REDWOOD TRUST INC quarterly report, Q2 FY2018

Redwood Trust, Inc. — Q2 2018 Form 10-Q

Reporting period: Quarter and six months ended June 30, 2018; unaudited. Redwood is a mortgage-focused specialty finance company operating Investment Portfolio and Residential Mortgage Banking segments.

Financial performance and position

Metric	Q2 2018	Q2 2017	Six months 2018	Six months 2017
Net interest income	$34.8 million	$35.0 million	$69.9 million	$68.6 million
Net income	$32.7 million	$36.3 million	$79.6 million	$73.3 million
Diluted EPS	$0.38	$0.43	$0.88	$0.85
Regular dividend per share	$0.30	$0.28	$0.58	$0.56

Q2 total interest income was $83.0 million and interest expense was $48.2 million. Net non-interest income was $19.5 million; operating expenses were $19.0 million.
Q2 annualized GAAP return on equity was 11%. Book value was $16.23 per share at June 30, up from $16.12 at March 31; management reported a 2.5% quarterly economic return, including dividends.
At June 30, total assets were $7.51 billion, liabilities $6.28 billion, and equity $1.23 billion. Cash and cash equivalents were $184.8 million, with another $15.3 million of restricted cash.
Short-term debt was $1.43 billion; long-term debt was $2.77 billion, including $2.00 billion of FHLB advances. The company reported recourse debt-to-equity leverage of 3.4x. The $2.00 billion FHLB borrowing was secured by loans valued at $2.31 billion.
Operating cash flow was negative $674.4 million for the first half, largely reflecting mortgage-loan purchases and sales; excluding held-for-sale loan purchase, sale, and principal flows, management reported operating cash flow of positive $101 million. Investing cash flow was positive $364.0 million and financing cash flow positive $363.6 million.

Changes versus comparable periods

Q2 net income declined $3.6 million year over year, and diluted EPS fell by $0.05. Lower mortgage banking margins and fewer portfolio gains than in Q1 contributed to sequentially lower earnings; management characterized Q2 earnings as more normalized.
For the first half, net income increased $6.3 million and diluted EPS rose $0.03 year over year. Mortgage banking income increased to $37.2 million from $29.7 million, while investment fair-value gains fell to $2.5 million from $9.7 million.
Interest income increased substantially, but higher borrowing costs—particularly on short-term debt, ABS and FHLB advances—absorbed much of that increase. Q2 net interest income was broadly flat year over year.
Residential loans held for investment increased to $4.39 billion from $3.69 billion at year-end, including growth in consolidated Sequoia Choice loans. Real estate securities declined to $1.45 billion from $1.48 billion.
Short-term debt fell from $1.94 billion at year-end, partly because $250 million of convertible notes matured and were repaid in April. Long-term debt increased, including issuance of $200 million of 5.625% convertible notes due 2024.

Outlook, management commentary and risks

Management said loan purchase volume rose 8% quarter over quarter and 60% year over year; Redwood Choice expanded-prime loans represented about one-third of mortgage banking volume. Q2 margins returned to the company’s long-term expected range as securitization pricing weakened amid increased supply. No numeric full-year earnings or margin guidance was provided.
Management described portfolio credit fundamentals as strong and said its hedging strategy helped deliver a ninth consecutive quarterly increase in book value despite rising benchmark rates. Fair-value results remain exposed to interest rates, credit spreads, prepayments and model assumptions.
Redwood estimated approximately $200 million of available capital at June 30 and raised approximately $117 million net in a July common-stock offering. The Board declared a Q3 dividend of $0.30 per share, payable September 28, 2018 to holders of record September 14.
Short-term warehouse and repo facilities are generally uncommitted, may be declined by lenders, and can require margin collateral if asset values fall. The company reported covenant compliance at quarter-end, with more than $200 million of headroom on equity/tangible-net-worth covenants and capacity for at least $600 million of additional recourse debt under specified leverage covenants.
Commitments and contingencies include $50 million committed to a clean-energy limited partnership, up to $8 million of additional funding for a loan warehouse participation, and $16.6 million of future lease payments. Risk-sharing arrangements had a maximum potential payment of $44 million, fully collateralized; no losses had been incurred under them.
Legacy securitization-related litigation and indemnity exposures remain. The reported litigation reserve was $2 million; Redwood cautioned actual losses could exceed reserves. The filing also notes that future fair-value estimates are inherently subjective and could differ materially from realized outcomes.
After quarter-end, Redwood purchased approximately $100 million of loans from a 5 Arches affiliate. It had acquired a 20% interest in 5 Arches in May, with an option to purchase the remaining equity for a stated $40 million consideration.

Most important facts for investors to verify

Whether mortgage banking volumes and margins remain within management’s long-term expectations, particularly as securitization supply and pricing change.
How rising rates, credit spreads, prepayments and fair-value assumptions affect earnings, book value and hedging results.
Liquidity and refinancing capacity for uncommitted warehouse and repo debt, including collateral and margin-call requirements.
Credit performance and retained exposure in Sequoia Choice securitizations, residential securities, and the new 5 Arches and warehouse-financing initiatives.
Whether taxable income, REIT distribution requirements, and the $0.30 quarterly dividend remain supported by operating results and available capital.
Potential developments in litigation, indemnities, repurchase claims and other contingencies that could increase losses beyond recorded reserves.