Description

Redwood Trust: $12.50 - Long

Redwood Trust is a closed-end bond fund in the form of a mortgage REIT.  It has about 60 million shares outstanding.

Virtually its entire business, today, is buying non-Agency mortgage securities (funded with equity or 30 year term borrowings) as long term value investments.  Redwood can be purchased at or around its liquidation value.  [as an aside, due to the stock's amazing volatility, this is a tough write-up to finalize!]

Redwood Trust is a heavily shorted mortgage REIT that at first blush appears to have 10x leverage and historically invests in junior parts of the capital structure in non-Agency Residential Mortgage Backed Securities (RMBS), Commercial Mortgage Backed Securities (CMBS), Collateralized Debt Obligations (CDOs) and other Asset Backed Securities (ABS).  Given that, why is it not bankrupt?  I thought all these things went bankrupt about 18 months ago.

Redwood is unlike most mortgage REITs.  It was built to last from its conception.  It does not borrow much (one Trust Preferred that comes due in 2027 at L+225 though overall it is and has been a net cash balance sheet).  Redwood's management was bearish going into the mortgage crisis and was one of the early warning flag raisers regarding the housing market, underwriting, and aggressive securitizations.  They sold 40% of their portfolio at the end of 2005 and held onto the cash until Q4 2007 when they began to dip their toe back in.  Redwood began reducing participation in the securitization markets several years ago and have performed better than nearly any other participant that did not aggressively short RMBS.  My personal experience with management is they are conservative underwriters that have aggressively bearish assumptions in their analytic models (though even extreme bearishness is starting to be a broadly accepted base case).  A risk adjusted return on capital mentality is embedded in their culture.

Redwood was founded in the mid-90s by George Bull and Doug Hansen with backing from value-maven Wally Weitz and his Weitz Fund family.  The Weitz funds are by far and away the largest shareholders and insider ownership is pervasive.  Other large holders include Davis Funds and D3 Partners.

Frankly, the rest of this write-up is gratuitous to the investment thesis and merely attempts to outline why the existing Redwood investment portfolio may be cheap.  The thesis can be stated simply: if you believe there's an opportunity in distressed mortgage securities, then you want to find a management team you trust to exploit that opportunity and a reasonable entry point if you're buying into an existing portfolio.  I feel highly confident that Redwood's management team is smart, skilled, shareholder oriented, ethical and conservative.  I also think the existing portfolio represents excellent value and incremental capital will be deployed at unusually attractive rates of return.

As with any investment in what is effectively an investment business, management is hugely important.  Over the past 18 months, we have interviewed well over 50 different teams launching "mortgage opportunity funds" including Redwood.  We put the folks at Redwood in our top three or four teams.  We may have or make investments in both the publicly traded units and any current or future Redwood third party fund offerings.

What is Redwood:

For those interested, I highly recommend reading the past few years of Redwood's "The Redwood Review" which they publish quarterly.  It is written in as close to plain English as a review of an ABS portfolio could possibly hope to be.  The Ks and Qs have additional useful information, but The Review is a great place to start.

An investment in Redwood is surprisingly straightforward.  Despite its seemingly debt-laden balance sheet, Redwood is actually a net cash pool of investment capital, not particularly different from a closed end mutual fund.  Rather than stocks, the primary investments historically have been various six-pack ABS and CDO securities (the "six-pack", in ABS parlance, are the junior most six tranches of a capital structure).  For the past nine months, Redwood has focused its buying on investment grade securities (IGS) ABS.  Redwood's investments generally are not in Agency securities, though they may purchase a few. 

