Purchase the Redwood Trust at a 13% yield. It’s Just Not ’08 (NYSE:RWT)

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What is a Redwood Trust?

For you, the 99.876% of Americans who have never heard of Redwood Trust, Inc. (New York Stock Exchange:RWT), is a SOCIMI that invests and originates residential mortgage debt. Some key facts about Redwood’s investment business:

  • He owns about $11 billion in residential mortgages. Through securitizations, he sold interests for around $10 billion, leaving him with a net investment of $1.2 billion.
  • Although Redwood transfers most of the interest rate risk through its securitizations, it retains most of the credit risk.
  • About half of mortgages are single-family loans. They are generally “non-compliant”, meaning that Fannie Mae and Freddie Mac cannot insure them. What makes them non-compliant is that they are too large (“jumbo” loans) or have some feature that is not within the Fannie/Freddie underwriting guidelines.
  • The other half of mortgages are “owner loans,” to owners of apartment buildings and single-family rental homes.

And here are some facts about Redwood’s home business:

  • Redwood originates the type of loans in which it invests. But many times, he finds that selling the loans outright rather than securitizing them makes more economic sense.
  • When you sell the loans, you transfer all of your credit and interest rate risk.

Redwood’s two massive discounts on par

Discount #1: For management. Because Redwood retains the credit risk of its investments, it initially values ​​the loans on its books below face value. I’ll let management put numbers to this, from their Q3 2022 conference call:

“Our portfolio of securities was held at a full $458 million discount to principal value, or just over $4 per share as of September 30. This translated to a weighted average holding price of approximately $0.69 per share. dollar on our balance sheet.

If the loans are lossless, it is obviously paid at par and the $458 million is recorded as profit. Incurred default losses reduce that $458 million of potential revenue.

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Discount #2: Mr. Market. Redwood’s current market capitalization of $819 million is nearly $300 million below the company’s current book value, meaning investors are discounting those loans even further.

The sum of the two discounts implies that Redwood will hold close to $750 million of default costs on its $11 billion of gross loans. Is that a reasonable assumption? I strongly say “No”.

Redwood Credit Protections

Oddly enough, Redwood doesn’t randomly make loans. It has subscription standards. These are the highlights of his house mortgage credit risk:

  • Its jumbo loans have an average home loan to value (LTV) of 44%. Yes, that’s right, 44%, because their average cure is 4 1/2 years and house prices have gone up 45% in the last 4 1/2 years. And the borrowers are solid – average FICO of 767. Will none of these default loans?
  • Redwood also invested in so-called “recovery loans” that were restructured after borrowers struggled during the Great Recession. That’s right, the average age of these loans is 16 years. His LTV averages 43% (home prices are up 65% since inception) and his average loan size is just $159,000. They are disorderly borrowers, 10% are currently delinquent, but they have managed for 16 years. Will the year 17 bring so much bad luck?

And here are some details about the homeowner loans:

  • Its average LTV is 67%.
  • Average cash flow for properties is 150% of your loan payment due to Redwood.
  • Many of the single-family rental homes are cross-guaranteed with other homes.
  • From management – “More than 90% of our bridge loans support a sponsor’s strategy of acquiring and stabilizing single-family or multi-family real estate, rather than traditional short-term sale and rehabilitation strategies..”
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Those are conservative lending standards. The housing market is going to have to get terribly bad to seriously delve into the $750 million of losses the market is expecting. Could another 2008 housing market kill off this conservative underwriting?

Why is this not ’08?

The next three images give you a lot of confidence about that statement. The first image puts the $750 million of alleged investor losses into perspective. $750 million is about 7% of the loans Redwood owns. How bad is 7% residential loan losses? Pretty disastrous, if Fannie Mae’s Great Recession experience is any guide. Here are Fannie Mae’s cumulative defaults on those ugly loans from 2004 to 2008:

Fannie Mae Cumulative Default Rates by Year of Origin

fannie mae

Cumulative “defaults” averaged about 10% on loans from 2004 to 2008. But the lender gets some money back when the foreclosed home is sold. Assuming a low 50% recovery rate, Fannie lost 5%. But the quality of Fannie’s loan was far worse than Redwood, from LTV to FICO to loan terms.

The second image compares housing vacancy rates from time to time. Vacancies are a good measure of the supply/demand balance. Here it is:

Historical vacancy rates for single-family and multi-family properties

Census Bureau

2008 was an all-time high vacancy rate, the present an all-time low. After there were an additional 2 million houses on the market. Now there is a shortage of more than 1 million. Home prices have to fall much less now for the market to regain balance. And Redwood borrowing landlords have a much better chance of meeting debt payments due to low vacancy rental rates.

Third and last is the quality of the borrower’s loan:

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Home Mortgage Borrower Quality Index

Urban Institute

A spectacular improvement. That means today’s housing market has far fewer financially unstable homeowners who might be forced to foreclose in a recession.

Bottom line: Redwood is cheap and highly volatile.

Two more charts to wrap this up. First, Redwood’s historical price-to-book ratio, updated through the end of last week:

Redwood Price-Book Value History

Redwood Trust, Yahoo Finance

The stock has just recovered from its lowest book price in history, a book value reduced by investors’ real estate fears. Redwood management is taking advantage of the fear of the market:

“Our analysis shows a compelling opportunity to invest in our own publicly traded stocks… We have already expressed this view by repurchasing nearly 60 million shares of common stock over the past five months. We anticipate doing much more in the near to medium term and have enough capital to do it.

This last chart simply shows Redwood’s stock price history:

Redwood Stock Price History

looking for alpha

What I find interesting is that four times during Redwood’s 25-year history, its stock price has more than doubled. This is a panic or frenzy action. We just had another panic. Is there a frenzy on the way? I think Redwood is at least a $10 share, and $12 is certainly reasonable. In the meantime, you have a good chance to cut a 13% dividend yield.

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