Redwood Trust, Inc. — Q2 2015 Form 10-Q
Reporting period: Three and six months ended June 30, 2015. Redwood invests in mortgage and real-estate-related assets and conducts residential and commercial mortgage banking. It operates as a REIT and reports three business segments.
Financial performance and position
| Metric | Q2 2015 | Q2 2014 | Six months 2015 | Six months 2014 |
|---|---|---|---|---|
| Interest income | $63.4 million | $58.0 million | $127.1 million | $113.5 million |
| Net interest income | $40.4 million | $36.8 million | $80.2 million | $73.3 million |
| Non-interest income | $14.1 million | $1.5 million | $9.1 million | $(3.2) million |
| Operating expenses | $25.2 million | $22.3 million | $50.3 million | $42.3 million |
| Net income | $27.1 million | $16.0 million | $41.9 million | $28.4 million |
| Diluted EPS | $0.31 | $0.18 | $0.47 | $0.32 |
- Q2 net interest income increased 10% year over year; management attributed the rise chiefly to growth in residential loans held for investment and higher average loan balances. First-half net interest income rose 9%.
- Q2 non-interest income included $6.3 million of realized gains, primarily from securities sales. First-half MSR income was a $10.1 million loss, including interest-rate effects and, in Q2, $21.8 million of losses on derivatives identified as MSR hedges.
- Q2 total interest income yield was 5.0%; average interest expense yield was 2.2%. These are portfolio yields, not a stated net interest margin.
- At June 30, total assets were $5.60 billion, total liabilities $4.33 billion, and equity $1.26 billion. Book value was $14.96 per share, down from $15.01 at March 31. Q2 declared dividends were $0.28 per share.
- Cash and cash equivalents were $226 million, versus $270 million at year-end. Available capital for long-term investments was approximately $150 million, as defined by management.
- Short-term debt was $1.37 billion, down from $1.79 billion at year-end. Long-term debt was $1.58 billion, including $882 million of FHLB advances. Management reported compliance with debt covenants; covenant headroom included more than $200 million above minimum equity requirements and capacity for at least $600 million of additional recourse debt.
- Six-month operating cash flow was negative $286 million; investing cash flow was positive $510 million and financing cash flow negative $267 million. Operating cash flow excluding cash flows for loans initially held for sale was negative $25 million, per management.
Material changes versus comparable periods
- Net income rose 69% in Q2 and 48% for the first half year over year. Higher net interest income, mortgage banking activity and realized gains contributed; expenses also increased, primarily from compensation and staffing growth.
- Operating expenses increased 13% in Q2 and 19% for the first half. Redwood had 233 employees at June 30, compared with 171 a year earlier.
- Residential loans held for investment at Redwood reached $1.16 billion, supported by FHLB financing; the company transferred $664 million of loans from held-for-sale to held-for-investment during the first half. Real estate securities declined to $1.16 billion from $1.38 billion at year-end, while MSRs rose to $168 million from $139 million.
- Q2 2015 results included a $2 million commercial-loan loss provision reversal; first-half provision was also a reversal of less than $1 million. No other-than-temporary impairment losses were recognized on AFS securities in the first half, versus $0.4 million recognized through earnings in first-half 2014.
- Effective January 1, 2015, Redwood early adopted ASU 2014-13 for consolidated Sequoia entities, measuring their loans and ABS at fair value. Adoption added $9.7 million to opening equity and materially changed period-to-period balance-sheet and income comparisons. Redwood also changed income-statement presentation for MSR hedges and combined certain mortgage banking and valuation lines; prior-period MSR hedge impacts were not conformed.
Outlook, management commentary and risks
- Management expects continued interest-rate volatility in the remainder of 2015 and said volatility can pressure asset prices, MSR and interest-only security values, hedging costs and earnings. It said early Q3 conditions had been calmer but continued to refine hedging and portfolio strategies.
- Residential loan-purchase outlook was reduced from beginning-of-year targets. Management expected 2015 purchases of $5.5–$7 billion of jumbo loans and $6–$7 billion of conforming loans, targeting 25–50 basis points of average loan-sale margins. Through July 31, purchases were $3.0 billion jumbo and $3.2 billion conforming.
- Commercial senior-loan origination outlook was reduced from $1.5 billion to $1.0–$1.25 billion for 2015, with a 1.5% margin goal. Management cited lender competition, rate volatility and CMBS liquidity challenges; the July 31 pipeline was $246 million.
- Management expected no significant change in operating expenses in the second half. It expected the regular dividend to remain $0.28 per share quarterly in 2015; a $0.28 Q3 dividend was declared in August.
- In July, Redwood entered a Freddie Mac risk-sharing arrangement covering the first 1% of credit losses on up to $1 billion of conforming loans expected to be delivered in Q3. The existing Fannie Mae arrangement had maximum potential payments of $10 million, fully collateralized; no losses had been incurred and no loss allowance was required at June 30.
- In August, the board authorized up to $100 million of share repurchases; none had been made as of August 7. The authorization is discretionary and would use available capital.
- Key risks include uncommitted short-term and FHLB borrowing facilities, collateral margin calls, market and credit losses, prepayment and interest-rate exposure, liquidity and counterparty risks, reliance on Level 3 valuations, and possible changes in REIT or FHLB rules. A residential RMBS-related lawsuit against underwriters remained pending; Redwood had indemnity exposure and a $2 million litigation reserve. Management cautioned actual losses could exceed the reserve.
Most important facts for investors to verify
- Whether loan-purchase and commercial-origination targets and stated margins were achieved, and whether the reduced commercial outlook changed further.
- Whether earnings and book value remain resilient as interest rates, credit spreads, prepayments and hedging costs change, particularly for MSRs and securities.
- Funding availability and collateral requirements under uncommitted facilities, the use of the expanded FHLB capacity, and liquidity after any repurchases or dividends.
- Credit performance and valuation assumptions for residential and commercial loans, retained securities, MSRs and consolidated Sequoia interests.
- Developments in RMBS litigation and indemnities, repurchase claims, and the Fannie Mae and Freddie Mac risk-sharing arrangements.