Redwood Trust, Inc. — 2015 Form 10-K
Reporting period: Fiscal year ended December 31, 2015. Redwood is a mortgage-focused REIT whose activities include residential mortgage banking and investments, mortgage servicing rights (MSRs), and commercial mortgage lending and investments.
Financial performance and condition
- Income: Interest income was $259.4 million, up from $242.1 million; net interest income was $163.5 million, up from $154.6 million. Net income was $102.1 million, or $1.18 per diluted share, versus $100.6 million, or $1.15 per diluted share. Fourth-quarter diluted EPS was $0.46, compared with $0.22 in the third quarter.
- Profitability and margins: Return on equity was 8.2%, versus 8.0%. Average interest-earning assets yielded 4.8% and average debt cost 2.1% for the year. Management reported a 16% GAAP yield on FHLB-financed residential loans after applicable hedging costs.
- Non-interest items: Net non-interest income declined to $25.3 million from $37.8 million. Mortgage banking and investment activities were a $10.4 million net loss, compared with $24.8 million of income; realized gains rose to $36.4 million from $15.5 million. A $10.3 million income tax benefit, versus a $0.7 million tax provision, helped support net income.
- Cash flow: Operating cash flow was negative $1.25 billion, mainly reflecting mortgage-loan purchases and sales in the mortgage banking business; excluding cash flows from loans initially classified as held-for-sale, operating cash flow was negative $46 million. Investing cash flow was positive $863 million and financing cash flow positive $337 million. Year-end cash was $220 million.
- Balance sheet and funding: Total assets were $6.23 billion and stockholders’ equity $1.15 billion. Short-term debt was $1.86 billion and long-term debt $2.04 billion; $633 million of long-term corporate debt was included in management’s $1.78 billion total-capital measure. Reported debt-to-equity leverage was 3.4x, including specified collateralized debt. Year-end book value was $14.67 per share, down from $15.05.
- Dividends and capital actions: Redwood declared $1.12 per share in regular dividends, unchanged from 2014. It repurchased about 6.5 million shares during 2015 at an average $13.76 per share.
Material changes versus 2014
- Net interest income increased by $8.9 million, driven principally by growth in residential loans held for investment, partly offset by lower interest income from securities and higher corporate borrowing costs.
- Mortgage banking and investment activity declined by $35.2 million, with weaker residential and commercial loan-sale margins and higher hedging costs. Operating expenses rose $7.3 million to $97.4 million, reflecting the expanded mortgage banking businesses.
- Residential investments grew to $3.01 billion from $2.01 billion, primarily as Redwood expanded FHLB-financed residential loans. Residential securities declined to $1.23 billion from $1.38 billion, while MSRs increased to $192 million from $139 million.
- Book value declined despite earnings exceeding dividends, principally due to reduced unrealized securities gains and equity award distributions. Share repurchases added an estimated $0.11 per share to book value.
- Redwood early-adopted ASU 2014-13, moving consolidated Sequoia entity assets and liabilities to fair value and recording a $9.7 million cumulative adjustment to equity. This changed reported balances and results and affects comparisons with 2014.
Outlook, management commentary, and risks
- In early 2016, Redwood announced it would stop aggregating conforming loans for resale to Fannie Mae and Freddie Mac and discontinue commercial loan originations. It plans to focus on conforming MSRs and risk-sharing investments, jumbo whole-loan sales and investments, and managing its existing commercial portfolio.
- Management estimated $6–7 million of restructuring and severance charges, mostly in Q1 2016, and expected about $150 million of capital to be freed for redeployment. Headcount was 153 at February 19, 2016, compared with 211 at year-end 2015.
- Management expected higher portfolio net interest income in 2016, improved residential mortgage banking margins, lower recurring expenses, and results better than 2015. It planned to allocate approximately 95% of capital to investment activities and stated its intention to pay a regular dividend of $0.28 per share per quarter in 2016. These are expectations, not guarantees.
- Available capital for investment was estimated at more than $200 million as of February 19, 2016. The FHLB-member subsidiary had $2.0 billion of advances outstanding; management expected its residential loan portfolio to reach $2.3 billion by the end of Q1 2016.
- A 2016 FHFA rule limits the captive insurer subsidiary’s FHLB membership to a five-year transition period and may prevent additional advances. Existing advances may remain to scheduled maturity, but future financing alternatives could be less favorable.
- Key exposures include interest-rate and credit-spread volatility, asset valuation and prepayment risk, short-term uncommitted financing and margin calls, counterparty risk, geographic concentration, REIT qualification, and potential changes to mortgage-market regulation. Much of the fair-value measurement relies on management assumptions for illiquid assets.
- Contingencies: Redwood reported a $2 million reserve for legacy litigation-related matters and indemnities; actual losses could exceed the reserve. It also reported a $6 million residential loan and MSR repurchase reserve and up to $39 million of potential payments under Agency risk-sharing arrangements, fully collateralized at year-end. Management reported no material off-balance-sheet arrangements.
Most important facts for investors to verify
- Whether 2016 restructuring savings and the expected improvement in mortgage banking margins and portfolio net interest income are realized, after the one-time charges.
- Whether FHLB advances remain available on acceptable terms under the new rules, and whether Redwood can manage the $2.0 billion facility and collateral requirements.
- Liquidity and refinancing capacity, including short-term debt and the $288 million convertible notes due in 2018 and $205 million exchangeable notes due in 2019.
- Portfolio performance and valuation assumptions, especially credit losses, prepayments, MSR values, and securities exposed to spread widening.
- Whether the $0.28 quarterly dividend is supported by REIT taxable income and cash generation; 2015 estimated REIT taxable income and GAAP income differ materially.
- Developments in litigation and indemnity exposure, loan repurchase claims, and Agency risk-sharing losses.