UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

Form 10-Q

 

 

 

Commission File Number 001-32958

 

Crystal River Capital, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

 

Registrant’s telephone number, including area code: (212) 549-8400

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o     Accelerated filer o     Non-accelerated filer þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The number of outstanding shares of the registrant’s common stock, par value $0.001 per share, as of May 14, 2007 was 25,001,800.

 

 

CRYSTAL RIVER CAPITAL, INC.

 

INDEX

 

 

 

 

 

See accompanying notes to consolidated financial statements.

Crystal River Capital, Inc. and Subsidiaries

Consolidated Statements of Income
(in thousands, except share and per share data)
(Unaudited)

 

 

See accompanying notes to consolidated financial statements.

 

 

See accompanying notes to consolidated financial statements.

 

 

See accompanying notes to consolidated financial statements.

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

 

References herein to “we,” “us” or “our” refer to Crystal River Capital, Inc. and its subsidiaries unless the context specifically requires otherwise.

 

We are a Maryland corporation that was formed in January 2005 for the purpose of acquiring and originating a diversified portfolio of commercial and residential real estate structured finance investments. We commenced operations on March 15, 2005, when we completed an offering of 17,400,000 shares of common stock (the “Private Offering”), and we completed our initial public offering of 7,500,000 shares of common stock (the “Public Offering”) on August 2, 2006, as more fully explained in Note 13. We are externally managed and are advised by Hyperion Brookfield Crystal River Capital Advisors, LLC (the “Manager”) as more fully explained in Note 11.

 

We have elected to be taxed as a Real Estate Investment Trust (“REIT”) under the Internal Revenue Code for the 2005 tax year. To maintain our tax status as a REIT, we plan to distribute at least 90% of our taxable income. In view of our election to be taxed as a REIT, we have tailored our balance sheet investment program to originate or acquire loans and investments to produce a portfolio that meets the asset and income tests necessary to maintain qualification as a REIT.

 

 

Basis of Quarterly Presentation—The accompanying unaudited consolidated financial statements have been prepared in conformity with the instructions to Form 10-Q and Article 10, Rule 10-01 of Regulation S-X for interim financial statements. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States (“GAAP”) for complete financial statements. In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and changes in cash flows have been made. These consolidated financial statements should be read in conjunction with the annual financial statements and notes thereto for the year ended December 31, 2006 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006 filed with the Securities and Exchange Commission (the “SEC”).

 

Principles of Consolidation—Our consolidated financial statements include the accounts of Crystal River Capital, Inc., three wholly-owned subsidiaries created in connection with our collateralized debt obligations, three wholly-owned subsidiaries established for financing purposes, three wholly-owned subsidiaries established to own interests in real property and our taxable REIT subsidiary (“TRS”). All significant intercompany balances and transactions have been eliminated in consolidation.

 

Use of Estimates—The preparation of financial statements in conformity with GAAP requires us to make a significant number of estimates in the preparation of the financial statements. These estimates include determining the fair market value of certain investments and derivative liabilities, amount and timing of credit losses, prepayment assumptions, allocation of purchase price to tangible and intangible assets on property acquisitions, and other items that affect the reported amounts of certain assets and liabilities as of the date of the consolidated financial statements and the reported amounts of certain revenues and expenses

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

during the reported period. It is likely that changes in these estimates (e.g., market values change due to changes in supply and demand, credit performance, prepayments, interest rates, or other reasons; yields change due to changes in credit outlook and loan prepayments) will occur in the near future. Our estimates are inherently subjective in nature and actual results could differ from our estimates and differences may be material.

 

Cash and Cash Equivalents—We classify highly liquid investments with original maturities of 90 days or less from the date of purchase as cash equivalents. Cash and cash equivalents may include cash and short term investments. Short term investments are stated at cost, which approximates their fair value, and may consist of investments in money market accounts.

 

Restricted Cash—Restricted cash consists primarily of funds held on deposit with brokers to serve as collateral for repurchase agreements, certain interest rate swap agreements and funds held by the trustee for CDO II (see Note 6) to fund future purchases of available for sale securities.

 

Securities—We invest in U.S. Agency residential mortgage-backed securities (“Agency ARMS”), Non-Agency residential mortgage-backed securities (“Non-Agency RMBS”), commercial mortgage-backed securities (“CMBS”) and other real estate debt and equity instruments. We account for our available for sale securities (Agency ARMS, CMBS, RMBS, asset-backed securities (“ABS”) and other real estate and equity instruments) in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 115, Accounting for Certain Investments in Debt and Equity Securities (“SFAS 115”). We classify our securities as available for sale because we may dispose of them prior to maturity in response to changes in the market, liquidity needs or other events, even though we do not hold the securities for the purpose of selling them in the near future.

