Terry Tate Buffett

Redwood Trust: Ravaged by Credit Losses

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