Redwood Trust, Inc. — 2011 Form 10-K
Business context and reporting period. Redwood is a real estate investment trust (REIT) that invests in residential and commercial mortgage loans and real estate securities. Its primary income source is net interest income. This annual report covers the fiscal year ended December 31, 2011; fourth-quarter results are also summarized below. Many securitization entities are consolidated for GAAP reporting, although their assets and liabilities generally are not Redwood’s legal obligations.
Financial results and position
| Metric | 2011 | 2010 |
|---|---|---|
| Interest income | $217.2 million | $230.1 million |
| Interest expense | $99.0 million | $84.7 million |
| Net interest income | $118.1 million | $145.4 million |
| Loan-loss provision | $16.2 million | $24.1 million |
| Net market valuation adjustments | $(40.0) million | $(19.6) million |
| Net income attributable to Redwood | $26.3 million | $110.1 million |
| Diluted earnings per share | $0.31 | $1.36 |
| Regular dividends declared per share | $1.00 | $1.00 |
Fourth-quarter 2011 net loss was $2.6 million, or $0.03 per share, versus net income of $14.7 million, or $0.18 per share, in fourth-quarter 2010. Fourth-quarter net interest income was $27.4 million, compared with $34.1 million a year earlier. The filing does not provide a single company-wide net interest margin figure.
- Cash flow: Operating cash flow was $17.8 million in 2011, versus $29.9 million in 2010. Investing activities used $415.6 million; financing activities provided $618.0 million. Cash and cash equivalents ended the year at $267.2 million, up from $46.9 million.
- Balance sheet and liquidity: Total assets were $5.74 billion, total liabilities $4.85 billion, and stockholders’ equity $892.6 million at year-end. Management estimated investment capacity of $214 million. The balance sheet included $71.98 million of posted margin, which is not equivalent to unrestricted cash.
- Debt: Short-term debt rose to $428.1 million from $44.1 million, including $307.1 million under residential loan warehouse facilities and $120.9 million under securities repurchase facilities. Long-term debt was $139.5 million. Consolidated asset-backed securities were $4.14 billion; much of this relates to bankruptcy-remote securitization entities, not direct Redwood obligations.
- Book value and returns: GAAP book value per share fell to $11.36 from $13.63. Fourth-quarter book value declined $0.86 per share, including unrealized security losses and dividends exceeding earnings. Management estimated non-GAAP economic value at $12.45 per share, a measure based partly on subjective valuations and not directly comparable to GAAP book value.
Material changes versus the prior comparable period
- Annual net income declined by about 76% and diluted EPS fell from $1.36 to $0.31. Net interest income decreased 19%, as lower asset yields and higher funding costs offset larger earning-asset balances.
- Net valuation adjustments worsened to a $40.0 million loss from a $19.6 million loss, with falling securities prices and residential pipeline hedging costs among the factors. Unrealized losses also contributed to a $125.5 million reduction in accumulated other comprehensive income and losses.
- Short-term debt increased substantially as Redwood expanded warehouse and securities financing. Cash also increased, primarily reflecting increased short-term borrowing.
- The commercial lending platform expanded: Redwood originated $128 million of commercial loans in 2011 and ended the year with a $158 million portfolio, compared with $31 million of commercial loans at year-end 2010.
- Redwood securitized $671 million of residential loans through Sequoia in 2011 and completed a separate $365 million residential-securities resecuritization to obtain permanent non-recourse financing. Redwood stated that the resecuritization largely left its economic credit exposure unchanged.
Outlook, commentary, risks, and contingencies
- 2012 plans: Management expected to invest $375–$500 million of capital overall, acquire approximately $2 billion of residential loans, and originate $200–$300 million of subordinate commercial debt and other commercial investments. It targeted $100 million of capital in third-party residential securities and $75–$100 million in new Sequoia securitizations.
- Management estimated GAAP yields of 11%–14% on new equity capital invested in residential securities in 2012, after planned short-term debt financing. It expected commercial portfolio yield of approximately 10% at year-end 2011 before potential credit costs and was seeking prudent debt financing for that portfolio.
- Management expected increased investment activity, net of funding costs, to support net interest income in the second half of 2012 and projected profitability improvement over the year, more apparent toward year-end. These are forward-looking estimates, not guarantees. The Board stated its intention to pay regular dividends of $0.25 per share per quarter in 2012; dividend decisions remain discretionary.
- Principal risks include housing and commercial property weakness, borrower defaults and losses, prepayment uncertainty, interest-rate and valuation volatility, illiquid assets, reliance on short-term and uncommitted financing, margin calls, counterparty risk, and the availability and profitability of future securitizations. Regulatory changes, GSE competition, REIT qualification, and Investment Company Act exemption requirements also present risks.
- Residential senior securities were backed by loan pools with 12.38% serious delinquencies at year-end; the figure was 9.67% for re-REMIC pools. Redwood reported $242 million of credit reserves on residential securities and expected future losses to extinguish the majority of outstanding principal in its residential subordinate securities. It also reported a $67 million allowance for consolidated residential loans.
- Three investor lawsuits related to Sequoia RMBS were pending, including claims by the Federal Home Loan Banks of Seattle and Chicago and Charles Schwab. Redwood disputed the claims; the filing stated that potential losses could not be reasonably estimated and that indemnities to underwriters could produce costs. The SEC and NCUA had also requested information in separate investigations; the filing stated that those requests were not findings of violations.
- Other unusual items include estimated 2011 dividend tax characterization of 25% ordinary income and 75% return of capital; management’s estimate of $9 million in negative net assets at fourteen Sequoia entities expected to reverse upon retirement or deconsolidation; and an intended 2012 change in accounting treatment for future near-term securitizations from financing to sale accounting.
Important facts for investors to verify
- Whether the planned residential loan acquisitions, Sequoia securitizations, commercial originations, and targeted investment yields were achieved, and whether they translated into recurring earnings.
- Current liquidity after posted collateral and other cash needs; renewal and availability of warehouse and repurchase facilities; and sensitivity to collateral haircuts, margin calls, and short-term refinancing.
- Subsequent credit performance, realized losses, delinquency trends, and adequacy of reserves across residential securities, legacy Sequoia loans, and the growing commercial portfolio.
- Progress and potential exposure in RMBS litigation, indemnity claims, and regulatory inquiries, including any new loss estimates or reserves.
- Actual GAAP and taxable income, dividend coverage and tax characterization, and whether the announced quarterly dividend can be sustained.
- How much of reported assets, liabilities, earnings, and book value reflects consolidated securitization entities, and how management’s non-GAAP economic-value estimate compares with amounts ultimately realized.