As of December 31^st on a mark to market (MTM) basis, Redwood had about (adjusted for the January secondary offering):

• $409 million of cash ($6.81/share)
• $145 million of third party RMBS ($2.41/share)
• $42 mm of third party CMBS ($0.70/share)
• $4 mm of third party CDO assets ($0.07/share)
• $97 million of Sequoia RMBS (Redwood's core credit enhancement and securitization business is referred to as Sequoia, so this represent's Redwood's ownership of its own securitizations) ($1.62/share)
• $16 mm of Acacia CDO securities (CDOs managed by Redwood operate under the Acacia brand name and Redwood often retains junior tranches in these securities). ($0.27/share)
• Redwood also has started an asset management business whose first investment vehicle is called the Redwood Opportunity Fund. Redwood has invested $50 million of prop capital in that fund and began deploying it near the end of 2007. The carrying value of that $50 million is $28 million (the fund has distributed to Redwood approximately $10 million and the balance of the $22 million decrease are mark to market losses). ($0.47)

All of this, as I noted, is owned via balance sheet equity investment from Redwood and some funding via a small sub-note issuance which itself would be a reasonable investment if you can get your hands on any.  Thus, we can add all of the assets ($741 million total), subtract the sub-note ($150 million) and divide by shares outstanding to arrive at the MTM value of Redwood's equity (around $10/share) - this is MTM on the asset side, we are keeping Redwood's sub-note at cost, even though it likely would trade 50% below that).  I assume Other Assets and Other Liabilities roughly offset each other.

This leads us to Redwood's seemingly debt filled balance sheet.  Accounting standards require Redwood to keep the entire asset and liability structure of the Sequoia RMBS and Acacia CDOs in which Redwood owns the majority of the unrated/equity tranches.  However, each of these structures is independent and bankruptcy-remote from Redwood.  In other words, the only money at risk by Redwood if a Sequoia structure has horrible performance is Redwood's ownership of ABS of that specific Sequoia.  There are no claims to other Redwood assets and the performance of any Sequoia structure has no impact on any other Sequoia.  If I own most of the equity of General Motors and GM goes bankrupt, creditors have no claims on my other, non-GM related assets.  In other words, while the assets Redwood invests in have leverage, and at times Redwood has to reflect that leverage on its balance sheet, Redwood is not explicitly using any leverage in the way we typically think of it.  During normal times, a more thorough discussion of Redwood's Sequoia business would be necessary to understand the opportunity in RWT units, but given the current securitization drought, I think the investment merits are primarily in thinking about Redwood's existing portfolio and capital deployment ability.

Going Forward:

Redwood management has been aggressively bearish, though clearly not bearish enough as they began investing some of their money for the first time in years in Q4 2007.  They invested slowly but steadily throughout the first half of the year but in July 2008, it became clear to Redwood management that the government was going to get involved in some big way and management was uncomfortable investing with such a big unknown variable.  Redwood stopped investing and hoarded their cash until October and November when asset prices began plummeting.  While Redwood was quite bearish on housing and credit performance, in my opinion, they did not forecast ABS pricing collapsing the way it did in Q4 (it capitulated once the Treasury announced TARP would not be used to buy troubled ABS). 

Having talked to several ABS specialists in November and December, it is my belief that many super senior AAA bonds were transacting at risk-free prices with incredible optionality.  There were super senior AAA 2005 vintage Option ARMs that transacted at prices (perhaps $0.45 on the $1.00) where the breakeven scenario to LIBOR required 90% of the mortgage pool to default at 70% severities (i.e., the mortgage loses 70 cents on the dollar).  If that happened over the course of several years, you would still receive a LIBOR return.  In my mind, that's virtually risk free and you have huge convexity to a better-than-Armageddon scenario.  While credit rallied a bit from those lows into late December, most of Redwood's carrying values still reflect enormous levels of economic depression. 

As quarter end approached, Redwood was getting closer to fully invested and management was faced with the prospect of basically slowing their investing activities to a purely re-investment level (excess cash generated minus dividends).  While I think rightsizing the business to that reality was the best choice, they instead chose to do a secondary offering (details in the next paragraph).  I believe the offering was priced at basically a neutral price for existing shareholder - obviously if, all else being equal, the trading environment for RMBS worsens substantially, the offering will turn out to be an excellent decision.  If it muddles for a time, I think it's fairly neutral and if the market rallies sharply and permanently, it will have been a value destructive decision.

