Redwood Trust, Inc. — Q2 2014 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2014. Redwood is a mortgage-focused specialty finance company operating residential mortgage banking, residential investments, and commercial mortgage banking and investments. Amounts below are in U.S. dollars; financial statement amounts are converted from thousands to millions where indicated.
Financial results and position
| Metric | Q2 2014 / June 30, 2014 | Comparable period / prior balance |
|---|---|---|
| Interest income | $58.0 million | $57.7 million in Q2 2013 |
| Net interest income | $36.8 million | $36.3 million in Q2 2013 |
| Net income; diluted EPS | $16.0 million; $0.18 | $65.6 million; $0.71 in Q2 2013 |
| Mortgage banking income, net | $6.3 million | $48.7 million in Q2 2013 |
| MSR income (loss), net | $(1.8) million | $10.5 million in Q2 2013 |
| Operating expenses | $22.3 million | $24.4 million in Q2 2013 |
| Six-month net income; diluted EPS | $28.4 million; $0.32 | $126.2 million; $1.40 in first half 2013 |
| Cash and total assets | $157.1 million; $5.38 billion | $173.2 million and $4.61 billion at Dec. 31, 2013 |
| Equity; book value per share | $1.25 billion; $15.03 | $15.14 per share at March 31, 2014 |
| Short-term debt | $1.72 billion | $862.8 million at Dec. 31, 2013 |
| ABS issued; long-term debt | $1.77 billion; $546.6 million | $1.94 billion; $476.5 million at Dec. 31, 2013 |
| Dividend declared per common share | $0.28 for Q2 | $0.28 in Q2 2013 |
For the first six months, net interest income was $73.3 million versus $71.5 million a year earlier. Operating cash flow was $(786.2) million, investing cash flow was $75.1 million, and financing cash flow was $695.0 million; cash declined by $16.1 million. Management said operating cash flow excluding loan purchase-and-sale activity was $(7) million. The filing does not present a single company-wide operating margin measure.
At June 30, consolidated variable-interest entities included $2.13 billion of assets and $1.77 billion of liabilities. These entities are legally separate, and their creditors generally have no recourse to Redwood; reported consolidated balances therefore include amounts that are not direct Redwood obligations.
Material changes versus prior periods
- Q2 net income and diluted EPS were substantially below Q2 2013, while net interest income was modestly higher. First-half net income also declined sharply year over year.
- Mortgage banking income fell to $6.3 million from $48.7 million in Q2 2013. Management attributed much of the comparison to a 2013 timing difference: gains on hedges were recognized while an estimated negative $34 million valuation adjustment on identified-but-not-yet-purchased loans was not recognized. Lower loan volumes and tighter sale margins also weighed on results.
- MSR income moved from a gain to a loss as falling mortgage rates and higher expected prepayments reduced fair values. Higher servicing fees from a larger MSR portfolio partly offset the valuation decline.
- Residential loans held for sale increased to $1.11 billion from $404.3 million at year-end; residential securities increased to $1.85 billion from $1.68 billion. Total short-term debt nearly doubled from year-end, while ABS balances declined.
- Book value per share fell from $15.14 at March 31 to $15.03 at June 30. The quarterly dividend of $0.28 and equity-award share distributions more than offset quarterly earnings and unrealized securities gains.
- Net unrealized gains on available-for-sale securities contributed to positive other comprehensive income, while cash-flow hedge values declined. Six-month realized gains were $2.2 million versus $12.8 million in first-half 2013.
Outlook, management commentary, and risks
- Residential growth: Q2 residential loan acquisitions were $1.8 billion, up 64% from Q1; conforming acquisitions were $868 million. Management was optimistic about reaching its goal of $1 billion of conforming loan acquisitions per month by year-end 2014. This is a stated goal, not formal earnings guidance.
- Commercial business: Q2 senior commercial originations were $149 million; the pipeline under application was $347 million at quarter-end. Management expected to exceed 2013 origination volume and meet its 2014 goal while maintaining healthy margins, and expected approximately $300 million of senior loans to enter a third-party CMBS transaction in September.
- FHLB Chicago: Redwood expected its MPF Direct loan-purchase program to begin a test phase early in Q4 2014. Separately, its subsidiary had $26 million of FHLB advances outstanding by the report date. FHLB financing is not committed and may not be available when requested.
- Capital and liquidity: Management estimated investment capacity at approximately $62 million at June 30 and said faster deployment could require additional capital before year-end. It planned to consider asset sales or financing first, then external debt or equity issuance if needed. Redwood sold securities after quarter-end to increase available capital.
- Leverage and funding risk: Most short-term facilities were uncommitted and collateralized; $1.07 billion of short-term debt was due within 30 days. Falling collateral values can trigger margin calls, while nonrenewal, covenant breaches, or counterparty problems could create liquidity pressure. The company reported covenant compliance and compliance with margin calls through the filing date.
- Credit, valuation, and rate risk: Fair values for many loans, securities, and MSRs depend on Level 3 inputs and management assumptions. Rate, prepayment, credit-loss, liquidity, and spread changes can create earnings and book-value volatility. Residential 90+-day delinquencies in legacy consolidated Sequoia loans were $74 million, or 4.56% of balances. Commercial held-for-investment loans had an $8.3 million allowance and one $26 million loan on watch list; no commercial loans were classified as impaired.
- Litigation and contingencies: Redwood had a $12 million reserve for three RMBS-related litigation matters. The company noted that actual losses could materially exceed the reserve; two matters were in discovery, and the FHLB-Seattle claims against underwriters remained pending. Redwood also described indemnification exposure. The residential repurchase reserve was $2.5 million; no repurchase requests or loan repurchases were reported for the first half.
- Tax and dividend: The company estimated first-half taxable income of $25.9 million and paid $46.3 million in shareholder distributions. It expected an additional $40 million of tax credit losses on residential securities over an estimated three-to-five-year period, but timing was uncertain. The board determines dividends and considers earnings, cash flow, capital, and liquidity.
- Other: The filing identifies fair-value estimation and expected credit losses as inherently uncertain. Management reported effective disclosure controls and no material second-quarter change in internal control over financial reporting.
Most important facts for investors to verify
- Whether residential and commercial origination growth, loan-sale margins, and securitization activity meet management’s stated objectives, especially the conforming-loan volume goal.
- Whether mortgage banking and MSR earnings recover, and how much reported performance depends on fair-value changes, hedge timing, and Level 3 assumptions.
- Short-term debt maturity, collateral availability, margin-call exposure, facility renewal terms, covenant headroom, and actual access to FHLB financing.
- Credit trends in legacy residential loans and commercial watch-list exposures, including allowance adequacy and realized losses.
- Developments in the RMBS litigation and indemnities, potential losses beyond the $12 million reserve, and changes in repurchase claims or reserves.
- Whether investment deployment requires new capital and how any financing or equity issuance affects leverage, book value, and the $0.28 quarterly dividend.