RWT

Business Context and Reporting Period

Company: Redwood Trust, Inc.
Filing Type: Form 10-Q (Quarterly Report)
Period Ended: June 30, 2008
Business Overview: Redwood Trust is a real estate investment trust (REIT) that invests in, finances, and manages residential and commercial real estate loans and asset-backed securities. The company utilizes securitization programs (Sequoia for residential loans and Acacia for securities) and sponsors the Opportunity Fund. Effective January 1, 2008, the company adopted FAS 159, electing the fair value option for assets and liabilities in its Acacia entities and certain investment-grade securities at Redwood.

Key Financial Metrics

Material Changes vs. Prior Period

• Net Loss vs. Net Income: The company reported a net loss of $45.9 million for the quarter ended June 30, 2008, compared to net income of $11.4 million for the same period in 2007. For the six months ended June 30, 2008, the loss was $217.5 million versus income of $29.7 million in 2007.
• Market Valuation Adjustments (MVA): Negative MVA increased significantly to $60.6 million in Q2 2008 from $29.4 million in Q2 2007. This was the primary driver of the earnings decline, driven by fair value declines in Acacia assets/liabilities and other-than-temporary impairments on available-for-sale (AFS) securities.
• Equity Position: Stockholders' equity improved from a deficit of $718.3 million at December 31, 2007, to a positive $564.0 million at June 30, 2008. This reversal was primarily due to a one-time cumulative effect adjustment of $1.47 billion to retained earnings upon the adoption of FAS 159 on January 1, 2008.
• Asset Base: Total assets decreased by approximately $1.89 billion from year-end 2007, largely due to the fair value write-down of Acacia liabilities and principal paydowns on loans and securities.
• Credit Losses: Provision for credit losses on residential loans increased to $18.1 million for the six months ended June 30, 2008, compared to $4.0 million in the prior year period. Delinquencies on residential loans rose to 1.87% of current balances.

Guidance, Outlook, and Risks

• Earnings Volatility: Management expects GAAP earnings to remain volatile in the near term due to mark-to-market adjustments, particularly related to the consolidation of Acacia entities under FAS 159.
• Dividend Policy: The Board reaffirmed the regular quarterly dividend of $0.75 per share for the third and fourth quarters of 2008. However, the company cautioned that REIT taxable income for the remainder of 2008, combined with undistributed income from 2007, may fall short of full-year distributions at the regular rate. No special dividend is expected in 2008.
• Capital Deployment: Capital deployment has slowed significantly in Q3 2008. The company is maintaining a strong liquidity position with $148 million in unrestricted cash and $132 million in excess capital. Future actions (investing, issuing, or repurchasing shares) will depend on market opportunities and capital pricing.
• Key Risks:
  • Credit Risk: Rising delinquencies and credit losses, particularly in non-prime residential and commercial portfolios.
  • Liquidity Risk: Continued contraction in credit availability and re-pricing of credit risk in capital markets.
  • Accounting Risk: Significant volatility in reported earnings due to fair value accounting for Acacia assets and liabilities and potential other-than-temporary impairments on AFS securities.

Investor Verification Checklist

• FAS 159 Impact: Verify the sustainability of the equity position improvement, noting it was driven by a one-time accounting adjustment rather than operational cash flow.
• Dividend Coverage: Monitor the company's REIT taxable income versus GAAP net loss to assess the ability to maintain the $0.75 quarterly dividend without eroding capital.
• Acacia Cash Flows: Review the status of cash distributions from Acacia equity investments, as six of ten entities had stopped receiving distributions by June 30, 2008, due to rating downgrades.
• Credit Reserve Adequacy: Assess the sufficiency of the $35 million reserve for credit losses on residential loans given the rising delinquency rate of 1.87%.
• Liquidity Runway: Confirm the $148 million cash balance and $132 million excess capital are sufficient to weather continued market illiquidity and potential further asset write-downs.