Redwood Trust, Inc. — Q1 2018 Form 10-Q
Reporting period: Three months ended March 31, 2018; balance sheet compared with December 31, 2017. Redwood is a mortgage-focused specialty finance company operating Investment Portfolio and Residential Mortgage Banking segments and electing REIT tax treatment.
Financial results and position
- Income: Net income was $46.8 million, or $0.50 per diluted share, versus $37.0 million, or $0.43 per diluted share, in Q1 2017. Net interest income was $35.1 million, up $1.5 million; non-interest income was $39.7 million, up $11.9 million. Operating expenses rose to $23.0 million from $18.2 million. The income-tax provision fell to $4.9 million from $6.2 million, primarily reflecting the lower federal corporate tax rate.
- Drivers and margins: Mortgage banking income increased to $26.6 million from $17.6 million, mainly on higher loan-purchase volume. Realized gains were $9.4 million, primarily from securities sales. Management said jumbo-loan gross margins were above its long-term expected range of 75–100 basis points and expected them to normalize into that range for the remainder of 2018.
- Cash flow: Operating cash flow was negative $143.2 million, versus positive $253.6 million in Q1 2017, reflecting working-capital effects and loan acquisition and sale activity. Excluding cash flows from purchases, sales, and principal payments on held-for-sale loans, operating cash flow was positive $79 million. Investing cash flow was positive $293.5 million and financing cash flow was negative $116.1 million. Cash and cash equivalents were $178.6 million, with restricted cash of $2.4 million, at quarter-end.
- Assets, equity, and returns: Total assets were $7.00 billion and equity was $1.22 billion. GAAP book value was $16.12 per share, up from $15.83 at year-end; management reported a 3.6% quarterly economic return on book value, including the dividend. Annualized GAAP return on equity was 15%. The declared regular dividend was $0.28 per share.
- Debt and liquidity: Total liabilities were $5.78 billion. Short-term debt was $1.50 billion, including $1.25 billion of secured facilities and $250 million of convertible notes due in April; long-term debt was $2.58 billion, including $2.00 billion of FHLB Chicago advances. Recourse debt-to-equity leverage was 3.4x. Management estimated available capital of approximately $380 million at quarter-end, part of which funded repayment of the $250 million notes in April. The company reported compliance with debt covenants.
Material changes versus comparable periods
- Net income increased by $9.9 million year over year, led by mortgage banking income and realized securities gains. Investment Portfolio segment contribution rose to $49.1 million from $45.6 million; Residential Mortgage Banking contribution increased to $20.7 million from $11.9 million.
- Interest expense nearly doubled to $41.5 million from $21.0 million, reflecting higher short-term borrowing balances and rates, new Sequoia Choice securitizations, and higher FHLB borrowing costs. Total interest income increased to $76.6 million from $54.6 million.
- Residential loans held-for-investment at Redwood incurred a $39.0 million fair-value loss, compared with a $2.3 million loss in Q1 2017; risk-management derivatives substantially offset market movements in the portfolio. Total investment fair-value changes were a net gain of $1.6 million in both periods.
- Real estate securities declined to $1.36 billion from $1.48 billion at year-end, while loans held-for-investment increased to $4.02 billion from $3.69 billion. Sequoia Choice securitization assets expanded materially during the quarter.
- Share repurchases totaled approximately $16 million in January. The board authorized up to $100 million of repurchases; the full $100 million remained available at March 31 after the authorization was replenished.
Outlook, commentary, and risks
- Management described the quarter as productive, citing portfolio optimization, four Sequoia securitizations, and Redwood Choice loans representing about one-third of jumbo lock volume. It said interest-rate changes had a minimal net earnings impact during the quarter.
- Management expected loan-purchase volumes for 2018 to exceed 2017 levels, both overall and for Choice loans, and planned to continue portfolio optimization. It expected increasing capital deployment into single-family rental and multifamily investments beginning in Q2. These are management expectations, not formal earnings guidance.
- In May 2018, Redwood agreed to acquire a 20% interest in 5 Arches, LLC for $10 million, with a one-year option to acquire the remaining equity for $40 million; the agreement also provides a loan-purchase relationship. Purchase volumes were expected to ramp over time.
- Key exposures include fair-value volatility, interest rates and credit spreads, mortgage prepayments and credit performance, and reliance on short-term, generally uncommitted warehouse and repo financing. Financing counterparties may decline borrowing requests; collateral declines can trigger margin calls. Management reported $51 million of net cash inflows associated with margin funding requirements during the quarter.
- Litigation and indemnity exposures remain, including potential claims connected with legacy securitizations. The company recorded $2 million of reserves for specified litigation matters and cautioned that actual losses could exceed reserves. A $5 million residential loan and MSR repurchase reserve was also reported. Risk-sharing arrangements had a maximum potential future payment of $44 million, fully collateralized; no losses had been incurred under those arrangements.
- Other commitments included $50 million committed to an unfunded clean-energy investment and approximately $17 million of future operating lease payments. Management noted GAAP earnings can be volatile due to fair-value changes, transaction timing, and estimates.
Important facts for investors to verify
- Whether mortgage banking margins normalize as management expects, and whether loan-purchase and Choice volumes meet its stated expectations.
- How the April repayment of the $250 million convertible notes affects available capital, funding costs, and liquidity.
- The sensitivity of portfolio fair values and earnings to rates, spreads, credit losses, and prepayment assumptions, including the effectiveness of hedges.
- Access to uncommitted warehouse and repo funding, collateral requirements, margin-call exposure, and covenant headroom.
- Potential changes in litigation, indemnity, repurchase, and risk-sharing exposures, including losses above recorded reserves.
- Execution, funding, and expected returns of the 5 Arches investment and planned expansion into single-family rental and multifamily lending.