Redwood Trust: Ravaged by Credit Losses

Redwood Trust's (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.

Disclosure: none

Comments

[Craigla1:]

Not only is the dividend in jeopardy, but valuation on a multiple of book is highly inflated. Consider the following:

First of all, this mortgage REIT is practically in runoff mode (despite the fact they managed to buy a few mortgage-backed securities last quarter). Real estate loans & securities have gone from $12.1bn a year ago to $7.6bn. Interest income has gone from $220mm to $127mm, Q2 2007 to Q2 2008. A veritable shrinking company, whose core business is gone (never to return).

In runoff mode, you can only value this based on book value, as an ongoing annuity from earnings cannot be expected.

Book is down to $17/share, from $31.50 a year ago - and declining.

That said, most of you realize Sequoia and Acacia's asset backed securities and loans offset each other - with no recourse to the parent (Redwood). So let's look at Redwood alone. The consolidating balance sheet shows $611mm of equity at the Redwood and Opportunity Fund levels. Yet you need mark down the parent's investment in the subs (as this is worthless). This adjusts the equity (apart from Sequoia and Acacia) down to $430mm, or $12.96/share.

Now, RWT is going out and investing in MBS (the only thing left to do, as the mortgage REIT business is terminably shut down). Do you trust these guys to create value buying these securities, in a housing market which continues to plummet?

If you answer "yes," I know a CFO at FRE and FNM who wants to talk to you about their upcoming equity offerings ...

How about a valuation of .99x book, like ANH? That would value this puppy at $12.83/share.

2008 Aug 07 10:41 AM

[Terry Tate ...:]

Patrick and Craigla,

Good thoughts. However, an issue is that REIT taxable income does not equate to intrinsic value. The fact that REIT taxable income may be zero or negative in 2009 has little to do with what excess cash flow will be. For instance, this past quarter Patrick noted that REIT taxable income was $4 million or -$0.11 per share. However, excess cash flow was $50+ million or over +$1.50 per share. Now, some of this excess cash flow is unsustainable due to expected credit losses on CES securities, but the company is poised to generate strong cash flows the rest of 2008 and on into the future.

REIT accounting can be misleading - follow the cash flow and follow the expected loss adjusted yields. Under these scenarios, RWT is trading at a mid-single digit future free cash flow multiple.

Saying that Redwood is overvalued because it trades for 1.3x "book" is ridiculous. The "book" is a mark to market concept and Redwood is very conservative on this front. Most of Redwood's assets are fairly illiquid and thus suffer from a wide bid/ask spread. Redwood marks its assets at the bid level, which understates value compared to typical "last trade" nomenclature. Additionally, these assets are expected to yield (including loss assumptions) greater than 25% p.a. going forward. Book value is not what is important; it is intrinsic value that matters. And if assets have loss adjusted yields of 25+%, then we have to accept that intrinsic value is well north of book value OR the discount rate we require is unbelievably high. In either case, long-term future returns are likely to be attractive.

Redwood's management has been disciplined, honest and forthright. They are amongst the best in the business.

-TTB

2008 Aug 08 12:41 AM

[REIT Wrecks:]

TTB, there is an significant nuance to your assertions here, which are otherwise mostly correct. Intrinsic value is so incredibly important in this sector, and as you point out, "market" value on any particular day these days is usually widly disconnected from true intrinsic value . This disconnection relates to the necessary requirements of mark to market accounting, which has depressed book values to such ridiculous levels as to make them nothing more than red herrings for the uninformed.

So, contending, as Criagla1 has done, that a particular Mortgage REIT is trading at an inflated level to "book value" is about as ridiculous as arguing that the GW Bridge is too far from the Hudson River after the tide has run out. Deflated book values are simply widly disconnected from the intrinsic value of cash flows, which in many cases have not changed (nor have have their prospects).

However, there is definitely something going on with RWT's cash flows. I look foward to reading the Redwood Review more closely, but the earnings information I did read indicated that RWT has been forced to convert some of these mark to market, non-cash book losses (temporary) into real, cash book losses (permanent), and that has reduced taxable cash flows and taxable income. Why?because that money is now completely gone, nevermind no longer generating attractive cash flows.

As Patrick points out, this is causing non-GAAP and GAAP to converge, eliminating the disconnect between fallacious, non-intrinsic "market" value and real, intrinsic book value. I don't believe RWT is destined for run off mode yet, but they can't keep experiencing actual realized losses like this. The whole play in this sector is that MTM losses are exaggerated and temporary. To the extent they are becoming permanent at RWT, that is a bad sign.

2008 Aug 08 02:55 PM

[User 232593:]

the voodoo of the accounting in finance has become a joke.wallst is more like vegas,slower losses & nobody brings you a drink.

2008 Aug 08 04:10 PM

[E Nuff Sed:]

I enjoying the good rational debate here and agree the mark of market taken to RWT are phony baloney accounting losses. If the security is held to maturity marks can be ignored. The cash flows being generated by the securities is key and a good measure of intrinsic value.

Also could some one comment on the potential for mark-ups here, if and when housing stabilizes and the Acacia and Sequoia SIV's stabilize?

2008 Aug 15 07:40 PM

[REIT Wrecks:]

Not so sure about Acacia and Sequoia stabilizing. Redwood owns the equity tranches in those deals, which is first loss. That money is gone for good, whether it's held to maturity or not. The marks can reverse though, and you need to pick through and see what, if anything, is likely to turn around. But even FSA, in last quarter's brief glimmer of hope after the Bear Stearns debacle, reported that they may be able to reverse some of their marks because spreads had tightened, I wrote about it here: www.reitwrecks.com/200...

2008 Aug 26 03:24 PM