Introduction: Heavy Mortgage Backed Securities Exposure Will Lead To Big Declines
Redwood Trust (NYSE:RWT) is a REIT-structured entity that makes leveraged investments in financial instruments that themselves are highly leveraged. It’s my candidate for the financial midcap stock most likely to lose 80% of its value in the next six months. Its portfolio is broadly similar to other mortgage REITs that have fallen more than 99% from their peaks to now, such as New Century Financial (NEWCQ) and Thornburg Mortgage (TMA). What has allowed RWT to not collapse 99% as several other mortgage finance REITs is (1) RWT wisely did not rely on short-term debt and debt subject to margin calls, and instead funded its most unwise investments with securitized debt; (2) its portfolio of MBS is of somewhat older vintage than TMA’s and NEWCQ; (3) its exposure is more to jumbo, ALT-A, and Neg-Am mortgages rather than subprime.
What follows is a detailed analysis of RWT’s assets, liabilities, and what I think the stock is worth. Those with a short attention span and/or little familiarity with modern real estate financial terms may want to skip to the bottom of this section for my conclusion. The short version: RWT, now trading for about $30, is worth perhaps $8 now and should decline to as little as $4 by the end of this year.
Balance Sheet Analysis: Big Writedows Will Be Reported For Q2 and Thereafter
- Questionable Accounting
To start, I am first going to note, and then temporally ignore, two major issues with RWT’s accounting practices. First, I would be cautious about accepting uncritically RWT’s repeated claims that most of its debt is “non-recourse,” “bankruptcy remote” and “legally not ours.” In fact, I suspect at least some of RWT’s counterparties, who have lost billions buying “investment grade” obligations issued by RWT’s arboreal “securitization entities” have a different view of this point. Nonetheless, it is still helpful to take RWT’s word on this issue and focus on what monsters lurk on the non-“securitization entities” part of its balance sheet.
Redwood’s second accounting issue is a very questionable attempt to understate its debt levels by marking-to-market certain liabilities. Showing good timing, right before its credit quality fell through the floor RWT issued $150 million in subordinated notes. Debt markets now think so little of RWT’s ability to pay its liabilities, however, that the company’s debt is trading for less than 50 cents on the dollar, even worse than GM’s. Redwood therefore carries this $150 million dollar debt as a $72 million debt, thus booking a $78 million dollar profit, not through good business practices, but because its MBS portfolio is so risky that debt markets rightfully predict the company has a very high chance of default and/or bankruptcy. The consumer equivalent would be if an individual with $30,000 in credit card debt, after defaulting on his mortgage, decides “Hey, now that my credit score is so low, my credit card debt just went down by more than half, since my creditors won’t be able to sell my debt to collection agencies for more than 50 cents on the dollar.”
Rather than as immediate risks, I view these questionable accounting practices as clouds hanging over the company’s head and greatly detracting from its credibility. While I think only companies in serious financial jeopardy would employ them to such a massive extent, I am going to ignore them for the sake of argument and look just at the company’s liabilities as it reports them, and then visit it again in my conclusion.
- Assets Facing Writedowns
RWT’s single largest asset class is “real estate securities.” Within this group are mostly “credit enhancement securities” (“CES”) which is an exotic financial term for the super-junior “first loss” tranches of a mortgage securitization. These are great investments as long as defaults on mortgages are at historic lows and the rate of mortgage pre-payments are at historic highs. That does not describe today, or the foreseeable future. Defaults are rapidly rising, and resales and refinances are at extremely low volumes.
RWT’s defenders like to point to the fact that much of these CES are based on prime mortgage securitizations. The problem is, what RWT considers “prime” are not the safe, conservative, conforming, 20%-down mortgages to people with verified incomes and good credit that most people think of when they hear the word “prime.” Instead RWT’s “prime” portfolio includes a risky hodgepodge of ARMs, hybrid ARMs, and worst of all Neg-Am ARMs.
This argument about the “prime” quality of the mortgages underlying RWT’s MBS portfolio also misses the mark since these “prime” CES have much more built-in leverage than subprime CES. In theory, a tranche of a prime and a tranche a subprime securitization with the same rating should have the same risk. Since prime mortgages are assumed when securitized to have much lower default rates, the degree of leverage can be much greater, so there is much less credit support on the prime CES that RWT owns. So what matters is not the obvious and unchanging fact that prime mortgages have much lower default rates than subprime. What matters is the ratio of actual defaults to those expected by the bond rating agencies, whose ratings criteria in practice determined the degree of leverage in MBS. It takes a much, much smaller spike in prime mortgage losses to completely wipe out RWT’s prime CES investments than it would a comparable investment in subprime CES.
