Redwood Trust, Inc. — Q2 2013 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2013. Redwood is a mortgage banking and real-estate investment company, organized as a REIT. It acquires residential loans for sale or securitization, originates and sells senior commercial loans, and invests in mortgage-related assets. Unless noted otherwise, dollar amounts below are in millions.
Financial results and position
| Metric | Q2 2013 | Q2 2012 | Six months 2013 | Six months 2012 |
|---|---|---|---|---|
| Interest income | $57.7 | $59.5 | $111.2 | $118.3 |
| Interest expense | $21.5 | $28.9 | $39.8 | $59.5 |
| Net interest income | $36.3 | $30.6 | $71.4 | $58.7 |
| Mortgage banking activities, net | $58.5 | $(3.6) | $104.6 | $1.3 |
| Operating expenses | $23.6 | $15.2 | $43.2 | $29.8 |
| Net income attributable to Redwood | $65.6 | $19.5 | $126.2 | $50.0 |
| Diluted EPS | $0.71 | $0.24 | $1.40 | $0.61 |
| Regular dividend declared per share | $0.28 | $0.25 | $0.56 | $0.50 |
- Q2 net income included $58.5 million of mortgage banking income, substantially reflecting gains on risk-management derivatives, retained Sequoia interest-only securities and mortgage servicing rights (MSRs). These gains were partly offset by losses on residential loans. Q2 operating expenses included $3.4 million of severance expense.
- At June 30, total assets were $5.44 billion, liabilities $4.23 billion and equity $1.21 billion. Cash and cash equivalents were $207.7 million; reported book value was $14.69 per share, up from $14.54 at March 31.
- Debt included $1.45 billion short-term debt, $2.21 billion asset-backed securities issued and $443.6 million long-term debt. The company issued $287.5 million of 4.625% convertible notes due 2018 in March.
- Six-month cash flows: operating activities used $742.2 million, investing activities provided $43.5 million and financing activities provided $825.3 million. Cash increased $126.6 million to $207.7 million. Operating cash use reflects the high-volume loan acquisition and sale pipeline.
Material changes versus comparable periods
- Q2 net income rose to $65.6 million from $19.5 million a year earlier; six-month net income rose to $126.2 million from $50.0 million. Higher mortgage banking results and net interest income contributed, while the 2013 result also included significant market valuation and hedging effects.
- Q2 net interest income increased despite lower interest income, as interest expense fell. For the first half, net interest income grew 22% year over year, primarily as higher average earning assets more than offset higher borrowing costs.
- Total assets increased to $5.44 billion from $4.44 billion at year-end 2012. Short-term debt rose to $1.45 billion from $551.9 million; cash increased to $207.7 million from $81.1 million.
- Residential loans held for sale rose to $1.22 billion from $562.7 million at year-end; residential securities increased to $1.31 billion from $1.11 billion. MSRs grew to $43.1 million from $5.3 million.
- Other comprehensive income was a loss of $24.6 million in Q2, including a $38.0 million unrealized loss on available-for-sale securities, partly offset by gains on interest-rate agreements. For the first half, other comprehensive loss was $20.0 million.
Outlook, commentary and risks
- Management cited a rapid rise in long-term interest rates—nearly 100 basis points in the 10-year Treasury yield during Q2—and wider RMBS spreads. It said markets appeared to be stabilizing later in July, but the duration and effects of the disruption remained uncertain.
- As of August 1, management estimated approximately $0.22 per share of net negative market valuation adjustments would be recognized in Q3 for loans owned or identified for purchase at June 30. Management expected associated hedges to offset the economic impact and forecast a small overall economic profit on selling or securitizing this pipeline. It also expected to retain about $90 million to $120 million of proprietary investments from the transactions.
- Management continued to target 25–50 basis points of residential loan-sale profit margin, net of hedging; acquisition of up to $8 billion of jumbo residential loans in 2013, described as challenging; and $1 billion of senior commercial loan originations, with the company saying it remained on track. It expected to begin acquiring Agency conforming loans by Q4 2013; no meaningful volume forecast was provided.
- At June 30, the residential pipeline comprised $1.22 billion of loans on balance sheet and $1.39 billion identified for purchase. Management reported approximately $130 million of investment capacity and said liquidity was sufficient for its 2013 objectives. Short-term facilities were generally uncommitted and subject to repricing, renewal, collateral and margin-call risks.
- Residential mortgage securities and loan values are sensitive to rates, spreads, prepayments, credit performance and illiquid-market valuation assumptions; most reported fair-value assets relied on Level 3 inputs. The company warned that accounting and valuation timing can create substantial GAAP earnings volatility.
- Three RMBS-related lawsuits involving Schwab and the Federal Home Loan Banks of Chicago and Seattle remained relevant. Redwood denied or contested the claims, said outcomes and potential losses could not be estimated, and noted potential indemnity exposure; no litigation reserve was recorded. Redwood was dismissed as a party in the Seattle case, but claims against underwriters remained pending.
- Management reported compliance with financing covenants and margin calls through the filing date. Disclosure controls were concluded effective at a reasonable assurance level, with no material quarterly change in internal control over financial reporting.
Key facts for investors to verify
- Whether Q3 realized valuation losses and hedge gains reconcile with management’s estimate of a small economic profit on the June pipeline.
- Actual loan purchases, securitizations, sales and retained investments versus the stated 2013 jumbo, commercial origination and Agency-conforming plans.
- Short-term funding availability, borrowing costs, collateral requirements and liquidity under changing rates and asset values.
- Performance of residential and commercial credit exposures, including delinquencies, credit reserves, loss assumptions and Level 3 fair-value estimates.
- Developments in the RMBS litigation and any resulting indemnity, settlement, reserve or disclosure obligations.
- Effects of the convertible notes and other share-based awards on dilution; diluted weighted-average shares rose to 96.2 million in Q2 from 78.8 million a year earlier.