Redwood Trust, Inc. — Q2 2016 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2016. Redwood is a mortgage and real-estate investment and mortgage-banking REIT, with Residential Investments, Residential Mortgage Banking, and Commercial segments. Financial statements are unaudited.
Financial performance and position
| Metric | Q2 2016 | Comparable period |
|---|---|---|
| Net interest income | $44.3 million | $40.4 million in Q2 2015 |
| Net income | $41.3 million; diluted EPS $0.48 | $27.1 million; diluted EPS $0.31 in Q2 2015 |
| Net income, first half | $53.3 million; diluted EPS $0.67 | $41.9 million; diluted EPS $0.47 in first half 2015 |
| Core earnings, non-GAAP | $40.0 million; diluted EPS $0.47 | First-half 2016: $77.2 million; diluted EPS $0.91 |
| Regular dividend declared | $0.28 per share | Unchanged from Q2 2015 |
Q2 net income benefited from higher net interest income, a smaller negative fair-value impact than in Q1, a $6.5 million reversal of commercial loan-loss provisions, and lower operating expenses. The reversal reflected the planned sale of most commercial mezzanine loans; Redwood excludes this benefit in its core-earnings measure.
- Interest and margins: Q2 interest income was $66.8 million and interest expense $22.4 million. Jumbo mortgage-banking gross margin was 68 basis points, within management’s 50–75 basis-point long-term range. Net interest income increased $4.0 million year over year in Q2.
- Fair value and other income: Q2 investment fair-value changes were a loss of $11.1 million, versus a $1.8 million loss a year earlier. First-half fair-value changes were a loss of $30.6 million. Realized gains were $9.9 million in Q2 and $19.4 million in the first half, primarily from securities sales.
- Cash flow: For the first half, operating cash flow was negative $360.7 million, investing cash flow positive $731.6 million, and financing cash flow negative $374.2 million. Cash ended at $216.9 million, down $3.3 million from year-end. Operating cash use reflected mortgage-loan purchase and sale activity; excluding held-for-sale loan purchases, sales, and principal payments, operating cash flow was positive $24 million.
- Balance sheet and liquidity: Total assets were $5.90 billion and equity $1.09 billion at June 30. Short-term debt was $1.06 billion, asset-backed securities $859.6 million, and long-term debt $2.68 billion. Management estimated $140 million of capital available for investments; this is distinct from reported cash. The $2.00 billion FHLB borrowing capacity was fully used.
Changes versus prior periods
- Compared with December 31, 2015, residential loans increased to $4.04 billion from $3.93 billion, while real estate securities fell to $883.8 million from $1.23 billion and MSRs declined to $110.0 million from $192.0 million.
- Short-term debt decreased to $1.06 billion from $1.86 billion; long-term debt increased to $2.68 billion from $2.03 billion, primarily reflecting increased FHLB advances. FHLB advances reached their $2.00 billion limit.
- Book value was $14.20 per share at June 30, versus $14.17 at March 31 and $14.67 at December 31. Q2 earnings above the dividend were partly offset by equity-award dilution and lower values of derivatives hedging long-term debt.
- Operating expenses were $20.2 million in Q2, down from $25.2 million in Q2 2015. First-half expenses were $50.6 million, including $10.5 million of restructuring charges.
Outlook, management commentary, and risks
- Redwood discontinued conforming-loan aggregation for resale and commercial loan originations. It engaged a broker to sell all but two commercial mezzanine loans, targeting a Q3 2016 closing and estimating $4–$6 million in gain-on-sale income. Management expects the sale to add $240–$260 million to investment capital available.
- Management expects 2016 residential-investment net interest income to exceed 2015, and anticipates further securities sales and gains during 2016, though timing and amounts are uncertain. Additional Sequoia securitizations depend on market conditions. A Q3 dividend of $0.28 per share was declared.
- Growth initiatives include expanded-prime jumbo lending (Redwood Choice), credit-risk transfer transactions, and portfolio risk-sharing with banks. Management noted that some structures remain in development, including REIT-eligibility considerations.
- Key risks include volatile rates and credit spreads, loan prepayments and credit losses, Level 3 valuation uncertainty, and dependence on short-term warehouse and repo facilities that are generally uncommitted and may require margin collateral. Redwood reported covenant compliance at June 30.
- One $17.7 million commercial loan was impaired after a maturity default; its refinance was expected but uncertain. Litigation-related reserves were $2 million, and indemnity exposure could exceed recorded reserves. Risk-sharing arrangements had a maximum potential payment of $44 million, fully collateralized; no losses had been incurred under them.
- Management cautioned that quarterly GAAP results can be volatile and are not necessarily indicative of full-year results. The filing reported effective disclosure controls and no material second-quarter change in internal control over financial reporting.
Important facts for investors to verify
- Whether the planned commercial-loan sale closed, at what price, and whether the expected proceeds and $4–$6 million gain were realized.
- How the wind-down of conforming and commercial operations affects recurring expenses, mortgage-banking earnings, and the company’s ability to deploy capital.
- Performance of the $2.00 billion FHLB-funded residential-loan portfolio and the availability and cost of replacement or additional financing.
- Fair-value assumptions, hedging effectiveness, margin requirements, and any material changes in credit spreads, rates, MSR values, or credit losses.
- Developments in the impaired commercial loan, litigation and indemnity matters, and the characterization and sustainability of dividends.