RWT

Business Context and Reporting Period

Company: Redwood Trust, Inc. (Redwood)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2008
Business Overview: Redwood is a Real Estate Investment Trust (REIT) focused on investing in, financing, and managing residential and commercial real estate loans and securities. Its primary investment vehicles include direct holdings, the Redwood Opportunity Fund LP (the Fund), and sponsored securitization entities known as Sequoia (residential loans) and Acacia (CDOs and securities). The company ceased new investing activity in mid-2008 to assess market conditions but resumed acquiring investment-grade residential securities in the fourth quarter.

Key Financial Metrics

Material Changes Versus Prior Period

• Improved Net Loss: The GAAP net loss improved significantly from $1.1 billion in 2007 to $444 million in 2008. This improvement was primarily driven by a reduction in negative market valuation adjustments (MVA) from $1.26 billion to $493 million, largely due to the adoption of FAS 159 which allowed for the offsetting of asset and liability MVA in Acacia entities.
• Equity Recovery: Stockholders' equity recovered from a deficit of $718 million in 2007 to a positive $302 million in 2008. This was aided by a one-time cumulative-effect adjustment of $1.47 billion to retained earnings upon the adoption of FAS 159 on January 1, 2008.
• Asset Base Contraction: Total assets decreased by approximately 44% to $5.58 billion, reflecting the paydown of loans, deconsolidation of certain Sequoia entities, and a strategic halt in new acquisitions for most of the year.
• Increased Credit Provisions: The provision for loan losses increased to $55 million in 2008 from $12.8 million in 2007, reflecting deteriorating credit performance in the residential loan portfolio.
• Dividend Reduction: While regular dividends remained at $3.00 per share in 2008 (matching 2007), the company eliminated the $2.00 per share special dividend paid in 2007. Management announced an intention to reduce the 2009 regular dividend to $0.25 per share per quarter.

Guidance, Outlook, and Risks

• Outlook: Management expects GAAP earnings to remain volatile in the near term due to mark-to-market adjustments. They anticipate taxable income for 2009 will likely be negative due to the realization of credit losses. However, they project generating over $100 million in positive cash flow from existing investments in 2009.
• Capital Raise: In January 2009, Redwood completed a public offering of common stock, raising $283 million in net proceeds. Management views this as accretive to future earnings once deployed into new investments.
• Investment Strategy: The company has shifted focus to acquiring senior cash flows from prime and near-prime residential mortgage-backed securities (RMBS) at significant discounts. They have no current plans to purchase commercial mortgage-backed securities (CMBS) due to expected difficulties in the commercial sector.
• Key Risks:
  • Credit Risk: Continued deterioration in the housing market and rising delinquencies could lead to higher-than-anticipated credit losses, particularly in non-prime and Alt-A securities.
  • Liquidity Risk: While the company has no short-term debt and significant cash reserves, access to capital markets remains constrained. The company relies on permanent capital (equity and long-term debt) to avoid margin calls.
  • Government Intervention: Potential legislative changes, such as bankruptcy cramdowns or loan modification programs, could adversely affect the value of mortgage securities.
  • Valuation Volatility: Fair value estimates for illiquid assets rely on significant management judgment and unobservable inputs (Level 3), leading to potential earnings volatility.

Important Facts for Investor Verification

• Dividend Sustainability: Verify the company's ability to maintain the reduced 2009 dividend rate of $0.25 per share given the expectation of negative taxable income and the need to fund distributions from cash reserves or capital raises.
• Credit Loss Realization: Monitor the actual realization of credit losses in the residential loan portfolio (Sequoia) and the impact on the allowance for loan losses, which stood at $35.7 million at year-end.
• Deployment of Capital: Track the deployment of the $283 million raised in January 2009 and the resulting yield on new investments to ensure accretion to earnings as projected.
• Mark-to-Market Volatility: Assess the impact of future mark-to-market adjustments on GAAP earnings, particularly regarding the Acacia entities where assets and liabilities are marked to market.
• Deconsolidation Impact: Review the long-term impact of the deconsolidation of three Sequoia securitizations in Q4 2008, which removed $1.3 billion in assets and liabilities but resulted in a $5 million net realized gain.