UncleLongHair

Redwood Trust: From $30 to $4 by Year-End?

Hi Greg, I hope you don't think I'm stalking you, I noticed this other article of yours and I happen to have been watching RWT along with CRZ. Really I don't have any position in either.

I feel that RWT is in a much better position than CRZ because, with no short-term financing, they can wait for their assets to run out if need be, and they'll naturally de-lever as loans prepay. If there is any discrepancy between today's panic-driven market value and actual intrinsic value of these assets, as I strongly suspect there is, RWT should be fine in the long term.

However, as you point out, I've been wondering about the quality and valuation of some of their assets, including the credit enhancement securities. The big question mark is how bad the default experience will be on prime loans. So far it has gone "from a very small number to a small number" but still basically within historical norms. If it breaks for the worse, the valuation of RWT's assets may see another leg down. But if it doesn't, which would be consistent with long term trends, maybe nothing will happen. I think this is a really tough call, and very little to use as the basis for a short position IMHO.

Regarding your concern over accounting treatments, I don't agree that non-recourse borrowings could end up being recourse. Even in the most catastrophic meltdown scenario (and there have been many over the past 12-18 months), in no situation did any mortgage bond holder have recourse to the originator's equity. That is a legal and financial firewall that has never been breached, nor should it be. The securitization markets might be dead for now, but a done deal is still a done deal.

Secondly, regarding FAS 159, I too had some questions about the prompt adoption of this by certain companies (RWT and CRZ to name two). On one hand, as you point out, one could envision some abusive scenario where a company quickly issues debt and then doesn't have to account for its full liability because paradoxically they made themself a poor credit.

But on the other hand, it doesn't seem right to me that a company's assets could be marked down severely due to temporary market fluctuations while their liabilities would not. Their liabilities, after all, are someone else's assets, and the other party is probably writing down the assets due to market fluctuations, whereas the liabilities are unaffected. So you've got one party marking down something on the left side of their balance sheet, but some other party, who has the very same financial instrument on the right side of their balance sheet, not making any changes. From this perspective, I think it makes perfect sense to mark both assets and liabilities to market in some situations where the two are directly related and well matched.

There is clearly some severe volatility going on in market valuations of financial assets of every kind. There are things to be worried about, but I also think that the valuations are overblown. Prime mortgages would have to default at many times the worst level in history in order for many of these valuations to make sense. The financial press thinks the sky is falling, but that doesn't mean that it is.