Redwood Trust, Inc. — Q1 2013 Form 10-Q
Reporting period: Three months ended March 31, 2013; balance-sheet comparisons are to December 31, 2012. Amounts are in U.S. dollars. Redwood is a REIT-focused mortgage banking and real estate investment company, with residential and commercial loan origination, securitization, sales, and investment activities.
Financial performance and position
- Net income: $60.6 million, or $0.69 per diluted share, versus $30.5 million, or $0.37 per diluted share, in Q1 2012. Regular dividend declared was $0.28 per share, up from $0.25.
- Interest income and expense: Interest income was $53.5 million versus $58.7 million; interest expense fell to $18.4 million from $30.7 million. Net interest income rose to $35.2 million from $28.1 million.
- Mortgage banking and gains: Mortgage banking activities produced $44.1 million, versus $4.3 million. The 2013 result included $34.8 million of residential-loan fair-value gains and $7.2 million of commercial loan sale and origination gains. Realized gains were $12.3 million versus $13.6 million, largely reflecting a $12.0 million gain on commercial securities sold.
- Costs and credit: Operating expenses rose to $19.6 million from $14.6 million, primarily due to compensation, staffing, legal, and systems costs. Loan-loss provision increased to $2.0 million from $0.3 million. Income tax provision was $10.9 million versus less than $0.1 million.
- Cash flow: Operating activities used $287.0 million, compared with $233.7 million used in Q1 2012, reflecting substantial loan purchases and sales in the mortgage banking business. Investing activities provided $8.6 million; financing activities provided $276.3 million. Cash declined $2.1 million to $79.0 million.
- Balance sheet and equity: Total assets were $4.80 billion, up from $4.44 billion at year-end; equity was $1.19 billion, up from $1.14 billion. GAAP book value increased $0.59 to $14.54 per share.
- Debt and liquidity: Short-term debt was $721.3 million, up from $551.9 million. Long-term debt was $443.6 million, including $287.5 million of 4.625% convertible notes issued in March, due 2018. Asset-backed securities issued were $2.36 billion, primarily obligations of consolidated securitization entities; creditors generally have no recourse to Redwood for those entity liabilities. Management estimated approximately $300 million of investment capacity. Short-term facilities were generally uncommitted, and $355.5 million of short-term debt matured within 30 days.
Material changes versus comparable periods
- Net income nearly doubled year over year, chiefly as mortgage banking results improved; Q1 2013 also benefited from residential loan fair-value gains. These gains are market-sensitive and do not necessarily represent recurring operating income.
- Net interest income improved despite lower interest income, as interest expense declined substantially, including lower expense on asset-backed securities. Operating expenses and loan-loss provision increased.
- Residential loan purchases reached $2.59 billion; Redwood completed four Sequoia securitizations totaling $2.24 billion. Residential securities held increased to $1.23 billion from $1.11 billion at year-end.
- Commercial loan activity expanded: Redwood originated and funded 11 senior loans totaling approximately $154 million, table-funded another four totaling $146 million, and sold six senior loans. All remaining commercial securities were sold, generating the $12.0 million gain.
- In Q1 2012, realized gains included a $7.0 million gain on deconsolidation; there was no corresponding gain in Q1 2013. Other comprehensive income was $4.6 million in Q1 2013, versus $55.0 million in Q1 2012.
Outlook, commentary, and risks
- Management said it was on track to meet or exceed 2013 operational goals. Based on its current run rate, Redwood planned to acquire up to $8 billion of jumbo loans in 2013, compared with a prior goal of $7 billion. It also set a goal to originate and sell $1 billion of senior commercial loans.
- Management expected residential loan-sale margins for the rest of 2013 to average nearer the high end of its long-term 25–50 basis-point range, after unusually high margins in late 2012 and much of Q1. It attributed recent margin pressure to widening triple-A RMBS spreads, higher benchmark rates, risk aversion, and supply-demand conditions. Redwood planned to use a “best execution” approach between securitizations and whole-loan sales.
- Redwood expected to begin acquiring Agency-conforming loans by year-end, subject to completing approvals and operational build-out; it had approval to sell to Freddie Mac and was seeking approval from Fannie Mae. Management also expected MSRs and net servicing fees to become a larger earnings contributor over time.
- Key business risks include credit losses, prepayment and interest-rate changes, illiquid or model-valued assets, fair-value and earnings volatility, and dependence on short-term financing. Repo and warehouse facilities may require rapid additional collateral, may not be renewed, and may be withdrawn; Redwood reported covenant compliance at quarter-end.
- Residential securities carried $186 million of designated credit reserves. Serious delinquencies were 10.38% for loans underlying senior securities, 9.54% for re-REMIC securities, and 4.65% for subordinate securities. Management anticipated an additional $105 million of tax-purpose credit losses on securities it currently owns, with timing uncertain.
- Three RMBS-related investor lawsuits remained matters of potential exposure, including indemnity obligations to underwriters. Redwood said it would defend the claims and could not estimate potential loss; it had not recorded a litigation reserve. The FHLB-Seattle claims against Redwood and its subsidiary were dismissed for lack of personal jurisdiction, but claims against underwriters remained pending. SEC and NCUA information requests concerning historical CDO/RMBS activities were also disclosed; the filing states that the requests do not themselves indicate a violation.
- Subsequent to quarter-end, Redwood reported that $1.01 billion of loans identified for purchase at March 31 had closed and been purchased through May 3; $233 million was transferred to Sequoia entities in April. Further purchases were expected, subject to availability and delivery.
Important facts for investors to verify
- How much of Q1 earnings and book-value growth came from recurring net interest and loan-sale activity versus fair-value changes and realized security gains.
- Whether residential securitization margins, jumbo loan acquisition volumes, and the up-to-$8 billion 2013 acquisition plan are sustained as RMBS spreads change.
- Liquidity available to meet near-term maturities and collateral calls, including the $355.5 million due within 30 days and reliance on uncommitted funding.
- Credit performance, reserve adequacy, and valuation assumptions for residential securities, loans, commercial mezzanine investments, and MSRs.
- Developments in the RMBS litigation and any resulting indemnity costs, as well as the timing and amount of anticipated tax-purpose credit losses.