REDWOOD TRUST INC quarterly report, Q2 FY2020

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Redwood Trust, Inc. — Q2 2020 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2020. Redwood is a specialty finance company focused on residential and multifamily mortgage investments and mortgage banking, with Residential Lending, Business Purpose Lending, and Third-Party Investments segments. Amounts below are in U.S. dollars; financial statement figures are generally in millions unless stated otherwise.

Financial performance and condition

  • Q2 earnings: Net income was $165.4 million, compared with $31.3 million in Q2 2019. Diluted EPS was $1.00 (basic EPS $1.41), versus $0.30 diluted in the prior-year quarter. The quarter’s result reflected $152.2 million of positive investment fair-value changes and $26.0 million of realized gains, including a $25 million gain from repurchasing convertible debt.
  • First-half results: Net loss was $778.0 million, versus net income of $85.7 million in H1 2019; diluted loss per share was $6.82. The loss chiefly reflected $718.6 million of negative investment fair-value changes, $34.2 million of mortgage banking losses, and an $88.7 million goodwill impairment.
  • Interest income and margins: Q2 interest income was $129.9 million, down from $148.5 million a year earlier; net interest income was $27.3 million versus $32.3 million. The filing reports a 5.1% average yield on interest-earning assets and a 4.3% average cost of interest-bearing liabilities for Q2. H1 net interest income increased to $78.7 million from $64.1 million.
  • Cash flow: For H1, operating cash flow was positive $55.6 million, investing cash flow positive $3.06 billion, and financing cash flow negative $2.83 billion. Cash, cash equivalents, and restricted cash totaled $573.1 million at period-end, including $528.6 million of cash and cash equivalents and $44.5 million of restricted cash.
  • Balance sheet and liquidity: Total assets were $10.36 billion, down from $18.00 billion at year-end 2019; total equity was $936.6 million, down from $1.83 billion. Management reported unrestricted cash of $529 million and a 1.4:1 coverage ratio of unrestricted cash to marginable debt. Recourse debt fell from $4.6 billion at March 31 to $1.8 billion at June 30; marginable debt fell from $3.5 billion to $375 million.
  • Debt: Reported liabilities included $662.8 million of short-term debt, $6.86 billion of asset-backed securities issued, and $1.74 billion of long-term debt. These balances include consolidated securitization entities; the filing states their creditors generally do not have recourse to Redwood. Redwood also had $529 million of unrestricted cash and $936.6 million of equity.
  • Dividends and book value: Book value per share was $8.15 at June 30, an increase of $1.83 during Q2. The company declared a Q2 dividend of $0.125 per share, down from $0.30 in Q2 2019.

Material changes versus comparable periods

  • Q2 investment fair values rebounded as spreads tightened and market liquidity improved, reversing part of Q1’s pandemic-driven declines; management said the portfolio had recovered nearly one-third of Q1 unrealized losses by quarter-end.
  • For H1, Redwood recorded a $777.0 million net loss compared with H1 2019 net income, reflecting Q1 market dislocation despite Q2’s recovery.
  • Redwood sold nearly all residential loans previously financed through its Federal Home Loan Bank of Chicago facility and repaid all but $1 million of that borrowing. It also sold assets and repaid debt, reducing earning assets and near-term net interest income.
  • In Q1, Redwood deconsolidated four Freddie Mac K-Series trusts after selling subordinate securities, removing $3.86 billion of multifamily loans and $3.72 billion of related ABS from its consolidated balance sheet; the transaction generated a $72 million market valuation loss.
  • In Q2, Redwood repurchased $125 million principal amount of convertible and exchangeable notes for $97 million, recognizing $25 million in gains. It also entered new non-marginable financing arrangements, including a non-recourse business-purpose loan facility.
  • In April, the company reduced headcount by approximately 35% and fixed compensation costs by approximately 25%. It recorded an $88.7 million non-cash goodwill impairment in Q1 for its Business Purpose Lending reporting unit.

Outlook, commentary, and risks

  • Management said it was premature to assess the pandemic’s full impact, but viewed the company as better positioned after reducing leverage and margin-call exposure. It stated that asset values could have further recovery potential if the economy continues to improve.
  • Management expected Q3 net interest income to decline further and remain lower until capital is redeployed and loan inventory increases. New non-marginable and non-recourse facilities reduce contingent liquidity risk but generally carry higher borrowing costs.
  • Management expected near-term residential and business-purpose loan volumes and mortgage banking margins to remain below pre-pandemic levels, while reporting a pickup in activity late in Q2 and expectations for continued recovery. No specific earnings or revenue guidance was provided.
  • As of June 30, approximately 96% of payments due that month had been received on loans underlying Sequoia securitizations and CoreVest securitizations. Sequoia forbearance was reported at 6.5%–7.0% of outstanding balances as of July 24. Management said early performance of borrowers exiting forbearance was encouraging; no Sequoia principal-and-interest servicing advances were outstanding at June 30.
  • Key risks include pandemic-related borrower delinquencies and forbearance, uncertain housing and credit conditions, fair-value volatility, financing availability, margin calls, covenant compliance, and reliance on uncommitted borrowing facilities. The company reported covenant compliance at June 30 and through the filing date, but warned that further asset-value declines could threaten compliance.
  • Residential loan seller demands include one breach-of-contract lawsuit alleging more than $2 million in damages. Redwood recorded $5 million for costs and estimated costs tied to certain resolution arrangements and estimated reasonably possible losses of $0–$1.5 million for remaining demands. It reported $2 million of reserves for other specified litigation matters and cautioned actual losses could be higher.
  • Redwood reported effective disclosure controls and no material changes in internal control over financial reporting during Q2.

Important facts for investors to verify

  • Whether the Q2 fair-value recovery persists, and how much of the H1 investment losses are ultimately realized.
  • Trends in Sequoia and CoreVest payment rates, forbearance, delinquencies, foreclosures, and any resulting servicing-advance needs.
  • Whether the $529 million unrestricted cash balance and reduced marginable debt remain adequate under stressed market and collateral conditions.
  • The costs and availability of new financing, covenant headroom, and the effect of higher financing costs on future net interest income.
  • Progress in restoring residential and business-purpose lending volumes, margins, and loan distribution channels.
  • Changes in the litigation, seller-demand, repurchase-reserve, and contingent-commitment exposures described in the filing.
  • How the reduced $0.125 quarterly dividend compares with future taxable income, cash generation, and board decisions; management provided no firm future dividend guidance.