REDWOOD TRUST INC quarterly report, Q2 FY2017

Redwood Trust, Inc. — Q2 2017 Form 10-Q

Business context and reporting period. Redwood invests in mortgage and other real-estate-related assets and conducts residential mortgage banking through its Investment Portfolio and Residential Mortgage Banking segments. This unaudited filing covers the three and six months ended June 30, 2017; comparisons below are with the same periods in 2016 unless noted.

Financial performance and position

Metric	Q2 2017	Q2 2016	Six months 2017	Six months 2016
Net interest income	$35.0 million	$44.3 million	$68.6 million	$82.7 million
Non-interest income, net	$25.3 million	$10.9 million	$53.1 million	$15.3 million
Net income	$36.3 million	$41.3 million	$73.3 million	$53.3 million
Diluted EPS	$0.43	$0.48	$0.85	$0.67
Regular dividend per share	$0.28	$0.28	$0.56	$0.56

Q2 annualized GAAP return on equity was 12% (13% for the first half). GAAP book value per share was $15.29 at June 30, up from $15.13 at March 31; management attributed the quarterly increase mainly to earnings exceeding dividends and securities valuation gains.
At June 30, total assets were $5.66 billion, total liabilities $4.48 billion, and equity $1.18 billion. Cash and cash equivalents were $217 million.
First-half operating cash flow was negative $267 million, investing cash flow positive $206 million, and financing cash flow positive $66 million; cash increased $4 million to $217 million. Operating cash flow included mortgage-loan purchases and sales. Excluding held-for-sale loan purchase, sale, and principal cash flows, operating cash flow was negative $10 million.
Short-term debt was $1.295 billion, including $1.045 billion of secured warehouse and repo facilities and $250 million of convertible notes due in 2018. Long-term debt, net, was $2.336 billion, including $2.0 billion of FHLB advances. The FHLB advances carried a 1.1% weighted-average rate and approximately eight-year weighted-average maturity.
Management estimated approximately $180 million of capital available for investment. Warehouse facilities had $1.33 billion of stated borrowing capacity; they and the securities repo facilities were generally uncommitted. Redwood reported compliance with debt covenants.
The filing does not provide a single company-wide net interest margin. It reports Q2 asset yields of 4.6% and interest expense yields of 2.2% on average balances.

Material changes versus the prior comparable period

Q2 net income declined $5.0 million and diluted EPS fell from $0.48 to $0.43. Higher non-interest income, including positive investment fair-value changes and stronger mortgage banking results, was more than offset by lower net interest income and higher income-tax expense.
First-half net income rose $19.9 million and diluted EPS increased from $0.67 to $0.85. The comparison benefited from a $30.6 million swing in investment fair-value changes, net, from a $30.6 million loss in 2016 to a $9.7 million gain in 2017, and from lower operating expenses. First-half 2016 included $11 million in restructuring costs.
Net interest income fell as commercial mezzanine loans sold in 2016 no longer contributed, partly offset by income from residential investments and securities. The 2016 periods also included reversals of loan-loss provisions ($6.5 million in Q2 and $6.2 million for the first half); 2017 had none.
Mortgage banking income increased to $12.0 million in Q2 and $29.7 million for the first half, from $7.7 million and $14.9 million, respectively. Management cited higher jumbo-loan gross margins and improved sale/securitization execution. It said margins remained above long-term expectations, but were lower than Q1 2017.
Real estate securities increased to $1.22 billion from $1.02 billion at year-end 2016; MSRs decreased to $63.8 million from $118.5 million, primarily reflecting sales of conforming MSRs and valuation changes. Short-term debt rose from $792 million at year-end, including the reclassification of convertible notes due within one year.

Outlook, risks, and unusual items

Management reported deploying $78 million of capital in Q2 and $274 million during the first half, including convertible-debt repurchases. It estimated $180 million available for investment at quarter-end and expected to free additional capital through portfolio optimization.
Management said it intended to pay a regular dividend of $0.28 per share per quarter in 2017. The board declared a Q3 dividend of $0.28 per share, payable September 29, 2017. No earnings or revenue forecast was provided.
Management warned that widening credit spreads or a market selloff could reduce asset values and near-term earnings in the second half of 2017. It also cited Federal Reserve balance-sheet actions, interest-rate and prepayment changes, market liquidity, financing availability, credit losses, and competition as factors that could affect results. It said lower asset prices could create investment opportunities.
Mortgage banking pipeline commitments were $1.4 billion in Q2, including growing Redwood Choice volume; Choice represented about 20% of Q2 volume and management planned a Choice securitization later in 2017. The filing says Choice yields were approximately 100–125 basis points above traditional Redwood Select loans.
A legacy RMBS trustee holdback reduced the value of one investment by approximately $0.5 million in Q2. Redwood said further trustee holdbacks could cause additional losses and disclosed potential indemnification exposure. Litigation-related reserves were $2 million; actual losses could exceed reserves.
Redwood repurchased $37 million principal amount of its 2018 convertible notes at a premium, recording a $1 million extinguishment loss. This debt was reclassified to short-term debt as it entered its final year before maturity.
Fair-value estimates rely substantially on Level 3 inputs and management assumptions. Redwood noted that actual results may differ materially from estimates. The reported $180 million investment-capital estimate and taxable-income figures are management estimates; taxable-income figures remain subject to tax-return filing.

Most important facts for investors to verify

Whether mortgage banking margins, loan purchase commitments, and Redwood Choice volumes remain resilient as competition and securitization issuance increase.
How credit-spread widening, interest rates, prepayments, and hedging affect fair values, book value, and earnings.
Liquidity and refinancing plans for the $250 million of 2018 convertible notes, alongside reliance on uncommitted short-term warehouse and repo facilities and margin-call requirements.
Whether the $180 million estimated investment capital and anticipated portfolio optimization proceeds are realized without weakening liquidity.
Potential losses from legacy RMBS trustee holdbacks, indemnities, repurchase claims, and litigation relative to the $2 million litigation reserve.
Whether the $0.28 quarterly dividend remains supported by REIT taxable income and cash generation, recognizing that GAAP earnings and taxable income differ.