 

All investments classified as available for sale are reported at fair value, based on quoted market prices provided by independent pricing sources, when available, or from quotes provided by dealers who make markets in certain securities, or from our management’s estimates in cases where the investments are illiquid. In making these estimates, our management utilizes pricing information obtained from dealers who make markets in these securities. However, under certain circumstances we may adjust these values based on our knowledge of the securities and the underlying collateral. Our management also uses a discounted cash flow model, which utilizes prepayment and loss assumptions based upon historical experience, economic factors and the characteristics of the underlying cash flow in order to substantiate the fair value of the securities. The assumed discount rate is based upon the yield of comparable securities. The determination of future cash flows and the appropriate discount rates are inherently subjective and, as a result, actual results may vary from our management’s estimates.

 

Unrealized gains and losses are recorded as a component of accumulated other comprehensive income (loss) in stockholders’ equity.

 

Periodically, all available for sale securities are evaluated for other than temporary impairment in accordance with SFAS 115 and Emerging Issues Task Force (“EITF”) No. 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (“EITF 99-20”). An impairment that is an “other than temporary

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

impairment” is a decline in the fair value of an investment below its amortized cost attributable to factors that indicate the decline will not be recovered over the remaining life of the investment. Other than temporary impairments result in reducing the carrying value of the security to its fair value through the statement of income, which also creates a new carrying value for the investment. We compute a revised yield based on the future estimated cash flows as described in the section titled “Revenue Recognition” below. Significant judgments, including making assumptions regarding the estimated prepayments, loss assumptions and the changes in interest rates, are required in determining impairment.

 

Real Estate Loans—Real estate loans are carried at cost, net of unamortized loan origination costs and fees, discounts, repayments, sales of partial interests in loans and unfunded commitments, unless the loan is deemed to be impaired. We account for our real estate loans in accordance with SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases (“SFAS 91”).

 

Real estate loans are evaluated for possible impairment on a periodic basis in accordance with SFAS No. 114, Accounting by Creditors For Impairment of a Loan—an Amendment of FASB Statement No. 5 and 15 (“SFAS 114”). Impairment occurs when we determine it is probable that we will not be able to collect all amounts due according to the contractual terms of the loan. Upon determination of impairment, we establish a reserve for loan losses and recognize a corresponding charge to the statement of income through a provision for loan losses. Significant judgments are required in determining impairment, including making assumptions regarding the value of the loan and the value of the real estate, partnership interest or other collateral that secures the loan.

 

Commercial Real Estate—Commercial properties held for investment are carried at cost less accumulated depreciation. In accordance with SFAS No. 141, Business Combinations, upon acquisition, we allocate the purchase price to the components of the commercial properties acquired: the amount allocated to land is based on its estimated fair value; buildings and existing tenant improvements are recorded at depreciated replacement cost; above- and below-market in-place operating leases are determined based on the present value of the difference between the rents payable under the contractual terms of the leases and estimated market rents; lease origination costs for in-place operating leases are determined based on the estimated costs that would be incurred to put the existing leases in place under the same terms and conditions; and tenant relationships are measured based on the present value of the estimated avoided net costs if a tenant were to renew its lease at expiry, discounted by the probability of such renewal.

 

Depreciation on buildings is provided on a straight-line basis over the useful lives of the properties to a maximum of 40 years. Depreciation is determined with reference to each rental property’s carried value, remaining estimated useful life and residual value. Acquired tenant improvements, above- and below-market in-place operating leases and lease origination costs are amortized on a straight-line basis over the remaining terms of the leases. The value associated with acquired tenant relationships is amortized on a straight-line basis over the expected term of the relationships. All other tenant improvements and re-leasing costs are deferred and amortized on a straight-line basis over the terms of the leases to which they relate. Depreciation on buildings and amortization of deferred leasing costs and tenant

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

improvements that are determined to be assets of the company are recorded in depreciation and amortization expense. All above-and below-market tenant leases and tenant relationships are amortized to revenue. Above- and below-market ground leases are amortized to operating expenses.

 

Properties are reviewed for impairment whenever events or changes in circumstances indicate the carrying value may not be recoverable. For commercial properties, an impairment loss is recognized when a property’s carrying value exceeds its undiscounted future net cash flow. The impairment is measured as the amount by which the carrying value exceeds the estimated fair value. Projections of future cash flow take into account the specific business plan for each property and management’s best estimate of the most probable set of economic conditions anticipated to prevail in the market.

