Why Redwood Survived

The question came up why Redwood Trust survived and Thornburg went down in a ball of flames.

Let’s roll back to the summer and fall of 2007, when Bear Stearns’ two mortgage hedge funds had already done face-plants, and the market was figuring out that if documented 85 LTV subprime loans were bad, maybe “no doc” alt-A or even premium FICO loans might have problems, too.

It’s one thing when a single stock with maybe a billion or three in market cap goes south, but another thing entirely when a trillion dollar asset class gets screamingly cheap.

Bonds basically have to trade down in sympathy when other bonds get cheap.  After all, unlike stocks, there’s really no upside.  If everything goes perfectly in the future, you get your principal back and the stated coupon.  If things go just OK in the future, you get your principal back and the stated coupon.  If you own a portfolio and things go badly, you get the stated coupon on all your bonds for a while, and principal back on most of them.

As the clouds gathered for the coming storm, all the mortgage investors were feeling the pressure of margin calls, both from lower prices and from less-generous leverage.  Naturally, the management teams at the two ultra-prime investors were willing to think that trouble in the subprime sector didn’t mean their bonds were going to take credit losses, though it did mean the market prices would decline to reflect higher yields and wider spreads in the whole market.

Thornburg hit the wall first, though Redwood was probably right behind them.  They were faced with the need to sell to meet margin calls, or alternatively, the need to raise more capital.  Wall Street offered to help them out with the latter.

Thornburg raised $500 million in preferred stock in the fall of 2007.  In order to make the deal even more attractive, Wall Street offered to create “super-senior” bonds out of AAA alt-A MBS from the Street’s own subsidiaries and sell them with six months of financing (my guess, not revealed fact).

The Street would take the “natural” AAA bonds that might represent 90% of the deal, and cut them into 80/20 credit preference.  Even though alt-A mortgages weren’t Thornburg’s main thing, it looked like a pretty good bet, and with Wall Street offering 4-1 leverage, they could raise $500 million, buy $1.5 billion in super-senior bonds (financing $1.2 billion) and have $200 million left over to give them breathing room so they wouldn’t have to sell their core portfolio of ultra prime MBS at a loss when rolling over the financing on those prime bonds.

Fast forward five months.  By then, Peleton had blown up because they switched from being short to being long, and Carlyle Mortgage blew up from owning Agency-guaranteed floating rate CMO’s at 30-1 leverage.  Bear in mind that Peleton was better known that Paulson at that point, and their investor return of 87% after fees for 2007 made them darlings of the fast money crowd.  Carlyle had even more attraction, as the private equity parent of the mortgage fund was where retired conservative politicians went to get rich (e.g. former President George H. W. Bush).

Then came the six-month anniversary of the preferred stock sale by Thornburg.  I believe that coincided with the rolling of the financing on $1.5 billion of alt-A super-Senior bonds.  (By the way, those were also what Chimera bought with most of their IPO money, which is why that $15 a share they raised is well and truly gone.)  My guess is that the new market value assigned to the bonds TMA bought with its preferred stock capital was in the 78-80 neighborhood.  Unfortunately for them, they had borrowed 80 cents on the dollar, so all the new money was gone, too.

Meanwhile, everything was getting cheaper, every week, and here’s why:

Once the highest rated (and structurally most protected) bonds in subprime mortgage deals were trading at 50 cents on the dollar or less, no one in their right mind would be willing to pay par, or possibly even 90 cents, for alt-A or even prime private-label MBS.  Basically anyone who owned that kind of paper with leverage was dead.

As I told our senior trader just after the Bear funds blew up — “It feels like they are trying to create their own RTC.”  There was just an air about it, as if the Street hadn’t made a big enough fortune buying bonds from a distressed seller in mortgage land, and they wanted a repeat of the hundreds of billions of sales that came from the Savings and Loan cleanup.

They got their chance in early 2008, but they got more than they bargained for.  The dealers and their hedge fund buddies had started a deflationary avalanche. By the fall of 2008, the “cheap” bonds the dealers bought from Thornburg were being sold by distressed sellers at less than 50 cents on the dollar.  The Street got a taste of its own medicine, a lesson that was doubly painful when the hedge funds they had been working with (those who didn’t go long) started pulling their cash out of the brokerage accounts.

At that point, only Paulsen (note that’s with an ‘E’, not an ‘O’) and Bernanke could save the dealers, and salvation consisted of agreeing to shotgun weddings.

Redwood lucked out by not raising capital when Thornburg did, and by sticking to its super-prime mortgages (sort of).  Another time we can talk about the retained exposure to CDO’s in the Sequoia series.  Luckily, that wasn’t big enough to take them down.

At least that’s how I remember it going down.



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