Seeking Alpha
Profile| Send Message|
( followers)  

Business Description

Redwood Trust (NYSE:RWT) is an internally managed Real Estate Investment Trust (REIT). It creates value for shareholders through two primary activities: securitizing real estate loans and purchasing real estate securities. Redwoods securitization platform is housed within its Taxable REIT Subsidiary (TRS) and currently is the largest issuer of jumbo Prime RMBS. It is also building out its commercial platform and will be working with the GSEs (Fannie Mae and Freddie Mac) in order to securitize conforming agency loans. These activities generate fee income as well as real estate securities that are purchased by Redwoods REIT subsidiary.

In normal environments, the REIT subsidiary would primarily own first/second loss (subordinated) tranches from real estate securitizations (residential, commercial, CDO). These securities act as insurance for the investment grade tranches as they are the first to absorb losses. Historically, Redwood has paid 25 -35% of principal value for first-loss tranches and 50 -70% on second-loss. However, they generate income based off of the full principal value and if there are zero defaults they will receive par value when the securitization is called or paid off. These securities thus perform best in an environment of low defaults and decreasing interest rates. After the financial crisis most of these securities became worthless or severely impaired. Redwood also purchases mezzanine debt, MSRs, IOs, non-prime real estate securities, investment-grade real estate securities, etc. They will use leverage to enhance the return on certain investments, but have stated that they will not use leverage on the first/second loss securities.

Investment Thesis

As internally managed REIT they have been able to 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. This incentivizes them to grow the size of the pool, not necessarily generate strong returns. However, Redwoods executives are incentivized based on ROE. Another difference with Redwood, compared to many of its peers, is that they have a mortgage banking operating business that generates fee income to go along with their pool of investments.

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 or bulk basis. Then they can decide to securitize the portfolio or sell it to a single customer. They typically keep the subordinated tranches, but can sell them to other investors if they wish. While Redwood can purchase assets from 3rd parties, the fact that they have built out their own securitization platform makes them less reliant upon them for investments. Their residential platform will soon be able to securitize conforming agency loans that will generate fee income and MSRs, which again they can keep or sell. Their commercial business can purchase senior or mezzanine commercial debt and has become a "one stop shop" for commercial borrowers. This business line will generally sell the senior loans in order to generate fees, but keep the mezzanine debt. Finally they can leverage assets if it makes sense.

Redwood has tried to build competitive advantages through its credit underwriting, relationships, stance on reps and warranties, its ability to meet a variety of needs, reputation, and the fact that it is not an originator of residential loans (therefore it is not a competitor to banks). Not being an originator is significant, as many banks do not like to work with competitors.

After the financial crisis Redwoods balance sheet had become relatively conservative. However, this is changing as they have been able to purchase mezzanine debt and first/second loss tranche securities from their securitization platform. Securitization volume for Redwood is accelerating which will create more subordinated tranches for internal investment as well as more fee income. In 2010, they had 1 securitization, in 2011 they had 2, in 2012 they completed 6, and in the first half of 2013 Redwood completed 8. RWT recently increased their 2013 securitization goal from $7 billion to $8 billion. This compares to a little over $2 billion in 2012. The company continues to expand its securitization platforms and believe that the fee income will become a larger part of Redwoods returns. Also, Redwood is likely to benefit from the government's role in shrinking the GSEs as proposed legislation is currently being discussed. The GSEs have maintained 90% market share since the financial crisis, so private companies, such as Redwood, could benefit greatly if/when they do shrink. Even if the GSEs do not shrink in the near future 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 in general, allowing Redwood to continue to purchase these assets at low-to-fair valuations.

The financial crisis has tightened credit standards and Redwood was already known for its conservative underwriting. This bodes well for Redwood's subordinated tranche investments. Up to this point, Redwood has experienced zero defaults from its securitization platform since restarting it in 2010. Their securitizations prior to the financial crisis also have generated lower default rates than peers. With the housing market continuing to strengthen it is likely that their default rates on new securitizations could be relatively low, therefore, increasing the potential returns on its subordinated tranches. Redwood also has historically been good capital allocator. On August 4, 1995, Redwood had its IPO with an opening price of $13.84/share and as of 06/28/13 the stock price was only $17.00. However, 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 coming years I believe it is likely that Redwood will substantially increase its dividend and provide strong returns to shareholders.

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 JPMorgan (NYSE:JPM), bring significant financial size and strength. There is also significant capital looking to invest in riskier real estate securities, which means that Redwood could have to pay more to obtain these assets. There have been significant losses of key personnel over the last several years. The former Chairman, who was one of the co-founders and previously was CEO, left the company in 2012. The other co-founder retired in 2007, but is still Vice Chairman of the Board. In June 2013, the Managing Director of their commercial business resigned and in March 2012 the CFO resigned. When each co-founder decided to step back they both had planned transition periods, but when the CFO and managing director resigned it was more of a surprise.

Rising interest rates could hurt the balance sheet as loans get extended and increased rates lower the value of some of their assets. Prepayment rates decrease with increasing interest rates which lengthens the time frame that Redwood must wait to receive full par payment on its first/second loss tranches, therefore reducing returns. Rising interest rates could slow down securitization volumes and assets held on the balance sheet, waiting to be securitized, could see losses if not properly hedged. On the positive side of increasing interest rates is that 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 fixed their floating rate debt, so if interest rates rise the derivative liability shrinks becoming a benefit to book value. Redwood also owns a small amount of IOs and MSRs that would benefit from increasing interest rates. If interest rates decrease it could lower interest income on future investments and increase the derivative liability. Demand for private label RMBS has been fickle at times and if housing has another downturn they could see losses on their new investments. Finally, widening credit spreads could decrease the value of assets on the balance sheet.

Conclusion

In my opinion Redwood Trust is a well-managed company that focuses on capital allocation and conservative credit underwriting. It has built a flexible business model that can generate value through multiple sources. The company does face some headwinds due to the low and increasing interest rate environment. However, there are substantial growth opportunities and I think the firm is positioned well to take advantage of them.

Source: Redwood Trust: Competitive Advantages, Growth Prospects, And Risks