Deerfield: A Difficult Rebalancing Trade

The following things that I write are more risky than normal, and may be wrong.  If you decide to imitate what I have done, you are doing so at your own risk.  Please do your own due diligence.

I have bought more Deerfield Triarc [DFR] today @ $9.76.  A sharp-eyed reader noted (see the first comment) that DFR must have been past my rebalance point, and wondered why I hadn’t bought more.   Truth is, I had been working on the issue for two weeks.  Whenever a security falls dramatically (it was close to a second rebalancing sell for me at one point), I do a review.  I don’t automatically do rebalancing buys when a company is under stress.

Okay, what gave me confidence to buy? DFR is levered; the main risk here is that they cannot continue to finance the positions that they hold.  Point one that gives me comfort is that the financing is likely secure.

Most of it is repo funding on prime mortgage collateral, most of which is floating rate.  Though there is a high degree of leverage there, the hedging inherent in managing such funding is a common skill.  You could contrast Deerfield and Annaly.  The collateral and leverage are similar; the main difference is that Deerfield uses swaps and floors to manage interest rate risk, and Annaly uses longer repo terms (1-3 years) than Deerfield (0-3 months).

The trust preferreds are not putable, and they lever up their alternative assets through CDO structures, which are not callable.  The risk there is that the equity and subordinate bonds that they hold could be worthless.  Unlikely, but a possible loss somewhere north of $50 million.  They also have warehouse lines, where assets are held prior to securitization.  I don’t know what might be in their warehouse lines now, but they did recently complete a securitization which freed up $230 million of those lines.  (Note: they couldn’t sell the BBB securities.)  The lines are capable of financing $375 million, and extend to April of 2008 at minimum.

Point two is that very little of the assets inside DFR’s CDOs are subprime.  The total risk to DFR is from the Pinetree CDO, which if they end up writing off the CDO equity, will reduce net worth by $12 million.  Not huge.

Point three is that they might not be able to consummate the merger with Deerfield  Capital Management [DCM], since DFR has to pony up $145 million.  I find it unlikely that they could not get the financing for what is a profitable asset where Debt/Operating Income is around 6.  But even if they can’t do the deal, that does not affect DFR, except that they don’t get to purchase an asset manager at a bargain price, which is even more of  bargain now, given that the stock price has fallen, and the deal terms (half stock, half cash) don’t adjust.

Point four is might the deal terms adjust?  Couldn’t DCM allege a material adverse change, and try to get the terms changed?  It’s a little late for that.  The DFR shareholders meeting is one week from today.  Besides, many of the same problems facing DFR are facing DCM.

Point five is that much of what DCM manages are ABS CDOs.  Much of the ABS collateral is subprime residential mortgages.  (For more details, here is an S&P report from last year.) Now, aside from about $20 million of investments in the CDOs that they manage, they don’t have any more risk exposure.  There is the outside possibility that they could be removed as manager on some of the deals that they manage, but that doesn’t happen often.  The current market environment could have a negative impact on their ability to issue more ABS CDOs and other CDOs, but once things clear up, those that  are still in the game of issuing CDOs will make much better interest spreads than they made in the last two years.

In summary, why did I buy more?

  • The losses look limited, if they occur at all
  • The financing seems secure
  • Exposure to subprime losses are small, and
  • I think the deal goes through.

Could I be wrong on some of these points and lose badly?  Yes.

Full disclosure: Long DFR