 

Accounting for Derivative Financial Instruments and Hedging Activities—We account for our derivative and hedging activities in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (“SFAS 133”) and SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (“SFAS 149”). SFAS 133 and SFAS 149 require us to recognize all derivative instruments at their fair value as either assets or liabilities on our balance sheet. The accounting for changes in fair value (i.e., gains or losses) of a derivative instrument depends on whether we have designated it, and whether it qualifies, as part of a hedging relationship and on the type of hedging relationship. For those derivative instruments that are designated and qualify as hedging instruments, we must designate the hedging instrument, based upon the exposure being hedged, as a fair value hedge, a cash flow hedge or a hedge of a net investment in a foreign operation. We have no fair value hedges or hedges of a net investment in foreign operations as of March 31, 2007.

 

For derivative instruments that are designated and qualify as a cash flow hedge (i.e., hedging the exposure to variability in expected future cash flows that are attributable to a particular risk), the effective portion of the gain or loss on the derivative instrument is reported as a component of other comprehensive income and reclassified into earnings in the same line item associated with the forecasted transaction in the same period or periods during which the hedged transaction affects earnings (i.e., in “interest expense” when the hedged transactions are interest cash flows associated with floating-rate debt). The remaining gain or loss on the derivative instrument in excess of the cumulative changes in the present value of future cash flows of the hedged item, if any, is recognized in the realized and unrealized gain (loss) on derivatives in current earnings during the period of change. For derivative instruments not designated as hedging instruments (including foreign currency swaps and credit default swaps), the gain or loss is recognized in realized and unrealized gain (loss) on derivatives in the current earnings during the period of change. Income and/or expense from interest rate swaps are recognized as an adjustment to interest expense. We account for income and expense from interest rate swaps on an accrual basis over the period to which the payments and/or receipts relate.

 

Dividends to Stockholders—We record dividends to stockholders on the declaration date. The actual dividend and its timing are at the discretion of our board of directors. We intend to pay sufficient dividends to avoid incurring any income or excise tax. During the three months ended March 31, 2007, we declared dividends in the amount of $0.68 per share of which

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

$17,032 was distributed on April 27, 2007 to our stockholders of record as of March 30, 2007, and of which $17 related to dividends on deferred stock units.

 

Offering Costs—Offering costs that were incurred in connection with the Private Offering and the Public Offering are reflected as a reduction of additional paid-in-capital. Certain offering costs that were incurred in connection with the Public Offering were initially capitalized to prepaid expenses and other assets and were recorded as a reduction of additional paid-in-capital when we completed the Public Offering in August 2006.

 

Trust Preferred Securities—Trusts that we form for the sole purpose of issuing trust preferred securities are not consolidated in our financial statements in accordance with Financial Interpretation No. 46R (FIN 46R) as we have determined that we are not the primary beneficiary of such trusts. Our investment in the common securities of such trusts is included in other assets in our consolidated financial statements.

 

Revenue Recognition—Interest income for our available for sale securities and real estate loans is recognized over the life of the investment using the effective interest method and recorded on the accrual basis. Interest income on mortgage-backed securities (“MBS”) is recognized using the effective interest method as required by EITF 99-20. Real estate loans generally are originated or purchased at or near par value, and interest income is recognized based on the contractual terms of the loan instruments. Any loan fees or acquisition costs on originated loans or securities are capitalized and recognized as a component of interest income over the life of the investment utilizing the straight-line method, which approximates the effective interest method. None of the interest income for the three months ended March 31, 2007 or 2006 included prepayment fees.

 

Under EITF 99-20, at the time of purchase, our management estimates the future expected cash flows and determines the effective interest rate based on these estimated cash flows and the purchase price. As needed, we update these estimated cash flows and compute a revised yield based on the current amortized cost of the investment. In estimating these cash flows, there are a number of assumptions that are subject to uncertainties and contingencies, including the rate and timing of principal payments (including prepayments, repurchases, defaults and liquidations), the pass-through or coupon rate and interest rate fluctuations. In addition, interest payment shortfalls due to delinquencies on the underlying mortgage loans and the timing and the magnitude of credit losses on the mortgage loans underlying the securities have to be judgmentally estimated. These uncertainties and contingencies are difficult to predict and are subject to future events that may impact our management’s estimates and our interest income.

 

We record security transactions on the trade date. Realized gains and losses from security transactions are determined based upon the specific identification method and recorded as gain (loss) on sale of available for sale securities in the statements of income.

 

We account for accretion of discounts or premiums on available for sale securities and real estate loans using the effective interest yield method. Such amounts have been included as a component of interest income in the statements of income.

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

 

We may sell all or a portion of our real estate investments to a third party. To the extent the fair value received for an investment differs from the amortized cost of that investment and control of the asset that is sold is surrendered making it a “true sale”, as defined under SFAS No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities—a replacement of FASB Statement No. 125 (“SFAS 140”), a gain or loss on the sale will be recorded in the statements of income as realized net gain (loss) on sale of real estate loans. To the extent a real estate investment is sold that has any fees that were capitalized at the time the investment was made and were being recognized over the term of the investment, the unamortized fees are recognized at the time of sale and included in any gain or loss on sale of real estate loans.

