Your math is excellent! The issue isn't the math - it's the assumptions. Before I address your post, please respond to this (if you don't mind).
The Redwood Report for 9/30 states the following (I believe on page 100):
Residential R/E Loans: $7.546bn
Internally Designated Credit Reserves: $15.195mm
External Credit Enhancements: 0
Total Credit Protection: $15.195mm, or .20% of Total Loans
Seriously Delinquent Loans: $56.068mm, or .74%
Please help me with your earlier contention that there are CES tied to this portfolio (Redwood's owned) that results in much higher effective reserves against the portfolio than the 20 basis points show above.
Of course, as I've stated, the short play here is the complete inadequacy of their reserves, a well as coming write downs on their CMBS portfolio (where spreads have widened to 500 basis points).
As for your contention about ROI on the cash, my first question is why they're raising equity at < $30/share? As a CFO of 4 companies, isn't this close to dilutive (given their claim their adjusted book value is over $28/share)? If this thing is so undervalued and oversold, why not do a follow-on offering in the $40s? And if they're going to be earning $8/share (or whatever you showed), do a convert with a 20% premium! CFO 101 ...
20% premium would give them equity at well over $40 - not under $30!
I think they NEED the liquidity NOW, as their constant prepayment rate is probably coming WAY DOWN given the fact consumers are having an extremely difficult time getting refinanced (high FICO scores notwithstanding).
SO they notion of investing this liquidity and attaining a 20% ROI is a great goal, and quite a sanguine view of Redwood. My counter is something much uglier is at work:
Much less liquidity due to less refinancing; credit defaults increasing (s they are nationally, across sub-prime AND prime portfolios).
Hello My Friend:
The resi loan portfolio only has traditional credit reserves of $15mm against the $7.5 billion of loans for a ratio of 0.20%. There are no CES tied to this and if I implied so earlier, I did not mean to. The CPR on this portfolio in 3Q07 was 37%, down from 44% in 2Q07, but still very high. RWT's high quality borrowers can refinance.
Only RWT's investment in CES have CES that are junior to RWTs. On page 98, the face value of the securities for which RWT holds a CES is $211.9 billion. RWT owns CES with a principal or face balance of $1.269577 billion of which $450.8 million has been allocated toward reserves, $127 million is unamortized discount, and $159 million are unrealized losses, which nets to an on-balance sheet value of $532.445 million. There are also $335.7 million of other CES owned by 3rd parties that are junior to RWT's CES. The correct way to look at the credit protectin for RWT's net investment of $532 million of CES is the company's own internally designated reserves of $451 million, plus all of the CES that are junior to RWTs ($336 million), which totals $786.5 million, or 0.37% of the $212 billion of total securities.
They sold equity at the spot close, about $29 million, which was not dilutive to core book of about $28. They sold it to take advantage of the opportunties they see to acquire assets at bargin prices that are being dumped in the market. Note that the Super SIV is being downsized since banks are deciding to sell assets rather than delay the final resolution. This will or is helping RWT.
I never understood how to price a convertible so I can't add anything there. I know RWT had converts in the past, and I was an investor then.
Finally, I don't think they will earn $8, but there is the potential if you take the current core run rate in 3Q, annualize it, and add the incremental EPS from this capital raise, and ASSUMING they invest thier existing excess $300 million of capital. That is the potential. It could even be higher if losses are not as high as their reserves indicate. Continued high prepayment rates will cause RWT to take some of those reserves into income (don't laugh!).
I enjoy the back and forth between us. Are you a CFO in the mortgage industry? Just curious.
Thanks to both of you for an excellent debate!
I wonder if the "light" RWT loan loss reserves can be explained this way. WMT (and most lendors in the business today) must value their loans at current market, which in a seized-up market such as this one is what they actually receive from buyers who know the loans are not good quality and that WMT must sell them NOW. RWT's model is to match maturities of assets and liabilties; it does not plan to or need to sell the loans. Does this model not allow them to arrive at a market value for their loans in a more traditional way, based on borrowers' payment histories, etc.? The absence of an overwhelming pressure to sell the loans immediately has to have an effect on estimates of their market value and the related loan loss reserves.
The credit profile and payment history of the borrowers who comprise RWT's loan portfolio is quite different than those of WMT. This also has to affect the market value of the loans.
RWT management apologized at the last shareholders' meeting for having pretty much withdrawn from the market during the latter half of 2005 (they were explaining why assets had shrunk). They said they did not like what was happening in the market and stopped buying loans. I believe they were saying they had tried to dodge the loan quality bullet that has now killed so many other players in the industry. Of course, we won't know how successful they were for some time yet, but they have been through markets somewhat similar in the past. But if they are correct, their loans are not only higher quality, they are more seasoned and more easily analyzed.
Last, if RWT knew they had loan loss problems and truly were strapped for cash, they could have avoided paying the special dividend by selling enough problem loans to reduce taxable income and obviate the need for the special dividend. That would have killed two birds with one stone. The stock was already in the tank, so there was little to lose on that front. I think the fact they did not take that step is significant.
I am not minimizing the risk of owning RWT, but I do believe they know their business and manage it well. I look forward to your responses!
That was funny about Lloyd, I guess that dates us. I guess it will depend just how much or not RWT is like WM. WM's reputation on mortgages has never been good. They bought several mortgage companies for about $30 billion in total, and had very poor results, including huge hedging lossses, and overall poor performance versus WFC and CFC. (I don't know how management survives.) Years ago, pershaps around 1999, WM unloaded $7.5 billion of mortgages in securitized form and RWT bought the CES, and they performed very well. However, RWT was able to influence the structure of the securitization early on in the process. Perhaps they will get a second chance, at RWT's price, of course. That was years ago and in a different underwriting period. Only time will tell on the reserve question. By the way, I did spend a little time with TMA's financials recently. If I recall correctly, TMA's credit losses on its whole loan portfolio were something around $100,000 in 3Q07, the first loss in something like 20 or 30 quarters. Unfortunately, although they also hold CES (they don't call them CES), and they own them at a discount to reflect future credit losses, they don't (as far as I could find) state how much discount they have or if there are any jr. securities to theirs. Losses at TMA will certainly increase, without question they will increase, as they will at RWT, but I would think that losses at both companies would be much higher by now if its going to get ugly.
Until then, time will tell. Have a nice evening.