Redwood Trust - Part I

First, before talking about Redwood I must disclose that I own shares in the company.  Second, I’m not providing investment advice, so make sure you do your own due diligence. 

Redwood Trust (ticker RWT) is a unique type of Real Estate Investment Trust (REIT).  REIT’s are companies that own physical real estate or real estate securities; Redwood is the latter.  Importantly, REIT’s have the advantage of not paying corporate taxes on qualified sources of income as long as they payout 90% of their taxable income.  The way Redwood is setup some subsidiaries are taxed while others are not.  Redwood has an interesting business model and generates profits through various activities.  However, I am going to simplify their business model in this post into two segments: investments and securitization platform. 

First let’s talk about investments.  Redwood is well known for investing in Credit Enhancement Securities (CES), also known as the equity tranche, or the first or second loss tranche in jumbo residential mortgage-backed securities (jumbo RMBS).  These assets are the riskiest assets in a securitization; however, they also have the highest expected return.  Now let me back up for a second.  RMBS is simply a collection of mortgage loans that have been pooled together and then sold to investors.  Pooling these mortgages reduces the risk of any one default having a sizeable negative impact on the investors return.  The “jumbo” in jumbo RMBS means that these loans are too large to qualify for government guarantees from any of the government sponsored enterprise (GSE’s), think Fannie Mae or Freddie Mac.  The GSE’s in essence protect the RMBS investors from any defaults.  However, since jumbo RMBS don’t qualify for the GSE’s, jumbo RMBS investors must find protection from somewhere else.  This is where Redwood steps in. Since they buy the first and second loss tranches they are providing insurance to the jumbo RMBS investors, but they only do this for a price.

I will explain this by giving an example.  Let’s say Redwood has pooled together several hundred jumbo mortgage loans and is creating a jumbo RMBS.  This RMBS will have two classes or levels, called tranches.  The first tranche makes up 90% of the securitization, is the first to get paid principal & interest, and is rated AAA.  We will call this the AAA tranche as it is the safest tranche.  The second tranche makes up 10% of the securitization, and will absorb all credit losses (bankruptcies) until the tranche is wiped out.  This is the equity tranche.  The AAA tranche will only see credit losses after the equity tranche is gone.  If there are zero bankruptcies then the equity tranche is paid in full.  For taking on this risk the equity tranche gets paid a higher interest rate than the AAA tranche.  Below is a diagram of a more complicated securitization; the equity tranche would be at the bottom of the illustration in the “unrated” section.

Redwood Trust will also purchase mezzanine (most junior) commercial loans or the most junior tranches in a CMBS, (Commercial Mortgage Backed Security).  CMBS is just a pool of commercial (business) mortgages.  Again, Redwood is looking at the riskiest, yet highest expected return assets.

Redwood will also invest in investment grade RMBS, IO’s (interest only), MSR’s (Mortgage Servicing Rights), and other types of real estate securities. 

Since Redwood wants to purchase risky assets it is important that they are mindful of how much they are being paid to take on these risks.  Since they can purchase various types of assets (RMBS, CMBS, IO, MSR, etc.) it is also beneficial to change the mix between assets in order to move from securities that are fair-to-over valued and into securities that are undervalued.  They can also create these securities themselves (see below) or buy them from a third party.  In essence they have to be good capital allocators to be successful. 

The second part of their business is their securitization platform.  Redwood earns fees from securitizing loans.  They primarily securitize jumbo mortgages, but will securitize commercial mortgages and are looking to securitize agency backed mortgages as well.  The securitization platform also is beneficial as they typically buy the junior most tranches in their own securitizations as well as IO’s and MSR’s that are created.  Since they are the company that is creating the securitization they have already completed the due diligence on the loans and should know the details intimately. 

In a post to come I will explain some of the pro’s and con’s of Redwood Trust.