 

We have retained substantially all of the risks and benefits of ownership of our rental properties and therefore we account for leases with our tenants as operating leases. The total amount of contractual rent that we receive from operating leases is recognized on a straight-line basis over the term of the lease; and a straight-line or free rent receivable, as applicable, is recorded for the difference between the rental revenue recorded and the contractual amount received. In addition to base rent, the tenants in our commercial real estate properties also pay substantially all operating costs.

 

Dividend income on preferred stock is recorded on the dividend declaration date.

 

Interest in Equity Investment—We account for our investment in BREF One, LLC, a real estate finance fund, under the equity method of accounting since we own more than a minor interest in the fund, but do not unilaterally control the fund and are not considered to be the primary beneficiary under FIN 46R. The investment was recorded initially at cost, and subsequently adjusted for equity in net income (loss) and cash contributions and distributions.

 

Income Taxes—We have elected to be taxed as a REIT under the Internal Revenue Code and the corresponding provisions of state law. In order to qualify as a REIT, we must distribute at least 90% of our annual REIT taxable income to stockholders within the statutory timeframe. Accordingly, we generally will not be subject to federal or state income tax to the extent that we make qualifying distributions to our stockholders and provided we satisfy the REIT requirements, including certain asset, income, distribution and stock ownership tests. If we were to fail to meet these requirements, we would be subject to federal, state and local income taxes, which could have a material adverse impact on our results of operations and amounts available for distribution to our stockholders.

 

The dividends paid deduction of a REIT for qualifying dividends to our stockholders is computed using our taxable income as opposed to using our financial statement net income. Some of the significant differences between financial statement net income and taxable income include the timing of recording unrealized gains/realized gains associated with certain assets, the book/tax basis of assets, interest income, impairment, credit loss recognition related to certain assets (asset-backed mortgages), accounting for derivative instruments and stock compensation and amortization of various costs (including start up costs).

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

 

SFAS No. 109, Accounting for Income Taxes (“SFAS 109”), establishes financial accounting and reporting standards for the effect of income taxes that result from an organization’s activities during the current and preceding years. SFAS 109 requires that income taxes reflect the expected future tax consequences of temporary differences between the carrying amounts of assets and liabilities for book and tax purposes. A deferred tax asset or liability for each temporary difference is determined based upon the tax rates that the organization expects to be in effect when the underlying items of income and expense are realized. A deferred tax valuation allowance is established if it is more likely than not that all or a portion of the deferred tax assets will not be realized.

 

We have a wholly-owned taxable REIT subsidiary that has made a joint election with us to be treated as our TRS. Our TRS is a separate entity subject to federal income tax under the Internal Revenue Code. For the three months ended March 31, 2007 and 2006, we recorded current income tax expense of $339 (federal income tax of $215 and state and local income tax of $124) and $0, respectively, which is included in other expenses. For the three months ended March 31, 2007 and 2006, we recorded a deferred tax benefit of $750 and $0, respectively, which is included in other expenses. As of March 31, 2007, we had a deferred tax liability of $150 attributable to mark to market adjustments on foreign currency swaps held in our TRS which is included in accounts payable, accrued expenses and cash collateral payable. As of December 31, 2006 we had a deferred tax liability of $900 attributable to mark to market adjustments on foreign currency swaps held in our TRS of $900 which is included in accounts payable, accrued expenses and cash collateral payable.

 

In June 2006, the Financial Accounting Standards Board (“FASB”) issued Financial Interpretation No. 48, Accounting for Uncertainty in Income Taxes, or FIN 48. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS 109. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. This interpretation was effective January 1, 2007. The adoption of FIN 48 did not materially affect our consolidated financial statements.

 

Our policy for interest and penalties on material uncertain tax positions recognized in our consolidated financial statements is to classify these as interest expense and operating expense, respectively. However, in accordance with FIN 48 we assessed our tax positions for all open tax years (Federal, years 2005 to 2006 and State, years 2005 to 2006) as of March 31, 2007 and concluded that we have no material FIN 48 liabilities to be recognized at this time.

 

Deferred Financing Costs—Deferred financing costs represent commitment fees, legal fees and other third party costs associated with obtaining commitments for financing that result in a closing of such financing. These costs are amortized over the terms of the respective agreements using the effective interest method or a method that approximates the effective interest method and the amortization is reflected in interest expense. Unamortized deferred financing costs are expensed when the associated debt is refinanced or repaid before maturity.

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

Costs incurred in seeking financing transactions that do not close are expensed in the period in which it is determined that the financing will not close.