RWT has $100 million in commercial CES and $88 million in residential CES. These investments are valued at “management’s estimates.” My rough estimate, based on the vintage and changes in Markit’s ABX and CMBX indices (specifically the oldest and most junior indexes for both, which most closely reflect what is in RWT’s portfolio) is that the $88 million in ABX will be written down to $43 million and its CMBX CES will be written down to $96 million, for a total Q2 write-down of CES investments of about $49 million.
Again based on changes to the most similar ABX indexes, I estimate RWT is going to have to mark down its remaining $25 in “investment-grade” (hahaha) RMBS by about 20% or $5 million. Next, RWT reported $3 million in “Other Real Estate Investments” which from its own description likely faced a similar markdown as residential CES, which would round to loss of $2 million. Finally the company has $15 million CDO “investment-grade” securities. The company does not disclose enough information about this mysterious investment for me to estimate the appropriate markdown (or markup), so I am going to assume a smaller 20% markdown of $3 million in line with the general deterioration in real estate credit markets in the 2nd quarter. This is only half of the $6 million markdown RWT suffered on these investments in the first quarter, so is by no means an aggressive estimate.
In summary, assuming no significant changes in real estate credit markets in the last few days of the second quarter, I estimate that RWT will mark down its portfolio of real estate securities by $59 million, from $212 million to $153 million.
RWT has on its books $214 of investments in its Sequoia and Acacia entities. It provides a “management’s estimate of the economic value” of these investments of $141 million. I think this is far too rosy an outlook, but assuming that management stays excessively rosy while still accounting to the deterioration of real estate credit in the second quarter, I expect the investment in Sequoia’s estimated valuation to decrease by about $19 million. RWT’s investment in Acacia is even more vulnerable to be overstated because it is entirely valued by model rather than by dealer bid, unlike Sequoia. Nonetheless, based on management’s expectation that all cash flow will end to some of its CES backed by several Acacia entities, I expect about $4 million in second quarter Acacia write-downs. In grand total, I am expecting write-downs of $82 million to be reported in Q2.
- Book Value
As of 3/31/08, book value was reported at $585 million ($17.89/share). The company also provides a “management’s estimate of economic value” that writes down the value of Sequoia and Acacia investments as well as marking to market subordinated note liability as discussed in the introduction. This total is the similar figure of $590 million ($18.04/share).
After the $82 million write-down I expect to be reported on RWT’s next earnings release, the “management’s estimate” should decrease to $15.46/share, excluding the effects of operating income and dividends. This means that RWT is trading at almost two times book value. This is an absurdly rich valuation for a company with a broken business model, no prospect of earnings after write-downs for the foreseeable future and expenses rapidly increasing as a percentage of assets. The table below shows the valuation of RWT and several other companies that made foolish real estate related investments at bubble prices.
click to enlarge image
Source for information is Yahoo! Finance unless otherwise noted
** Source AOL Market Watch
Since RWT no longer has access to credit markets, the company, just like TMA, NCT, and JRT, is essentially like a huge bond-focused mutual fund sitting on very low quality assets, with very high expenses, and the prospects of big losses later in the year. Why on earth would somebody pay an almost 100% premium over assets to own such a bond fund?
Conclusion: RWT stock is set up for a big fall
I am not sure what the catalyst will be that causes RWT to fall down to a level more in line with its peers, which would be at most 0.5 times Q2 book value, or about $8 per share, but I suspect it is loyalty of unsophisticated investors brought on by years of consistently paying a high normal dividend and sometimes even bigger special dividends. I do expect RWT to make its next dividend payment of 75 cents per share, but this may end up being the last one. Even if the dividend is maintained for a few more quarters, these will not be distributions of income generated from interest spreads and securitization profits, but simply returns of capital that will further reduce the company’s equity.
Also, there will likely be even more write-downs in the third and fourth quarters. In particular, I expect that RWT’s commercial CES investments, which I think will only face small (roughly 4%) writedown at the end of this quarter, may face 30%-60% write-downs in the second half of this year as commercial credit suffers from the growing weakness in the retail, office, and casino/resort sectors. Since RWT holds the “first loss” positions in commercial mortgage pools, the decline in CRE does not have to be too large to inflict serious losses on RWT’s commercial CES portfolio.
Now getting back to the accounting issues I discussed the start of this article, RWT’s Q2 book value if you count its $150 million in subordinated notes as a $150 million liability instead of a $72 million liability, drops to a tad more than $13 per share, giving a target price of about $6.65 at 0.5 times book value. With additional losses coming later this year in both residential and commercial real estate, RWT, fairly valued at the end of the year, should probably be a four dollar stock. In a market where companies with big mortgage debt portfolios frequently lose half or more of their value in a matter of days or weeks, I don’t think it will be long before RWT’s stock price crashes down to the levels of its peers.
Disclosure: Author is short RWT common stock and long RWT puts.