BLACKSTONE MORTGAGE TRUST, INC. quarterly report, Q2 FY2011

Business context and reporting period

Registrant identification: The supplied filing is Capital Trust, Inc. (NYSE: CT), not Blackstone Mortgage Trust, Inc. It is the unaudited Form 10-Q for the quarter and six months ended June 30, 2011; comparisons are with the corresponding 2010 periods. Capital Trust was a commercial real estate finance and investment-management company operating as a REIT.

The March 31, 2011 restructuring fundamentally changed the business. Capital Trust transferred most legacy lending assets to CT Legacy REIT, eliminated its recourse debt, and retained a 52% common equity interest in CT Legacy REIT, its investment-management platform, and other investments. Management described the legacy portfolio as a liquidating portfolio and said it was originating investments only for its investment-management business. Consolidated financial statements include securitization vehicles and CT Legacy REIT; much of their debt is non-recourse and their assets are generally restricted to satisfying those entities’ obligations.

Financial results and condition

Unless otherwise stated, figures below are in millions of dollars. Consolidated GAAP figures include non-recourse VIEs and should not be read as parent-only results.

Earnings quality and margins: Six-month 2011 net income included a reported $250.976 million gain on extinguishment of debt, primarily related to the restructuring and termination of a loan participation. Net interest income declined 33.7% year over year for the six-month period and 96.7% for Q2. The filing attributes weaker interest income largely to a smaller asset base and increased non-performing loans; Q2 interest expense also included non-cash expense associated with hedge-accounting changes and mezzanine-loan costs. No comparable standalone operating margin measure is reported.

Cash flow: For the six months ended June 30, 2011, operating cash flow was $12.439 million, investing cash flow was $1.712 billion, and financing cash flow was a $1.720 billion outflow. Cash increased $3.981 million to $28.430 million. The unusually large investing and financing flows largely reflect principal collections and repayments within consolidated securitization vehicles, not freely available parent-company cash.

Balance sheet and debt at June 30, 2011: Total assets were $2.365 billion and total liabilities were $2.482 billion; Capital Trust shareholders’ deficit was $110.947 million, with a further $5.223 million deficit in noncontrolling interests. Cash and cash equivalents were $28.430 million; an additional $10.225 million of CT Legacy REIT cash was restricted and unavailable to Capital Trust. Capital Trust’s direct secured notes were $7.529 million. CT Legacy REIT had $119.343 million of repurchase obligations and a $63.0 million mezzanine loan principal balance ($51.631 million carrying value). Consolidated securitization vehicles had $2.130 billion of securitized debt, generally non-recourse to Capital Trust. CT Legacy REIT’s mezzanine loan carries 15% interest, with up to 7% deferrable; the company reported an 18.74% all-in cost before hedge effects.

Material changes versus prior periods

• Following the restructuring, parent-level recourse debt fell from $615 million at December 31, 2010 to zero; the remaining parent secured notes are non-recourse. Legacy repo obligations were assumed by CT Legacy REIT, and the senior credit facility and junior subordinated notes were extinguished.
• Consolidated total assets declined from $4.121 billion at year-end 2010 to $2.365 billion at June 30, 2011, largely reflecting portfolio transfers, repayments, and reduced securitized balances. The consolidated balance sheet is not directly comparable across the restructuring.
• CT Legacy REIT received $207 million of portfolio repayments during Q2, about 41.5% of its March 31 net book value. It repaid $185.4 million of legacy repurchase obligations, including termination of the Morgan Stanley and Citigroup facilities, and paid down $20 million of the mezzanine loan.
• The six-month earnings swing from a $60.551 million loss in 2010 to $260.140 million income in 2011 was chiefly driven by the unusual extinguishment gain and lower loan-loss provisions. The 2011 result should not be treated as a recurring earnings run rate.
• Q2 consolidated net income was positive, but Capital Trust reported a $1.845 million attributable loss after an $8.069 million allocation of net income to noncontrolling interests.

Outlook, risks, contingencies, and unusual items

• Outlook and liquidity: No numerical earnings or portfolio guidance is provided. Management said current capital sources should meet near-term cash requirements. It identified cash, CT Legacy REIT preferred dividends initially accruing at $7.5 million annually, and management and servicing fees as liquidity sources. CT Legacy REIT common distributions are restricted until its mezzanine loan and repurchase obligations are repaid; the company said it did not expect near-term common distributions from that entity.
• Credit and portfolio risk: CT Legacy REIT reported seven impaired loans with $296.956 million gross book value and $252.282 million in provisions. Eight of its 20 loans were rated in the filing’s higher-risk 6–8 categories. For consolidated securitization vehicles, 42.7% of interest-earning assets were on the watch list; 13 impaired loans had $221.397 million net book value. Loan collateral values, cash-flow assumptions, property performance, and recoveries involve significant management judgment.
• Funding and structural constraints: CT Legacy REIT’s JPMorgan facility requires balance reductions to $110 million by December 2011, $65 million by December 2012, and $30 million by December 2013. CT Legacy REIT common dividends are barred until the mezzanine loan is repaid. CT CDO covenant breaches redirect cash flows to senior noteholders, limiting cash otherwise available to Capital Trust.
• Interest-rate exposure: Management estimated that a 100-basis-point LIBOR change would affect net income by approximately $4.4 million. Repayments made some CT Legacy REIT swaps ineffective as cash-flow hedges; the company expected about $2.4 million to be reclassified from other comprehensive income to interest expense over the following 12 months. Counterparty and derivative-market risks remain.
• Contingencies: A plaintiff sought $100 million in a lawsuit concerning a property acquisition by a fund managed by an affiliate, alleging fiduciary-duty-related claims, aiding and abetting fraud, and tortious interference. Capital Trust said it was vigorously defending the case, considered the claims meritless, and had a motion to dismiss pending. The company also disclosed potential CT CDO asset-repurchase exposure up to $919.5 million for alleged breaches of representations and warranties; it reported no repurchase demands or notices of asserted breaches to date.
• Tax and distributions: The company reported REIT compliance at June 30, 2011, but warned that maintaining REIT status had become more difficult after the restructuring and reduced replacement investment activity. It expected approximately $180.5 million of cancellation-of-indebtedness income for 2011, reducing available net operating losses, and approximately $2 million of alternative minimum taxes. No dividends were declared in the first half of 2011.
• Other unusual items: General and administrative expense rose in the first half, including $2.75 million of restructuring awards and $2.98 million of management incentive-plan expense. The filing reports no material change in internal control over financial reporting and says disclosure controls were effective.

Most important facts for investors to verify

• Confirm the issuer: the supplied 10-Q is Capital Trust, Inc., not Blackstone Mortgage Trust, Inc.
• Reconcile the $250.976 million debt-extinguishment gain to its components and distinguish it from recurring operating performance.
• Review parent-only liquidity and the timing and availability of CT Legacy REIT preferred dividends, given restricted cash and debt-related distribution blocks.
• Assess CT Legacy REIT’s impaired and higher-risk loans, collateral recoveries, and required JPMorgan balance reductions against actual repayments and portfolio cash flows.
• Review the $100 million lawsuit, the CT CDO representation-and-warranty exposure, and any subsequent developments or loss accruals.
• Check the filing’s per-share disclosures: the statements report six-month diluted EPS of $10.52, while an MD&A comparison table states $11.18; the filing text does not explain this inconsistency.