 

Earnings per Share—We compute basic and diluted earnings per share in accordance with SFAS No. 128, Earnings Per Share (“SFAS 128”). Basic earnings per share (“EPS”) is computed based on net income divided by the weighted average number of shares of common stock and other participating securities outstanding during the period. Diluted EPS is based on net income divided by the weighted average number of shares of common stock plus any additional shares of common stock attributable to stock options, provided that the options have a dilutive effect. At March 31, 2007 and March 31, 2006, options to purchase a total of 130,000 shares of common stock and 126,000 shares of common stock, respectively, have been excluded from the computation of diluted EPS as they were determined to be antidilutive.

 

Variable Interest Entities—In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities—An Interpretation of ARB No. 51 (“FIN 46”). FIN 46 provides guidance on identifying entities for which control is achieved through means other than through voting rights and on determining when and which business enterprise should consolidate a variable interest entity (“VIE”) when such enterprise would be determined to be the primary beneficiary. In addition, FIN 46 requires that both the primary beneficiary and all other enterprises with a significant variable interest in a VIE make additional disclosures. In December 2003, the FASB issued a revision of FIN 46, Interpretation No. 46R (“FIN 46R”), to clarify the provisions of FIN 46. FIN 46R states that a VIE is subject to consolidation if the investors in the entity being evaluated under FIN 46R either do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support, are unable to direct the entity’s activities, or are not exposed to the entity’s losses or entitled to its residual returns. VIEs within the scope of FIN 46R are required to be consolidated by their primary beneficiary. The primary beneficiary of a VIE is determined to be the party that absorbs a majority of the VIE’s expected losses, receives the majority of the VIE’s expected returns, or both.

 

Our ownership of the subordinated classes of CMBS and RMBS from a single issuer may provide us with the right to control the foreclosure/workout process on the underlying loans, which we refer to as the Controlling Class CMBS and RMBS. There are certain exceptions to the scope of FIN 46R, one of which provides that an investor that holds a variable interest in a qualifying special-purpose entity (“QSPE”) is not required to consolidate that entity unless the investor has the unilateral ability to cause the entity to liquidate. SFAS 140 sets forth the requirements for an entity to qualify as a QSPE. To maintain the QSPE exception, the special-purpose entity must initially meet the QSPE criteria and must continue to satisfy such criteria in subsequent periods. A special-purpose entity’s QSPE status can be affected in future periods by activities undertaken by its transferor(s) or other involved parties, including the manner in which certain servicing activities are performed. To the extent that our CMBS or RMBS investments were issued by a special-purpose entity that meets the QSPE requirements, we record those investments at the purchase price paid. To the extent the underlying special-purpose entities do not satisfy the QSPE requirements, we follow the guidance set forth in FIN 46R as the special-purpose entities would be determined to be VIEs.

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

 

We have analyzed the pooling and servicing agreements governing each of our Controlling Class CMBS and RMBS investments for which we own a greater than 50% interest in the subordinated class and we believe that the terms of those agreements are industry standard and are consistent with the QSPE criteria. However, there is uncertainty with respect to QSPE treatment for those special-purpose entities due to ongoing review by regulators and accounting standard setters (including the FASB’s project to amend SFAS 140 and the recently added FASB project on servicer discretion in a QSPE), potential actions by various parties involved with the QSPE (discussed in the paragraph above) and varying and evolving interpretations of the QSPE criteria under SFAS 140. We also have evaluated each of our Controlling Class CMBS and RMBS investments as if the special-purpose entities that issued such securities are not QSPEs. Using the fair value approach to calculate expected losses or residual returns, we have concluded that we would not be the primary beneficiary of any of the underlying special-purpose entities. Additionally, the standard setters continue to review the FIN 46R provisions related to the computations used to determine the primary beneficiary of VIEs.

 

Our maximum exposure to loss as a result of our investment in these QSPEs totaled $238,278 as of March 31, 2007.

 

The financing structures that we offer to the borrowers on certain of our real estate loans involve the creation of entities that could be deemed VIEs and therefore, could be subject to FIN 46R. Our management has evaluated these entities and has concluded that none of them are VIEs that are subject to the consolidation rules of FIN 46R.

 

Stock Based Compensation—We account for stock-based compensation in accordance with the provisions of SFAS No. 123R, Accounting for Stock-Based Compensation (“SFAS 123R”), which establishes accounting and disclosure requirements using fair value based methods of accounting for stock-based compensation plans. Compensation expense related to grants of stock and stock options are recognized over the vesting period of such grants based on the estimated fair value on the grant date.

 

Stock compensation awards granted to the Manager and certain employees of the Manager’s affiliates are accounted for in accordance with EITF 96-18, Accounting For Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services, which requires us to measure the fair value of the equity instrument using the stock prices and other measurement assumptions as of the earlier of either the date at which a performance commitment by the counterparty is reached or the date at which the counterparty’s performance is complete.

