Redwood Trust, Inc. — Q3 2012 Form 10-Q
Business context and reporting period. Redwood invests in residential and commercial real estate loans and mortgage-backed securities, and earns interest, mortgage-banking fees and gains. This unaudited report covers the quarter and nine months ended September 30, 2012; balance-sheet comparisons are with December 31, 2011. Unless stated otherwise, dollar amounts below are in millions.
Financial performance and position
| Metric | Q3 2012 | Comparable period / balance-sheet comparison |
|---|---|---|
| Interest income | $59.7 | $53.4 in Q3 2011 |
| Interest expense | $28.3 | $24.3 in Q3 2011 |
| Net interest income | $31.4 | $29.1 in Q3 2011 |
| Net interest income after loan-loss provision and other market valuation adjustments | $26.6 | $11.7 in Q3 2011 |
| Mortgage banking activities, net | $16.7 | No comparable activity reported in Q3 2011 |
| Operating expenses | $17.1 | $11.5 in Q3 2011 |
| Net income attributable to Redwood | $39.7; diluted EPS $0.48 | $1.3; diluted EPS $0.01 in Q3 2011 |
| Nine-month net income attributable to Redwood | $89.7; diluted EPS $1.09 | $28.9; diluted EPS $0.35 in 2011 |
| Regular dividend declared per share | $0.25 | Unchanged from Q3 2011 |
- At September 30, total assets were $5.30 billion, equity was $1.05 billion and GAAP book value was $12.88 per share, up from $12.00 at June 30. Cash and cash equivalents were $39.4, down from $267.2 at December 31, 2011.
- Debt included $522.2 of short-term borrowings, versus $428.1 at year-end, and $139.5 of long-term debt. Asset-backed securities issued were $3.43 billion, down from $4.14 billion. Much of the ABS and related assets sit in consolidated, bankruptcy-remote securitization entities and are not Redwood’s direct legal obligations.
- For the nine months, operating cash flow was negative $342.2, investing cash flow was positive $557.8 and financing cash flow was negative $443.4. Cash decreased $227.8 to $39.4. The operating outflow reflects substantial mortgage-loan purchases and sales activity.
- Management estimated available investment capacity of $141 million at quarter-end and said it expected to meet capital needs into Q1 2013, subject to investment activity and market conditions. The filing does not provide a conventional net-interest margin figure.
Material changes and significant items
- Q3 earnings rose sharply year over year, supported by mortgage-banking income, RMBS gains and improved market valuations. Mortgage banking included $15.0 of positive residential-loan valuation changes and $4.6 of net gains on mortgage-loan sales; realized gains were $13.9, principally from securities sales.
- Management cautioned that the combination of rising RMBS prices, tighter securitization spreads and the accounting election for newly acquired residential loans boosted Q3 results and may not be readily repeatable. The fair-value election brings loan valuation changes into current-period earnings and is expected to reduce later sale-gain volatility.
- Other market valuation adjustments were negative $3.5 in Q3, compared with negative $13.4 a year earlier. Net interest income after provision and those adjustments increased to $26.6 from $11.7, reflecting lower loan-loss provision expense and less negative valuation effects, alongside higher net interest income.
- Accumulated other comprehensive income moved to positive $73.9 from a loss of $13.2 at year-end, mainly reflecting unrealized gains on securities. Q3 unrealized securities gains also contributed to the increase in book value.
- Redwood deconsolidated five older Sequoia entities in Q1 and recorded a $7.0 realized gain. One Acacia entity was liquidated in Q3, extinguishing $470 million of ABS principal and producing a $1 million positive market valuation adjustment.
- Residential loan-loss allowance was $53.7 at September 30, down from $66.9 at year-end; commercial-loan allowance was $1.8. The securities portfolio had $240 million of designated credit reserves. Serious delinquencies in consolidated Sequoia loans were $115 million, or 3.72% of outstanding balances.
Outlook, commentary and risks
- Management said the residential platform was expanding: 49 active loan sellers at quarter-end, with a target of 55 by year-end; the company identified $1.1 billion of loans for purchase in Q3. Its 12-to-18-month goal was to reach capacity to securitize at least $300 million of residential loans monthly. These are objectives, not guaranteed results.
- After quarter-end, Redwood completed a $320 million Sequoia securitization. It also planned to seek authorization to sell conforming loans to Fannie Mae and Freddie Mac, with pricing options targeted for early 2013, subject to approval and further platform investment.
- Commercial mezzanine investments totaled $286 million across 31 investments, with an approximately 10% gross yield. Management anticipated investing a further $40–$60 million in Q4 and was developing senior-loan origination and distribution. A $150 million, three-year warehouse facility was obtained in Q3.
- Management cited potential support from housing recovery, agency guarantee-fee increases and renewed private-label securitization demand, while emphasizing uncertainty around market conditions, regulatory changes, loan volumes, funding access and investment returns.
- Key risks include credit deterioration, prepayment and interest-rate changes, illiquid or Level 3 valuations, short-term uncommitted funding and margin calls, counterparty performance, and the variability of GAAP earnings and taxable income. Management reported compliance with borrowing covenants at quarter-end.
- Litigation remains a material uncertainty. Redwood and its subsidiary obtained a final dismissal for lack of jurisdiction in the FHLB-Seattle matter, but a claim in another jurisdiction was possible. Schwab litigation and FHLB-Chicago litigation remained active; the Chicago court denied dismissal motions in September 2012, and defendants were pursuing appellate review. Redwood said losses could not be reasonably estimated and disclosed potential underwriter-indemnity exposure. The filing also describes SEC and NCUA information requests and a Woori Bank claim against Acacia entities; indemnities could expose Redwood to costs.
- One Acacia entity had an early termination event under an ISDA agreement after failing to make a required swap payment. The filing states that this liability is not a legal obligation of Redwood.
Most important facts for investors to verify
- How much Q3 earnings depended on fair-value gains, securities-sale gains and other items that management described as potentially nonrecurring, versus recurring net interest and fee income.
- Whether residential loan purchases, seller growth and securitization volumes meet management’s stated objectives, and whether the planned agency channel receives approval.
- Whether the $141 million investment-capacity estimate and $39.4 million cash balance remain adequate given short-term debt maturities, margin requirements and ongoing loan purchases.
- Credit performance and reserve adequacy across legacy Sequoia loans, mortgage securities and the growing commercial-loan portfolio, including serious delinquencies and realized losses.
- Developments in the FHLB-Chicago and Schwab cases, potential follow-on proceedings in the FHLB-Seattle matter, and any related indemnity or repurchase claims; management could not estimate potential litigation losses.
- Valuation sensitivity of Level 3 assets and liabilities, and the effect of interest rates, prepayments, market liquidity and credit assumptions on earnings and book value.