REXI STRONG SELL RECOMMENDATION - Part 2 Accounting Irregularities
Part one of our report, (found here), Message 5896925
detailed a history of transactions by REXI management that appeared to be both self serving, unethical and appeared in some cases detrimental to the shareholder's best interests. We have significant concerns that REXI management has failed to act in a fiduciary capacity to the company and its shareholders.
Part two of our report discusses issues of accounting irregularities regarding REXI's use of two controversial methods of accounting for revenue; “accretion of discount”; and “gain on sale”. We feel REXI has improperly used gain on sale and accretion of discount to inflate their revenue, income and earnings. We also believe REXI has used non-standard accounting which is not in compliance with GAAP, contrary to the September 17, 1998 letter from Grant Thornton. We feel REXI will be forced to restate their earnings, significantly reducing their revenue and income.
GRANT THORNTON'S LETTER BACKING REXI ACCOUNTING METHODS
On Sept. 18, 1998 REXI released a letter from their auditor, Grant Thornton, which in essence stated they backed REXI's accounting methods, as noted here in that release:
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After we reviewed this press release, we reviewed various accounting standards including APB-6 that Grant Thornton in their letter claimed backed REXI's accounting methods. We feel it is rather clear from reading APB-6 that REXI does not qualify for this “accretion of discount” treatment.
APB-6 talks about loans that are bought at discount because it is unclear whether the borrower is able to pay. In other words, if someone makes a loan at a 9% yield and then sells the loan to someone else at an 11% yield, the person who buys the loan at 11% yield is entitled to earn 11% compounded over the life of the loan. That would be the proper accounting.
What's interesting here is REXI does not buy loans because of the borrowers inability to pay, rather because of the property's historic inability to produce adequate cash flow. REXI buys “non-recourse” loans on specific properties. So that you understand clearly, let me define “non-recourse” loan.
A non-recourse loan is a loan that is made to a borrower - lets say Donald Trump for the purpose of our example. Mr. Trump is the real-estate owner of lets say - the Empire State Building. Now, Mr. Trump has a non-recourse loan on the Empire State Building and the building has not performed i.e. - not produced enough cash flow to service/pay the monthly loan payments. REXI comes along and buys the loan for 50 cents on the dollar. Now, after REXI buys the loan, should it go into default - because it is a non-recourse property specific loan - REXI does not have recourse back to Donald Trump. REXI can only go to the property to recover the amount of the loan. REXI cannot go to Mr. Trump and say - give me your casino to pay off any unpaid balance of the Empire State Building loan.
This is an important distinction in REXI's use of accretion of discount accounting, because when you read through the actual requirements as stated in APB-6, it says to qualify to use accretion of discount, you are generally looking at the borrower's ability to repay the loan. In a non-recourse property specific loan, there is no borrower. In APB-6, in the case of a non-recourse collateral loan, the accounting is rather clear. It says:
If enterprises acquire loans primarily for the rewards of ownership of the underlying non-monetary collateral, they should record the collateral rather than the loan.
That makes sense, but that's not what REXI is doing.
According to APB-6, if you are buying a non-recourse loan at 50 cents on the dollar, because you are looking to the value of the collateral as opposed to the credit worthiness of the borrower you have to treat the building as an asset and you cannot accrete a discount. That would seem to be the proper accounting under APB-6 but that's not what REXI is doing. Instead, REXI is trying to treat these non-performing, non-recourse loans as if they are distressed loans, when actually they are distressed collateral.
To take this argument one step further, for these loans to qualify as distressed loans, rather than distressed collateral, there are certain standards that a distressed loan must meet in order to, as APB-6 says, “reverse the presumption” that a discount shouldn't be amortized. In other words, there is a presumption when you buy a property specific non-recourse loan that you shouldn't be able to accrete discount. But APB-6 provides specific criteria, based on the loan's collectability, that will allow you to reverse this presumption.
Following are the six tests a loan must meet to reverse the presumption and allow accretion of discount:
1. The financial condition of the borrower.
We have already addressed this issue. REXI's non-recourse loans have no borrower to look to for financial condition, they only have a building as collateral, thus they would fail this test.
2. Substantial equity of the borrower in the collateral underlying the loan that is not funded by the lender.
To the extent that these loans are way underwater as non-performing loans, the borrowers have no remaining equity, or have minimal remaining equity, so they would fail this test.
3. Historical cash flows from acquired loans.
Here again REXI's these loans would fail this test because the loans would not be at such deep discounts if the cash flows had been adequate.
4. Prospect for near term cash flows from the acquired loans.
Several reports on REXI's loans show the cash flows the properties are generating - and the near term cash flows are not terrific. Thus they would also fail this test.
5. Other credit enhancements - such as irrevocable letters of credit and enforceable personal guarantees or take out commitments from credit worthy parties.
In other words, if the loans go bad is there someone else you can look to. As we have already discussed, on non-recourse loans you can look only to the property, thus they fail this test also.