 

Concentration of Credit Risk and Other Risks and Uncertainties—Our investments are primarily concentrated in MBS that pass through collections of principal and interest from the underlying mortgages and there is a risk that some borrowers on the underlying mortgages will default. Therefore, MBS may bear some exposure to credit losses. Our maximum exposure to loss due to credit risk if all parties to the investments failed completely to perform according to the terms of the contracts as of March 31, 2007 is $2,823,027. Our real estate loans and other investments may bear some exposure to credit losses. Our maximum exposure to loss due to credit risk if parties to the real estate loans, related and unrelated, and other investments failed completely to perform according to the terms of the loans as of March 31, 2007 is $252,680.

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

 

We bear certain other risks typical in investing in a portfolio of MBS. Principal risks potentially affecting our financial position, income and cash flows include the risk that (i) interest rate changes can negatively affect the market values of our MBS, (ii) interest rate changes can influence decisions made by borrowers in the mortgages underlying the securities to prepay those mortgages, which can negatively affect both the cash flows from, and the market value of, our MBS and (iii) adverse changes in the market value of our MBS and/or our inability to renew short term borrowings would result in the need to sell securities at inopportune times and cause us to realize losses.

 

Other financial instruments that potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents and real estate loans. We place our cash and cash equivalents in excess of insured amounts with high quality financial institutions. The collateral securing our real estate loans and other investments are located in the United States, Canada and the United Kingdom.

 

Credit risk also arises from the possibility that tenants may be unable to fulfill their lease commitments. We have a significant concentration of rental revenue from both of our commercial properties given that JPMorgan Chase is the main tenant of both properties. Therefore, we are subject to concentration of credit risk, and the inability of this tenant to make its lease payments could have an adverse effect on us. Our exposure to this credit risk is mitigated since we have long-term leases in place for both properties with a tenant that has an investment grade credit rating.

 

Other Comprehensive Income (Loss)—Comprehensive income (loss) consists of net income and other comprehensive income (loss). Our other comprehensive income (loss) is comprised primarily of unrealized gains and losses on securities available for sale and net unrealized and deferred gains and losses on certain derivative investments accounted for as cash flow hedges.

 

Securities Repurchase Agreements—In securities repurchase agreements, we transfer securities to a counterparty under an agreement to repurchase the same securities at a fixed price in the future. These agreements are accounted for as secured financing transactions as we maintain effective control over the transferred securities and the transfer meets the other criteria for such accounting. The transferred securities are pledged by us as collateral to the counterparty.

 

Foreign Currency Transactions—We conform to the requirements of SFAS No. 52, Foreign Currency Translation (“SFAS 52”). SFAS 52 requires us to record realized and unrealized gains and losses from transactions denominated in a currency other than our functional currency (U.S. dollar) in determining net income.

 

Recent Accounting Pronouncements Not Yet Adopted—In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 clarifies the definition of fair value, establishes a framework for measuring fair value in GAAP and requires expanded financial statement disclosures about fair value measurements for assets and liabilities. SFAS 157 requires companies to disclose the fair value of their financial instruments according to a fair value hierarchy as defined in the standard. SFAS 157 is effective for fiscal periods beginning after November 15, 2007. SFAS 157 will be effective for us beginning January 1,

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

2008 and we are currently evaluating the effects of SFAS 157 on our consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial instruments and certain other items at fair value to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between entities that choose different measurement attributes for similar types of assets and liabilities. SFAS 159 is effective for financial statements issued for fiscal periods beginning after November 15, 2007. SFAS 159 will be effective for us beginning January 1, 2008 and we are currently evaluating the effects of SFAS 159 on our consolidated financial statements.

 

Presentation—Certain reclassifications have been made in the presentation of the prior periods consolidated financial statements to conform to the March 2007 presentation.

 

 

Our available for sale securities are carried at their estimated fair values. The amortized cost and estimated fair values of our available for sale securities as of March 31, 2007 are summarized as follows:

 

 

We pledge our available for sale securities to secure our repurchase agreements and collateralized debt obligations. The fair value of the available for sale securities that we pledged as collateral as of March 31, 2007 is summarized as follows:

 

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

The aggregate estimated fair values by underlying credit rating of our available for sale securities as of March 31, 2007 was as follows:

 

 

The face amount and net unearned discount on our investments as of March 31, 2007 was as follows:

 

 

For the three months ended March 31, 2007 and the three months ended March 31, 2006, net discount on available for sale securities accreted into interest income totaled $3,201 and $1,997, respectively.

 

Commercial Mortgage Backed Securities (“CMBS”)—Our investments include CMBS, which are mortgage backed securities that are secured by, or evidence ownership interests in, a single commercial mortgage loan, or a partial or entire pool of mortgage loans secured by commercial properties. The securities may be senior, subordinated, investment grade or non-investment grade.

