Redwood Trust's (NYSE:RWT) shocking second-quarter results are a painful reminder of a very important mortgage REIT tenet: over time, cumulative GAAP and taxable income should converge, suggesting that GAAP income should increase or taxable income decrease over time relative to the other.
Unfortunately for Redwood, it's quite clearly the latter case. Estimated taxable earnings for this quarter were just $4 million ($0.11 per share). These taxable earnings included $30 million (-$0.92 per share) of taxable income deductions related to credit losses, up from $14 million in the prior quarter. RWT also noted that it expects credit losses will increase in subsequent quarters, perhaps not peaking until 2009 or 2010. These increased credit losses will continue to pressure REIT taxable income throughout the period.
As a REIT, Redwood's minimum dividend distribution requirements is determined by its REIT taxable income. The Company is now estimating that 2008 REIT taxable income generated in 2008, together with the undistributed REIT taxable income carried over from 2007, could fall somewhat short of full-year distributions at the regular dividend rate of $0.75/share. Considering that Redwood had over two quarters' worth of 2008 dividends covered by 2007 spillover, the current year's taxable earnings have decelerated at a dramatic pace. For the second half of 2008, Redwood had only $1.32/share in undistributed REIT taxable income.
Although Redwood's Board of Directors reaffirmed its intention to maintain the regular quarterly dividend rate of $0.75 per share for both the third and fourth quarters of 2008, the Company expects that the amount of undistributed taxable income carried over into 2009, if any, will be minimal. The dividend is clearly in jeopardy for 2009 and beyond.
Trading at the lofty valuation of 1.3 times GAAP book value, RWT shares are in trouble without the support of a generous dividend yield. Although Redwood management has done an excellent job of managing its liquidity through the year-old credit crisis, the frozen securitization market has completely undercut the RWT business model.