Investment
Thesis
Since Redwood Trust
(RWT) is an internally managed REIT with an operating business it has put in
place an incentive compensation plan that more closely aligns management with
shareholders. Many REITs that hold real
estate securities are externally managed pools that charge an AUM fee which
incentives them to grow the size of the pool, not necessarily generate strong
returns. However, RWT exec’s are incentivized
based on ROE. Another difference with
RWT is that they have an operational business that generates fees along with
their pool of investments which is different from many real estate securities
based REITS that only own securities.
The business model
they have created and continue to develop appears to have a significant amount
of flexibility. They can purchase jumbo residential
loans on a flow basis or purchase an entire pool then decide to securitize the
portfolio or sell it in a bulk transaction.
They can keep the lower rated tranches or sell them to other investors. Having their own platform also makes them
less reliant upon third parties for investments. Their residential platform will soon be able
to securitize conforming agency loans that will generate MSR’s which again they
can keep or sell to someone else. Their
commercial business can purchase senior or mezzanine commercial debt and will
generally sell the senior loans in order to generate fees. Commercial borrowers can go to RWT as a “one
stop shop” for their commercial lending needs.
Finally, RWT can purchase assets from 3rd parties and can
decide on the amount of leverage, if any, they want to use on different types
of assets.
Redwood Trust has a
reputation for strong credit underwriting as not a single loan they have
securitized has went into default since they restarted their securitization
platform in 2010. Securitizations prior
to the financial crisis have also had a lower default rate than peers. RWT also has historically been good capital
allocator. On August 4, 1995, Redwood
IPO’ed with an opening price of $13.84/share and as of 06/28/13 the stock price
was only $17.00, but the firm had paid out cumulative dividends of $52.20/share
since inception. These cash flows have generated an IRR of
about 19%/year since its IPO. Over the upcoming
years it is likely that RWT will substantially increase its dividend payment
and provide strong returns to shareholders.
RWT has tried to
build a competitive advantage through its credit underwriting, relationships it
has built, stance on reps and warranties, its ability to meet a variety of
needs and the fact that it is not an originator; therefore it is not a
competitor to banks that originate residential loans. Not being part of a bank is significant as
many banks do not like to work with other banks due to competitive reasons.
Coming out of the
financial crisis RWT’s balance sheet had become relatively conservative. However, this is changing as they have been
able to purchase mezzanine debt as well as first/second loss tranche securities
from their securitization platform. Securitization
volume for RWT is accelerating which will create more subordinated tranches for
internal investment. In 2010 they had 1
securitization, in 2011 they had 2, in 2012 they completed 6 securitizations,
and in the first half of 2013 RWT had completed 8 securitizations. RWT recently increased their 2013
securitization goal from $7 billion to $8 billion. The increased volume will create more
investments as well as fee income and should eventually increase the yield on
the investment portfolio. The company
continues to expand its securitization platforms and believes the fee income
will become a larger part of Redwoods returns.
Redwood may potentially benefit from the government’s role in shrinking
the GSE’s as proposed legislation is currently being discussed. The GSE’s have maintained a 90% market share
since the financial crisis, so private companies, such as Redwood, could
benefit greatly if/when they do shrink. Also,
Freddie Mac is already building out a risk sharing platform that would sell
first loss securities to private investors and Fannie Mae is expected to do the
same. This not only could create more
securities for Redwood to purchase, but could increase the supply of
subordinated debt securities therefore helping to maintain or increase pricing
of subordinated tranches in general.
The financial
crisis has tightened credit standards which bodes well for RWT’s subordinated
tranche investments which have benefitted from the conservative
underwriting. Up to this point RWT has experienced
zero defaults from its securitization platform since restarting it in 2010. Historically, RWT has experienced lower
default rates than peers as it tends to be a more conservative credit
underwriter. With the housing market
continuing to strengthen it is likely that foreclosures and default rates on
its new securitizations could be relatively low, therefore, increasing the
potential returns on its first loss tranches.
Risks/Concerns
There is a lot of
competition entering Redwood’s markets. Both
large and small firms are looking to securitize real estate assets and certain
firms, like JP Morgan, bring significant financial size and strength. There is also significant capital looking to
invest in riskier real estate securities, which means that RWT could have to
pay more to obtain some assets.
There have been
significant losses of key personnel over the last several years. There Chairman, who also was one of their co-founders
and previously was CEO, left the company in 2012. The other co-founder retired in 2007 and is now
Vice Chairman of the Board. In June 2013
the Managing Director of their commercial business resigned and in March 2012
the then CFO resigned. The co-founders did
have transition periods before they left, but the CFO and managing director
were more of a surprise.
Rising interest
rates could hurt the balance sheet as loans get extended and increased rates
lower the value of current assets. Also, widening credit spreads could decrease the value of assets on the balance sheet. Prepayment
rates decrease with increasing interest rates which lengthens the time frame
that RWT must wait to receive full par payment on its first/second loss
tranches; therefore reducing returns. Rising
interest rates could also slow down securitization volumes if housing
affordability drops and assets held on the balance sheet, waiting to be
securitized, could create losses if not properly hedged. If housing has another
downturn they could see losses on their new investments. However, if rates rise they should be able to
invest in higher yielding assets that will generate higher interest income over
the long-term. Also, some of the real
estate securities they own are adjustable rate or hybrids that adjust to
interest rates. They have also fixed
their floating rate debt, so if interest rates rise the derivative liability
shrinks becoming a benefit to book value.
RWT owns a small amount of IO’s and MSR’s that would benefit from
increasing interest rates. Decreasing
interest rates could lower future interest income on future investments and
could increase the derivative liability.
