acquisition exits in the coming months according to multiple reports.  If it wants a smooth exit, it better consider making the deals as good for new IPO buyers as it is for Blackstone.  KKR wants to bring back the giant Dollar General as a public company despite the thought that the dollar-store investment play may have already seen its best days during the recession.

As Gordon Gecko would say, there are many dogs with fleas.  Some will do well in the future, but investors were just too shell-shocked from late 2008 into the first quarter of 2009 to buy up other peoples’ mess.  Investors feel little need to support a private equity-backed IPO where all the proceeds are going straight back to the private equity firms.  Companies that are unprofitable also have less appeal to investors.  And complicated structures also offer conservative investors much comfort.

You can join our open email distribution list to get daily updates on top analyst upgrades and downgrades, top day trader alerts, IPO’s, secondary offerings, Warren Buffett and other guru activity, M&A and more.

JON C. OGG
OCTOBER 17, 2009

Pathetic demand for two real estate investment trust IPOs today speaks to continued worries that commercial mortgage-backed real estate may be the next leg of the financial stool to get kicked out from under the market.

Colony Financial (Nasdaq: CLNY) and Apollo Commercial Real Estate Finance (NYSE: ARI) each roughly halved their stock offerings today. They had been expected to raise about $900 million, but together they will now raise only $450 mln.

Along with a third REIT IPO expected to price Tuesday, Foursquare Capital Corp. (Nasdaq: FSQR), the three IPOs each plan to invest heavily in the CMBS market, with help from loans offered by federal programs including the TALF and PPIP.

All three are betting on market timing. The argument is that very low volumes in the wake of the real estate bust has resulted in great CMBS values, particularly in the lower tranches of the market. The IPOs seek to use experienced managers who can navigate a low-vol market where the banks still fear to tread. They will seek long-term deals that give favorable spreads over borrowing costs.

In theory, the IPOS may be an opprtunity for the REIT investors, too. The last big REIT boom was in 1990, just when the California real estate bubble burst was bursting. And between the end of 1990 and the beginning of 1995, REITs gained nearly 1.5-fold. But there may be good long-term fundamental reasons why banks continue to steer clear. In Q2, commercial loan delinquencies were still climbing. And the commercial property prices continue to fall, down nearly 40% from the 2007 peak. And in almost every U.S. geography, commercial occupancy and rental rates continue to drop.

All of that speaks to the worries of fixed income traders that CMBS could become the epicenter of the next financial contagion, resulting in higher TED spreads and greater systemic risk across all asset classes.

Even for hedge funds who might want to dabble in the lower tranches of CMBS, a deeper look into the S-11 filings of the IPOs provides reason for pause. Each of the three IPOs are starting from scratch with a newly organized financial company that will be externally advised by a manager. The CEOs and investment managers will have decades of market experience. But unlike most every IPO, there is no existing balance sheet, income statement or record of cash flows. There’s not much of a track record on paper.

For the two that halved their offerings, there may be deeper concerns. A look at Apollo reveals that there is no formal policy limiting the amount of debt the IPO may incur. And the board can change that leverage policy without shareholder consent. In the case of Colony, the manager it has hired has no experienced managing a public company, and only limited experience managing REIT assets.

All told, professional investment managers may see the new IPO REITS as a lose-lose situation. They provide big exposure to a market many managers still won’t touch.

And the skilled hedge funds brave enough to delve the lower-tranche depths of CMBS may be better served doing so on their own.

24/7 Wall St. editors