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(I posted the message below to the last debate while this one was starting. I'm hoping it was overlooked--but maybe no one thought it was worth replying! I guess I'll know soon...)
Thanks to both of you for an excellent debate!
I wonder if the "light" RWT loan loss reserves can be explained this way. WM (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 WM 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 WM. 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RWT management apologized at the last shareholders' meeting for having pretty much withdrawn from the market during the latter half of 2005 (they were explaining why assets had shrunk).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!
Iner2512: A loan loss is a loan loss. The fact that a company is not forced to sell a mortgage, does not prevent them from losing money on it. Just start increasing their loan losses from 0.20% to 0.40% and then 0.60% and re-calculate their income statement and balance sheet and how much you can expect to receive in dividends, and you will start to see a whole new picture. Considerably more negative than what management puts forward.
As for the special dividend, I suspect it was more of an attempt to temporarily boost the stock price so they could sell the latest stock issue at a more inflated price(take a look at the boost in share price once they announced that dividend. Those were shorts covering and sellers waiting for the dividend, that did that. Nothing else more concrete). That rise too will disapate.
Shareholders are putting a tremendous amount of faith in RWT management if they feel that they have some ability to buy mortgages that much better than anyone else. They do seem to be pretty smart guys but I also believe they are as human as everyone else and todays RWT share price is quite a leap in faith in these guys, in my opinion.
I am really not sure I should respond to someone who does not know what he is talking about. The special dividend had to be paid or else they would lose their status as a REIT. REITs must pay 90% of their taxable earnings to shareholders to avoid having to pay tax on those earnings. They did not pay a special dividend to hype the share price, how stupid to even post that, not to mention that such an action would be potentially criminal. Do you really think the D3 Family Fund, that bought 1.7 million shares on or about 11/29, was hoodwinked into buying nearly $50 million of shares because RWT declared a $2 special dividend? I suspect they are not day traders.
I will agree that they may not be able to buy mortgages or more likely CES better than other "smart" guys, but they are taking advantage of forced sales from dumb guys that are too highly leveraged. Remember, RWT has essentially no recourse debt. At 9/30/07, RWT had total owned - not GAAP - assets of only $746 million and cash of $310 million (page 89 of the Redwood Review), and that was before the equity raise.
Clearly a doubling of the reserves (or in RWTs case a write down of its CES by the amount of the expected increase in losses) would lower its earnings and dividends. But what are you basing that on? Just because Wamu or WB or BAC raised reserves? I hope so because they don't do what RWT does, which is to invest in support bonds of securities backed almost exclusively of high quality residential loans. Try looking at First Republic Bank's FDIC call report for a better comparison, since RWT and FRC focus on the same borrower. At 6/30/07, FRC last filed call report before it was acquired by Merrill, showed nonaccrual 1-4 first mortgages of $8 million compared to a portfolio of $3.9 billion, which is a 0.21% nonaccrual rate. Those loans like RWT have a LTV or about 70% or better. I am probably wasting my time but hopefully not since someone else might read this.
A loan loss is indeed a loan loss--when it is realized. But we're talking about reserves for expected future loan losses that are based on forecasts and expectations, not actual experience yet. At least that is true for RWT, which has no need to sell their loans on the open market. If RWT did pull in their horns in mid-2005, most of their loans are at least somewhat more seasoned and easier to analyze and reserve based on loss expectancies developed from actual experience with those borrowers. I believe RWT thus has the ability to establish loan loss reserves based on their best estimate of expected future collections and be in compliance with GAAP in valuing loans. In the long run, of course, RWT must be correct in their loan valuations.
For WAMU and others that are under-capitalized and must sell their loans immediately, the loss is dictated by what they can actually get in the current market. Quite a different kettle of fish, I think, especially in this market.
I agree that if you double or triple RWT's loan loss provision, their P&L goes down the tubes, although their cash flow remains the same. But if you believe they are that wide of the mark, you should short the stock, as I gather you have done.
Do you mistrust management across the board or just disagree with their loan loss reserves? I believe management is the single most important part of this business, and I'd be interested in any examples of bad management you have in addition to your thoughts on loans.