Redwood Trust (RWT)

Redwood Trust recently completed a private label securitization of jumbo mortgages, the first since 2008. I have a long term position in the stock (RWT) and am hopeful this news will be a catalyst for further gains. The earnings release for the first quarter should have more detail on the economics of the deal for Redwood. At 12/31/09, the company had $243m in cash compared to $878 million in securities and investments. Secondary market prices of historical vintage MBS had reached relatively unattractive levels, according to the Company, which raised the question of how the excess cash will be deployed. Great statistic from the Redwood Review on how selective they are being at current market levels: "During the fourth quarter, we bid on approximately $2.4 billion (market value) of residential securities and we acquired $68 million of those securities, consisting of $65 million of prime and non-prime senior securities and $3 million of prime re-REMIC securities." More detail on the economics of the securitization and long term capital deployment plan should be released in the first quarter Redwood Review in the first week of May.

Key points for this stock:
1) The historical business model was the purchase and securitization of whole mortgages while retaining the subordinate piece of the securitization, as well as resecuritization of subordinate MBS through CDOs. While the Company positioned itself for a downturn in housing, it did not anticipate the full extent of the downturn and did not sell enough of its historical assets in hindsight. In contrast to many mortgage REITs, however, it was virtually debt free (despite the suggestion to the contrary from GAAP accounting which requires consolidation of non-recourse securitization debt). This enabled RWT to avoid the dramatic losses / bankruptcies experienced by many mortgage REITs depending on short term financing from broker-dealers, which forced REITs to sell assets at fire sale prices as banks pulled warehouse funding. Due to a lack of debt, RWT was ablt to buy assets at attractive prices in 2008 and 2009 and was strong enough financially to issue stock in the public market to further invest in securities.

2) The underlying cash flow per share is in excess of the dividend rate. Dividends are tied to taxable income, which is still negative due to losses on historical investments, as there is no credit reserving similar to GAAP for taxable income. The Company has elected to pay a $1 annual dividend. Looking at page 23 of the 12/31/09 Redwood Review, Total Business Cash Flow was $57M and $68M for the last two quarters, roughly 3x the $20M paid in dividends. Now this does not necessarily mean this rate of business cash flow is sustainable, as the economic value of the current investment portfolio consists of securities purchased in 2008 and 2009 at distressed prices. The company's ability to recycle capital into attractive opportunities as pre payments of its securities occur is still to be seen and why the news of the securitization was so important. Additionally, the Company is expanding its commercial platform as a means for possible investments.

3) Book value is understated as the market prices of the Company's portfolio are well below par. In 2008 and 2009 investments were made in senior securities focused on the 2004 and 2005 vintages, with largely better credit underwriting and homeowners more likely to still have equity in their homes after house pricing declines. Between the credit support in the securitization structures, Redwood's securitiy selection, massive support of the housing sector, the hope for bulls is that much if not all of these securities are money good/par eventually. The company's senior securities portfolio has $249 million/$3.20 per share in discounts on its senior securities ($115 from senior securities with prime collateral and $134M from senior securities with non-prime collateral). There is an additional $111M in unamortized discounts in the re-Remic portfolio.

I view $25 per share as a good target for the stock, given the strong potential for an increase in the dividend rate for 2011 and the growth from book value that will continue to occur as the Company pays out less than its earning. $25 per share would be a 10% yield on a $2.50 dividend and a 1.5x book multiple on $16.67 book value (compared to the current book value of $12.50/$13.03 for GAAP/economic book value). Although the vagaries of GAAP accounting mean the $3 per share cash income less $1 in dividends paid does not directly mean a $2 increase in book value over this year, I think the $15 - $16BV is a likely year end target. GAAP book value increased $3.5o over 2009 and economic book value increased about $2. Additionally, as cash is deployed into higher yielding assets, this will improve the Company's income and rate of book value increases.