6. The nature and probability that any asset underlying the loan will generate sufficient future cash flow to cover future principal and interest payments when due.
What is important to note here is the test specifies “cash flow”. For example, to meet this test, REXI's forecasted cash flow of a commercial property must cover future principal and interest payments on a loan. Note it says “principal and interest”. REXI's loans don't do that. REXI's loans assume that at the end of their 5-7 year forbearance agreement they would be able to recover as Quote “principal” whatever the Quote “appraised value is”. And that's where REXI runs into a big problem. The appraised value of the property is not a timed principal payment, rather it is used more as a balloon payment.
This issue becomes an even greater problem for REXI's accounting methods when you look at the discussion in the appendix to APB-6. It talks about when you can cannot accrete discount. It says if you are relying substantially on a balloon payment, you are not eligible to accrete discount.
REXI is using the appraised value as a sort of terminal value which would be used to pay off the principal at the end of the forbearance agreement, which is tantamount to a balloon payment. Thus it appears APB-6 says quite clearly that what REXI is doing would disqualify them to use accretion of discount as they are.
EITF 89-4
In their recent conference call REXI also referred to EITF 89-4 as backing their accounting methods for use of accretion of discount. This also seems to be false. EITF 89-4 does not qualify because it is accounting for collateralized mortgage obligations and REMICS and other quote “high quality monetary assets”.
REXI's assets, although they are real estate assets - and therefore in some sense similar to a CMO, they are not high quality monetary assets - as evidenced by their defaults. They are also not CMO's which are pools of loans. REXI's one off loans, fail the test of high quality monetary assets - and they themselves admit these are not CMO's. Thus we see no reasoning REXI can stand behind EITF 89-4 to back their accounting for accreting of discount..
GAIN ON SALE
Along with the known lack of reliability, and miss-representative issues of gain on sale accounting, REXI appears to have additional problems regarding the way they account for gain on sale revenue.
The issue with REXI is what they have neglected to do to qualify to use gain on sale accounting. This issue questions if any of the revenue they have reported to date, (based on their gain on sale accounting), was proper. We feel it was not, and REXI will need to substantially restate past 10Q's and 10K's.
To record gain on sale, FAS 125 requires the calculation of the fair value of the senior piece and the subordinated piece. It says that the first choice is to find a market price and in the alternative there are other methods you should use - most notably Discounted Cash Flow (DCF) evaluation.
REXI in fact does not do either of these things. Instead they rely on an analysis which says:
“The value of the property is X the value of the A piece is Y, therefore the value of the B piece must be X minus Y.”
This analysis is incorrect for a number of reasons. First off, it does not consider if they did a good job selling the A piece. For example, if you sold the A piece at an 8% yield or you sold it at a 12% yield, using REXI's method, you would come to the same outcome. But if you did a Discounted Cash Flow of the B piece you would come to very different outcomes.
Using a DCF you are supposed to discount the future cash flows out of the property to your subordinated piece on a periodic basis. Using a DCF there will be a certain number of dollars in the first year, the second year so on and so forth. You are supposed to then assign an appropriate risk adjusted discount rate to those cash flows and you are supposed to discount them back to the present to figure out what the subordinated piece is worth.
To use gain on sale, the accounting standards, (FAS 125), require that REXI update this quarterly. REXI management has admitted they also do not do this, and thus they fail the requirements of FAS 125.
For these reasons, we believe all past revenue reported by REXI produced by their gain on sale accounting will need to be restated, which may cause some significant changes in their earnings. Furthermore, we believe this means their financials are not current which could cause a trading halt on the shares of their stock.
CONCLUSION
We have no confidence in REXI's management to act in the shareholder's best interests based on their history of self dealing transactions. Furthermore, we feel REXI's accounting methods are improper, not in compliance with GAAP and their past quarterly and annual SEC filings will need to be restated.
The effect of these accounting problems could cause the shares of their stock to be halted due to lack of current reporting, and could cause significant litigation pitting REXI Vs their auditor, Grant Thornton, further delaying the resolution of this problem. We recommend avoiding the purchase of REXI shares at all costs, and we recommend the sale of REXI stock by all shareholders who are now long the stock.
Pluvia Securities Research is a securities research boutique specializing in corporate valuations, equity research and investigation of fraudulent stock promotions. This report should not be construed as an offer to sell or solicitation of an offer to buy any securities. Opinions expressed are subject to change without notice. None of the persons preparing this report are trained accountants. This report has been prepared from original sources and data which we believe to be reliable but accuracy is not guaranteed. Certain matters described in this report are forward-looking statements and are subject to risks and uncertainties that could cause actual results to differ materially from those projected. This research report was prepared by Pluvia Securities Research whose friends, associates, spies, snoops, affiliates, cohorts, highly trained experts and undercover contacts may from time to time acquire, hold or sell a position in the securities mentioned herein. Mr. Pluvia and affiliates of Pluvia Securities Research currently hold positions consistent with the above rating.
e-mail Pluvia2@aol.com
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