The mortgage industry has been going through an incredibly difficult stretch. Last year was absolutely awful as the Federal Reserve began to rapidly hike the federal funds rate to combat high inflation. Mortgage bankers saw loan origination volumes collapse as the incentives for most customers to refinance evaporated and home affordability declined.
In addition, mortgage real estate investment trusts (REITs) saw their book values per share decline as mortgage products fell in value faster than Treasuries. Redwood Trust (RWT +0.17%) is one of the biggest non-agency mortgage REITs, originating loans for professional real estate investors. Here is how it is dealing with the slowdown.
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Redwood Trust focuses on non-guaranteed mortgage products
Redwood Trust is a mortgage REIT that focuses primarily on non-agency products. This means many of the loans it makes are not guaranteed by the U.S. government.
These loans fall all over the spectrum, but the majority are business-purpose loans generally made to professional real estate investors. These are usually either bridge loans or single-family rental loans. Bridge loans are short-term loans (usually less than three years) made to a real estate investor who wants to rehabilitate a property and then refinance it when it is eligible for a lower-rate loan. Rental loans are made to investors who are ineligible for a government-guaranteed loan. Business purpose loans accounted for about 62% of Redwood Trust's investment portfolio at the end of 2022.
The next largest component is third-party loans, which include reperforming loans, home equity loans, multi-family investments, and credit risk transfer securities. Reperforming loans consist of mortgages where the borrower went delinquent and then began making payments again. These types of loans were popular investments in the immediate aftermath of the Great Recession and were generally available at deep discounts to face value. Credit Risk Transfer securities are a sort of reinsurance product for Fannie Mae and Freddie Mac. The final major category of loans in its portfolio is jumbo loans, which are too large to be guaranteed by the government.
Higher credit risk means higher rates, but liquidity is always a concern
The non-agency loans in Redwood Trust's portfolio generally pay higher interest rates than the agency loans held by mortgage REITs like AGNC Investment (AGNC +0.94%). Redwood Trust, and originating lenders it buys these loans from, set rates on those loans higher due to the greater credit risk they present, and also their liquidity risk. Although there is a highly liquid market for agency mortgage-backed securities, liquidity in the non-agency market tends to be spotty and can dry up at times. Lack of liquidity in this area ended up sinking a couple of major mortgage banks last year, including Sprout Mortgage and First Guaranty. Since Redwood isn't dependent on the securitization market, it can ride out these periods better than some of its competitors.
The mortgage origination side of Redwood's business suffered in 2022 as rates rose and refinancing activity declined. Home affordability took a turn for the worse as rising rates and pandemic-driven home price appreciation combined to drive monthly payments upward at a pace well in excess of wage growth. This caused many potential home sellers to reconsider putting their homes on the market, and many first-time homebuyers were priced out of the market. As a result, Redwood has significantly reduced its working capital allocation to the origination side of the business and is cutting costs. Like many originators, it has been laying off people.
Redwood will be tied to the fortunes of professional landlords
Ultimately for Redwood Trust, much will depend on how rental inflation and cap rates play out. Cap rates are the embedded returns on properties. If cap rates are high, it means that these properties have high yields and are cheap. If cap rates are low, it means that real estate is overpriced. Cap rates are how professional real estate investors determine whether to invest in properties. If the U.S. economy slides into a recession, then we could see a decline in real estate prices and an increase in delinquencies. That said, professional real estate investors generally put up sizable down payments, so they have a lot of equity at stake, which will deter them from walking away. This should help prevent credit losses on these loans.
The jumbo loan side of the business will be held hostage to the Fed and monetary policy. Given the affordability challenges, mortgage banking is probably in for another tough year unless we hit a recession and the Fed responds to that by starting to cut benchmark interest rates. Otherwise, the affordability challenge will have to be fixed by rising wages, which will take some time.
Redwood Trust reported a net loss in the fourth quarter. That means the $0.23 per share quarterly dividend, with a tempting yield of 12%, is at risk. So investors should be wary. Like the shares of many mortgage originators, the stock underperformed during the past year.