Redwood recently priced a secondary offering for around 26 million shares at about $11/share net of costs.  It is worth noting that before the offering, Redwood had a pristine balance sheet, so management's rationale is that this is purely an opportunistic offering.  This was a somewhat transformative transaction on several fronts: 1) Redwood had indicated they would not do a secondary offering anywhere near this price for most of 2008 and had plenty of chances to do one at higher prices, but obviously they didn't which was a bad mistake; 2) Redwood now has about $7.00 of cash on its balance sheet that it can deploy into investments - this also serves to limit downside; 3) Despite growing their asset base substantially, the fixed cost base needed to manage those assets will not change, so it reduces the operating expenses per dollar of assets (i.e., it improves operating scale); and 4) The scope of transactions Redwood can undertake has substantially increased.  They can easily participate in capital relief transactions, which are generally chunky, or equity funded whole loan deals.

Prior to the secondary, I expected Redwood to easily generate over $3.00/share in excess cash flow (over $105 million) in 2009.  It will almost certainly be way over $100 million now, but how much depends on the price, performance, and timing of Redwood's investment program with the $400+ million it has on its balance sheet. 

We can begin by saying Redwood will likely generate, net of costs, $105 million of cash from its existing portfolio.  That translates to about $1.75 of per share cash flow.  If Redwood is able to deploy its $410 million of cash at a 15% loss adjusted annualized return (I think it's likely to be double that or more), it would generate a further $62 million of cash flow ($1.03/share).  That would imply about $2.80/share of annual cash generation.  It is incredibly difficult to know what portion of that is truly "excess", since some amount of it would need to be reinvested to maintain the cash flow stream but it's safe to say the $2.80 is largely sustainable.  So, perhaps $2.00 is sustainable.  In that scenario, Redwood is priced at a 16% annual sustainable cash flow yield (6.3x earnings) and a 22% total cash flow yield with enormous positive optionality and a fortress like balance sheet limiting the downside.  I believe both of these numbers have substantial upside given the investment opportunity is likely to be well north of 15% loss adjusted yields.  To show the sensitivity, if instead the return opportunity today is 30% loss adjusted yields, the $410 million of cash will generate $123 million of incremental cash flow.  When combined with the $105+ million on the existing portfolio, Redwood would generate $228 million of cash flow or $3.80/share.  This would increase both yields by 8% and lower the earnings multiples by 2 turns (4.3x sustainable earnings).

The current dividend is $1.00 (8%'ish yield).  Due to losses on investments, Redwood does not actually have to distribute any cash for the time being, so toward the end of 2008 they reduced the dividend from $3.00/share to $1.00/share in order to improve their ability to reinvest in today's environment.

The Opportunity:

If, like me, you believe there is an opportunity to make attractive returns from well selected distressed and stressed ABS (specifically RMBS) today, then I believe owning RWT units is an unusually attractive way of participating from a variety of perspectives:

