Redwood Trust, Inc. — Q3 2010 Form 10-Q
Reporting period: Three and nine months ended September 30, 2010. Redwood is a REIT investing in, financing, and managing residential and commercial real estate loans and mortgage-backed securities. Financial statements consolidate the Fund and certain Sequoia and Acacia securitization entities; many of their assets and liabilities are legally separate from Redwood and their creditors generally have no recourse to Redwood.
Financial results and position
| Metric | Q3 2010 | Q3 2009 | Nine months 2010 | Nine months 2009 |
|---|---|---|---|---|
| Interest income | $59.0 million | $70.4 million | $174.3 million | $226.1 million |
| Net interest income | $35.3 million | $45.5 million | $111.3 million | $114.7 million |
| Loan-loss provision | $2.4 million | $10.0 million | $16.2 million | $40.6 million |
| Net market valuation adjustments | $(1.6) million | $(11.1) million | $(19.9) million | $(83.4) million |
| Realized gains on sales and calls, net | $1.6 million | $17.6 million | $62.0 million | $43.5 million |
| Net income attributable to Redwood | $19.9 million | $27.1 million | $95.3 million | $(1.1) million |
| Diluted earnings per share | $0.25 | $0.34 | $1.18 | $(0.02) |
| Dividend declared per share | $0.25 | $0.25 | $0.75 | $0.75 |
- Operating expenses were $12.2 million in Q3 and $40.8 million for the first nine months. Nine-month expense increased from $36.2 million, primarily reflecting a $4 million non-recurring charge for accelerated vesting of the former CEO’s awards and costs of expanding the businesses.
- At September 30, total assets were $5.16 billion, total equity $1.03 billion, and stockholders’ equity $1.02 billion. Cash and equivalents were $189.3 million; restricted cash was $24.1 million. Cash declined $53.6 million during the first nine months.
- Operating cash flow was $(13.0) million for the first nine months, versus $168.0 million provided in 2009. Investing activities provided $194.6 million and financing activities used $235.2 million.
- Redwood had no short-term debt outstanding and $140 million of corporate long-term debt. Consolidated asset-backed securities (ABS) were $3.83 billion at carrying value and $6.52 billion at principal value; these securitization obligations are generally payable only from the entities’ assets.
- Management estimated risk-adjusted investment capacity of $222 million and stated it believed capital was sufficient for foreseeable investment growth. GAAP book value was $13.02 per share; management’s non-GAAP estimated economic value was $13.73 per share.
Material changes and operating developments
- Q3 net income fell year over year, chiefly as lower net interest income and realized gains outweighed improvement in loan-loss provisions and valuation adjustments. Management said net interest income was approximately level with Q2 2010; lower gains versus Q1 and Q2 contributed to lower Q3 earnings.
- For the first nine months, Redwood returned to GAAP profitability from a loss in 2009. Lower provisions and substantially smaller negative market valuation adjustments helped; realized gains increased to $62.0 million from $43.5 million.
- The residential loan platform began acquiring newly originated prime jumbo loans for future securitization. In April, Redwood securitized $238 million of loans, issuing $211 million of ABS to third parties. By October 31, it had purchased $160 million of residential loans and had $138 million of purchase commitments.
- Redwood funded its first commercial mezzanine loan shortly after quarter-end: $12 million. Management reported a growing pipeline and expected commercial lending could represent a significant portion of 2011 investment, but provided no quantified target.
- GAAP book value rose $0.52 per share from December 31, 2009. Q3’s $0.31-per-share increase from June 30 primarily reflected appreciation in mortgage securities; quarterly earnings matched the dividend.
Outlook, risks, and unusual items
- Management hoped to complete another residential securitization in Q1 2011, subject to favorable markets and resolution of rating-agency issues. It warned a temporary SEC measure supporting public ABS ratings was due to expire in late January 2011, potentially disrupting issuance absent an extension or alternative.
- Management expected a taxable loss for 2010 and anticipated the year’s dividends would generally be classified as return of capital, while noting a portion could be ordinary income if Q4 credit losses were substantially lower. The estimated Q3 taxable loss was $8.6 million, compared with a $19.9 million GAAP profit attributable to Redwood.
- Management did not anticipate raising capital in the near term or paying a special dividend. It intended to use excess cash to accumulate loans before securitization and stated it would be prudent about borrowing. The cash balance was $79 million as of November 1, 2010.
- Credit quality remains a central risk: the residential loan allowance was $59.1 million; serious delinquencies on consolidated Sequoia loans were $131 million, or 3.55% of balances. Redwood reported serious delinquencies of 11.46% in underlying senior-security pools and 8.07% in subordinate-security pools. Management cautioned that additional losses could affect Sequoia senior securities.
- Fair values rely heavily on Level 3 estimates for illiquid securities and ABS. Management received dealer marks for 78% of securities and 94% of ABS issued; internal marks averaged 1% below dealer marks for securities and 3% above dealer marks for ABS. Valuation assumptions and market liquidity can materially affect earnings and equity.
- Three RMBS-related legal matters involved FHLB-Seattle, Charles Schwab, and FHLB-Chicago, alleging misstatements or omissions in offering materials. Redwood said it considered the claims without merit and would defend them; outcomes could not be predicted, and the filing warned of possible material adverse effects. No clear quantified loss exposure is provided.
- Other material risks include interest-rate, prepayment, liquidity, counterparty, regulatory, and mortgage-market risks. Management described foreclosure-process and mortgage-transfer documentation issues as likely to have minimal impact on Redwood, but acknowledged uncertainty.
- Disclosure controls were concluded effective at a reasonable assurance level; no material change in internal control over financial reporting was reported for the quarter.
Investor verification points
- Track residential loan purchases, commitments, funding needs, and whether the planned Q1 2011 securitization proceeds amid rating-agency and risk-retention uncertainty.
- Verify the trend in Sequoia delinquencies, defaults, charge-offs, loss severity, and the adequacy of the $59.1 million loan allowance and securities credit reserves.
- Assess how much reported earnings and book value depend on realized gains, Level 3 valuations, and changes in credit-loss or prepayment assumptions.
- Monitor cash and liquidity after the decline to $79 million by November 1, planned loan accumulation, and any use of recourse short-term financing.
- Follow the three RMBS lawsuits, including motions and potential exposure; the filing does not provide a reliable estimate of possible loss.
- Confirm final 2010 taxable income and the tax characterization of dividends; management’s return-of-capital expectation was preliminary.