REDWOOD TRUST INC quarterly report, Q2 FY2019

Full document

Business context and reporting period

Redwood Trust, Inc. (NYSE: RWT) filed this unaudited Form 10-Q for the quarter and six months ended June 30, 2019. The specialty finance company invests in residential and multifamily mortgage-related assets and operates Investment Portfolio and Mortgage Banking segments. It is taxed as a REIT.

In March 2019, Redwood acquired the remaining 80% of 5 Arches, a business-purpose residential loan originator, and began consolidating its results.

Financial performance and condition

Unless stated otherwise, amounts are in millions. Second-quarter results compared with Q2 2018:

  • Interest income was $148.5, up from $83.0; interest expense rose to $116.2 from $48.2. Net interest income declined 7% to $32.3 from $34.8.
  • Non-interest income increased to $27.5 from $19.5, led by mortgage banking income of $19.2 versus $10.6. Investment fair-value gains were $3.1 versus $0.9.
  • Operating expenses rose to $26.3 from $19.0, primarily reflecting 5 Arches and higher compensation costs.
  • Net income was $31.3 versus $32.7; diluted EPS was $0.30 versus $0.38. Annualized GAAP return on equity was 8%.

For the first six months, net income increased 8% to $85.7 from $79.6, while diluted EPS fell to $0.78 from $0.88. Net interest income decreased to $64.1 from $69.9; non-interest income increased to $74.3 from $59.2. Management attributed the period’s investment fair-value gains partly to tighter credit spreads.

At June 30, total assets were $13.85 billion, total liabilities $12.29 billion and equity $1.56 billion. Book value was $16.01 per share, compared with $16.00 at March 31. The quarterly dividend was $0.30 per share; $0.60 per share was declared for the first half.

Cash and cash equivalents were $218 million, with another $34 million restricted. Management estimated approximately $200 million of available capital. Operating cash flow was negative $558 million for the first half, including cash used in loan purchases and derivative settlements; investing cash flow was positive $497 million and financing cash flow positive $108 million.

Short-term debt was $2.46 billion, including $201 million of exchangeable notes due November 2019; long-term debt was $2.57 billion. The $2.00 billion FHLB advance balance was secured by residential loans. Separately, $6.91 billion of asset-backed securities issued was reported as liabilities of consolidated securitization entities; creditors generally have recourse only to those entities’ assets. Total capital, as management defines it, was $2.34 billion, including $1.56 billion of equity and $0.77 billion of unsecured corporate debt.

Blended second-quarter yields reported for interest-earning assets and interest-bearing liabilities were 4.6% and 4.0%, respectively, compared with 4.9% and 3.3% a year earlier. Management said mortgage banking gross margins exceeded its long-term target range in Q2; it expects margins to normalize and volume growth to stabilize during the rest of 2019.

Material changes versus the prior comparable period

  • Q2 net income and diluted EPS declined despite higher mortgage banking and investment fair-value income; net interest income and realized gains were lower, and expenses were higher.
  • First-half net income rose, but diluted EPS fell amid a substantially larger share count. Redwood issued 11.5 million shares in January, raising approximately $177 million net, and issued additional shares through its at-the-market program.
  • Multifamily loans at consolidated Freddie Mac K-Series entities increased to $3.75 billion from $2.14 billion at year-end. Business-purpose residential loans increased to $251 million from $141 million.
  • Total assets increased to $13.85 billion from $11.94 billion, largely alongside growth in consolidated securitization assets and liabilities. These VIE assets are not freely available to Redwood to meet its own obligations.
  • Market-rate declines benefited mortgage banking but increased hedging costs and hurt interest-rate- and prepayment-sensitive investments, including certain jumbo loans and MSRs. Q2 GAAP book value per share was nearly unchanged.

Outlook, risks and unusual items

  • Outlook: Management planned to continue ramping 5 Arches originations and focus investment deployment on multifamily securities, re-performing loan securities and business-purpose loans. It reported more than $100 million deployed in July and approximately $200 million of available capital at quarter-end. No formal numerical earnings guidance is provided.
  • Subsequent investment: In July, Redwood deposited $60 million toward subordinate securities in a Freddie Mac-sponsored securitization and expected to pay approximately $150 million more at a third-quarter closing, partly financed with repo debt.
  • Debt and liquidity: Many warehouse and securities-repurchase facilities are uncommitted and may be withdrawn or subject to margin calls. $871.5 million of securities repo debt was due within 30 days at quarter-end. The $201 million exchangeable note maturity in November 2019 is a near-term funding consideration. Management said available capital and expected portfolio liquidity were sufficient for operations and contemplated activity, while noting it may raise capital.
  • Market and credit risks: Results and fair values are sensitive to interest rates, credit spreads, prepayments, borrower performance, financing access and collateral values. Many assets and liabilities are Level 3 fair-value measurements using significant unobservable assumptions. Redwood reported 11 delinquent residential bridge loans with $12 million fair value, nine in foreclosure with $7 million fair value; the consolidated SLST pool included $78 million of loans over 90 days delinquent and $15 million in foreclosure.
  • Commitments and contingencies: 5 Arches earn-out payments could total up to $27 million; the recorded fair value was approximately $25 million. A multifamily partnership commitment had $49 million remaining, and a related Freddie Mac guarantee had maximum exposure of $135 million, though management considered performance remote. Litigation reserves were $2 million; the filing warns actual losses could exceed reserves. A $33 million commitment to fund residential bridge loans was also outstanding.
  • Other items: Q2 included 5 Arches amortization expense; first-half results included a gain on remeasurement of the prior 5 Arches investment. Management said housing and portfolio credit fundamentals remained strong, while noting slowing home-price appreciation. It viewed potential expiration of the GSE QM Patch and policy shifts toward private mortgage capital as opportunities, but outcomes remain uncertain.

Important facts for investors to verify

  1. How Redwood plans to repay or refinance the $201 million exchangeable notes due November 2019, and whether liquidity and facility access remain adequate.
  2. Whether mortgage banking margins normalize as management expects, and whether 5 Arches originations scale while controlling expenses and credit performance.
  3. How interest rates, spreads, prepayments and hedges affect fair values, book value, earnings and margin requirements.
  4. Credit trends in residential bridge loans, the SLST pool and servicing investments, including delinquency, foreclosure and loss levels.
  5. The assumptions and potential cash and share impact of the 5 Arches earn-out, multifamily partnership commitment and Freddie Mac guarantee.
  6. Whether litigation or indemnity exposures require reserves above the $2 million recorded, and how policy changes around the GSEs and QM Patch develop.