Redwood Trust Part II - Pro's/Cons

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 3^rd 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.