1. Liquid balance sheet ready to be deployed at highly attractive, safe rates of return.
2. Proven Management: Redwood management was one of the early warning flag raisers regarding the housing market, underwriting, and aggressive securitizations. They sold 40% of their portfolio at the end of 2005 and held onto the cash. They began reducing participation in the securitization markets several years ago and have performed better than nearly any other participant that did not aggressively short RMBS. My personal experience with them is they are conservative underwriters that have aggressively bearish assumptions in their analytic models. A risk adjusted return on capital mentality is embedded in their culture.
3. Non-replicable Investment in Systems: Redwood has spent the last dozen years building out its first rate technology, data collection, human capital and analytics platform. You cannot just choose to replicate this and expect to be successful on any near-term time frame.
4. Relationships: Via its role as a leading securitization firm and its experience creating and marketing CDOs, Redwood has built up a knowledgebase and set of relationships with groups that are interested in selling assets quietly and off-market. This is difficult to replicate.
5. Seasoned, High Yielding Portfolio: Unlike many Opportunity Funds being raised today, Redwood already has a good chunk of its portfolio in place. As discussed above, the portfolio primarily consists of 2004 and earlier collateral with 2005 being the next largest component (by far). Redwood's portfolio is also better than average from a borrower credit perspective and from a geographic perspective.
6. Evaporating Competition: To the extent the prime securitization market comes back, Redwood's competitive position is tremendous right now as all of its typical competitors (Thornburg, Wall Street, hedge funds etc.) are substantially hampered and are exiting the business.
7. Capital Relief Transactions: This is sort of 6(a), but I believe there is a substantial opportunity for Redwood to offer highly customized capital relief transactions to banking partners. These deals generally allow someone like Redwood to pick through a portfolio of loans on a bank's balance sheet and build a portfolio of attractive assets at compelling prices. In exchange for giving someone like Redwood a sweetheart deal, banks receive "capital relief" by being able to change the amount of capital they are required to hold against the remaining loan pool in a disproportionate way versus the amount of capital Redwood actually provides. A typical capital relief deal might require $50-100 million of capital from Redwood. Not many of these deals have been done by anyone in the market to date, but Redwood is well positioned in the event they gain favor.
8. Third Party Asset Management Business: Redwood launched its first third party asset management vehicle (excluding CDOs) called the Redwood Opportunity Fund toward the end of 2007. It has a private equity fund-type legal and fee structure. I expect they will continue to grow this business in the future by launching follow-on funds and by adding new funds with different strategies. This may someday provide an attractive revenue stream to which the market is ascribing zero value.
9. Other Embedded Options: MBS bonds trading below par serve as call options on substantial inflation and pre-payment speeds. Prepayments have slowed to never before experienced lows. Any uptick in prepayments would be incredibly accretive to the Redwood portfolio. I believe Redwood's credit performance assumptions build in a continued slow-down in prepayments in order to be conservative, so even a stabilized CPR would be a victory.
10. Naturally built in catalysts: the company is generating huge amounts of cash (without any use of its existing cash hoard, over $105 million in 2009). While it may be able to take some tax losses and defer distributing a portion of the cash it generates, that cash or the cash it generates upon reinvestment will have to be distributed at some point. So, even if we do not receive a re-rating of the shares, we are generating a huge amount of cash. The stock has a dividend yield of about 8% today.
11. Wonderful hedge to financials shorts: For those of us that have been busy shorting financials elsewhere in our portfolio, even if you disagree with me that there is much upside here, owning Redwood is a great way to hedge many of the risks we are assuming by shorting financials. If somehow the housing market stabilizes, Redwood's upside is fantastic and would offset some of the pain of shorts bouncing in your face. If asset deterioration continues, I expect Redwood to do well. Of course, I believe Redwood is an unusually attractive stand-alone long idea, but it can serve this dual purpose as well.
12. Cheap: Most importantly, I believe Redwood units can be acquired at unusually attractive prices even if the negative housing environment persists and worsens substantially. As mentioned above, the investment has the potential to be rocket fuel powered if housing turns out to be less than unbelievably horrific.

Disclosure: My firm and I may buy, sell, or ignore Redwood Trust units in the future.  I and we may invest in existing investment partnerships and/or future partnerships that Redwood has an economic relationship with.  I and we may choose not to disclose this to anyone.  Please do your own research.  Invest at your own risk.  Drugs kill.

Last word: I am more than happy to discuss the specifics of ABS or Redwood's portfolio in the Q&A.  I just didn't want to convolute an already long write-up with an enormous amount of detail on the portfolio.

Catalyst

Generates and distributes tons of cash.