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

 

The following is a summary of our CMBS investments as of March 31, 2007:

 

 

Residential Mortgage Backed Securities (“RMBS”)—Our investments include RMBS, which are securities that represent participations in, and are secured by or payable from, mortgage loans secured by residential property. Our RMBS investments include (i) Agency mortgage pass-through certificates, which are securities issued or guaranteed by the Federal National Mortgage Association (“Fannie Mae”), Federal Home Loan Mortgage Corporation (“Freddie Mac”) or Government National Mortgage Association (“Ginnie Mae”), (ii) Agency Collateralized Mortgage Obligations issued by Fannie Mae or Freddie Mac backed by mortgage pass-through securities and evidenced by a series of bonds or certificates issued in multiple classes (collectively, “Agency Adjustable Rate RMBS” or “Agency ARMS”) and (iii) Non-Agency pass-through certificates which are rated classes in senior/ subordinated structures (“Non-Agency RMBS”).

 

The following is a summary of our Non-Agency RMBS investments as of March 31, 2007:

 

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

The following is a summary of our Agency ARMS investments as of March 31, 2007:

 

 

Asset-Backed Securities (“ABS”)—As of March 31, 2007, we invested in asset-backed securities with an estimated fair value of $44,162. Aircraft ABS generally are collateralized by aircraft leases. Issuers of consumer and aircraft ABS generally are special-purpose entities owned or sponsored by banks and finance companies, captive finance subsidiaries of non-financial corporations or specialized originators such as credit card lenders.

 

The following is a summary of our ABS investments as of March 31, 2007:

 

 

Other Securities—We invested in the preferred stock of Millerton I CDO with an estimated fair value of $1,968 as of March 31, 2007, and the preferred stock of Millerton II CDO with an estimated fair value of $2,050 as of March 31, 2007. The preferred stock of Millerton I CDO was rated Ba3 and the preferred stock of Millerton II CDO was not rated at March 31, 2007.

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

 

Unrealized Losses—The following table sets forth the amortized cost, fair value and unrealized loss for securities we owned as of March 31, 2007:

 

 

The unrealized losses on all securities were the result of changes in market interest rates subsequent to their purchase. The unrealized losses on non-rated bonds were also due to market conditions and price volatility. Because we have the ability and intent to hold these investments until a recovery of fair value, which may be maturity, we do not consider these investments to be other than temporarily impaired at March 31, 2007.

 

Other Than Temporary Impairments—For the three months ended March 31, 2007, we determined that four RMBS securities were impaired. In connection with the impairment of these securities, we recorded impairment charges of $635 in our statement of income for the three months ended March 31, 2007 that has been reclassified out of other comprehensive income. As of March 31, 2006, we held four Agency ARMS securities that we determined to be impaired. As a result, we recorded an impairment charge of $1,258 in our statement of income for the three months ended March 31, 2006 that was reclassified out of other comprehensive income.

 

Sale of Available for Sale Securities—During the three months ended March 31, 2007, we sold 11 securities for proceeds of $393,501 and realized a gain of $1,682 and we sold 4 securities for proceeds of $118,660 and realized a loss of $62. During the three months ended March 31, 2006, we sold one security for proceeds of $3,263 and realized a gain of $327, we sold five securities for proceeds of $179,219 and realized a loss of $895.

 

 

We invest in mezzanine loans, B Notes, construction loans and whole loans. A mezzanine loan is a loan that is subordinated to a first mortgage loan on a property and is senior to the borrower’s equity in the properties. Mezzanine loans are made to the property’s owner and are secured by pledges of ownership interests in the property and/or the property owner. The mezzanine lender can foreclose on the pledged interests and thereby succeed to ownership of the property subject to the lien of the first mortgage.

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

 

A subordinated commercial real estate loan, which we refer to as a B Note, may be rated by at least one nationally recognized rating agency. A B Note is typically a privately negotiated loan that is secured by a first mortgage on a single large commercial property or group of related properties; and is subordinated to an A Note secured by the same first mortgage on the same property.

 

A construction loan represents a participation in a construction or rehabilitation loan on a commercial property that generally provides 85% to 90% of total project costs and is secured by a first lien mortgage on the property. Alternatively, mezzanine loans can be used to finance construction or rehabilitation where the security is subordinate to the first mortgage lien. Construction loans and mezzanine loans used to finance construction or rehabilitation generally would provide fees and interest income at risk-adjusted rates.

 

A whole mortgage loan is a loan secured by a first lien mortgage that provides mortgage financing to commercial and residential property owners and developers. Generally, mortgage loans have maturities that range from three to 10 years for commercial properties and up to 30 years for residential properties.

 

The following is a summary of our real estate loans as of March 31, 2007 and December 31, 2006:

 

 

The carrying values of our loans as of March 31, 2007 and December 31, 2006 include unamortized underwriting fees of $202 and $180, respectively.

 

The maturities of our real estate loans as of March 31, 2007 are as follows: $12,440 in 2007, $22,245 in 2008, $8,037 in 2009, $41,893 in 2010, $5,276 in 2011 and $161,352 thereafter.

 

In 2005, we originated a $9,450 mezzanine construction loan to develop luxury residential condominiums in Portland, Oregon. The loan provides for an aggregate of $6,695 of advances for construction costs and $2,755 for capitalized interest on the outstanding loan balance. The loan bears interest at an annual rate of 16% and has a maturity date of November 2007, which

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

can be extended at the borrower’s option, subject to satisfying certain conditions, until May 2008. Under the agreement governing the terms of the loan, interest on the loan was paid in cash through March 2006, and was capitalized thereafter. As of March 31, 2007, we have made advances of $8,385, including capitalized interest of $1,489.

 

Currently, the projected total costs to complete the project have increased from $41,400 to $58,600, including capitalized interest. Of the 70 units available, 50 units have been sold subject to scheduled completion dates, which are not expected to be met. We have commenced negotiations with the senior lender and the developer regarding the developer’s need to obtain additional financing to cover these additional construction costs.

 

We have evaluated the financial merits of the project by reviewing the projected unit sales, estimating construction costs and evaluating other collateral available to us under the terms of the loan. Our management believes that it is probable that the entire loan balance, including the capitalized interest, will be recovered through the satisfaction of future cash flows from sales and other available collateral. Accordingly, we have not recorded any impairment related to this loan. We will continue to monitor the status of this loan. However, housing prices, in particular condominium prices, may fall, unit sales may lag projections and construction costs may increase, all of which may increase the risk of impairment to our loan. No assurance can be given that this loan will not be impaired in the future depending on the outcome of the future negotiations with the senior lender and the borrower and the borrower’s ability to complete the project without additional cost overruns. In the event that we determine that it is probable that we will not be able to recover the total contractual amount of principal and interest due on this loan, the loan would be impaired.

 

We pledge our real estate loans to secure our repurchase agreements and collateralized debt obligations. The fair value of the real estate loans that we pledged as collateral as of March 31, 2007 is summarized as follows:

 

 

As of March 31, 2007, our real estate loans included non-U.S. dollar denominated assets with a carrying value of $43,328.

 

5.  COMMERCIAL REAL ESTATE

 

On March 20, 2007, we acquired two properties located in Houston, Texas and Phoenix, Arizona totaling approximately 428,600 and 724,000 square feet, respectively, for an aggregate purchase price of $234,710. Both properties are leased on a triple net basis to one tenant under leases that expire in 2021. In addition to the sale and purchase agreement, we entered into rent enhancement agreements with the seller under which we will receive payments through 2015 totaling $15,905. The present value of such payments is recorded as other receivables totaling

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

$13,617 on our balance sheet as of March 31, 2007, which partially offsets the below-market lease terms.

 

The purchase price has been preliminarily allocated based on estimated fair values of the assets acquired and liabilities assumed at the date of acquisition, pending the completion of an independent appraisal relating to certain of the lease origination costs included in intangible assets, which we anticipate to be completed in the second quarter of 2007. Accordingly, the fair value of assets acquired and liabilities assumed could differ from the amounts presented currently in our consolidated financial statements. We do not expect the final allocation to be materially different from that presented below.

 

The following is a summary of the amounts preliminarily assigned to each major class of asset and liability at the date of acquisition:

 

 

The transaction was financed with a $198,500 mortgage loan that bears interest at an annual rate of 5.509% (hedged rate 5.65%) and matures on April 1, 2017. We incurred financing costs of $186, which have been deferred and are being amortized over the term of the loan.

 

The following is a schedule of future minimum rent payments to be received under the leases at the two properties acquired:

 

 

The components of intangible assets and their respective weighted average lives are as follows:

 

 

Crystal River Capital, Inc. and Subsidiaries

Notes to Consolidated Financial Statements
March 31, 2007
(in thousands, except share and per share data)
(unaudited)

 

As of March 31, 2007, the components of intangible assets are as follows:

 

 

The estimated amortization of these intangible assets for the next five years is $4,207 for the remainder of 2007, $5,609 in 2008, $5,609 in 2009, $5,609 in 2010 and $5,609 in 2011.

 

Below market leases, net of amortization, which are classified as intangible liabilities, are $73,403 as of March 31, 2007. The estimated amortization for the next five years is $3,797 for the remainder of 2007, $5,062 in 2008, $5,062 in 2009, $5,062 in 2010 and $5,062 in 2011.

 

 

The following is a summary of our debt as of March 31, 2007: