Redwood Trust, Inc. — 2012 Form 10-K Summary
Business context and period. This annual report covers the fiscal year ended December 31, 2012, including fourth-quarter results. Redwood is an internally managed mortgage banking and investment company, taxed as a REIT. It acquires residential loans for sale or securitization, originates commercial loans, and invests in mortgage-related securities and loans. Many securitization entities are consolidated for GAAP reporting, although their assets and liabilities are generally legally separate from Redwood’s.
Financial performance and condition
| Metric | FY 2012 | FY 2011 |
|---|---|---|
| Interest income | $231.4 million | $217.2 million |
| Interest expense | $120.8 million | $99.0 million |
| Net interest income | $110.6 million | $118.1 million |
| Loan-loss provision | $3.6 million | $16.2 million |
| Other market valuation adjustments, net | $(10.2) million | $(40.0) million |
| Mortgage banking income, net | $46.6 million | Not reported as a separate line in 2011 |
| Operating expenses | $65.3 million | $47.7 million |
| Net income attributable to Redwood | $131.8 million | $26.3 million |
| Diluted earnings per share | $1.59 | $0.31 |
| Return on average equity | 13.3% | 2.6% |
| Regular dividends per share | $1.00 | $1.00 |
- Fourth quarter: Net income was $42.1 million, or $0.50 per diluted share, versus a $2.6 million loss, or $0.03 per share, in Q4 2011. Mortgage banking income was $23.9 million. GAAP net interest income was $20.4 million; management’s adjusted comparison was $31 million after reclassifying an $11 million one-time expense related to Acacia deconsolidation.
- Assets and equity: Total assets were $4.44 billion, down from $5.74 billion; stockholders’ equity was $1.14 billion, up from $892.6 million. Book value per share increased to $13.95 from $11.36. Net unrealized gains recorded in accumulated other comprehensive income were $138.3 million, compared with a $13.2 million loss at year-end 2011.
- Cash and cash flow: Cash and cash equivalents were $81.1 million, down from $267.2 million. Cash from operating activities was negative $450.2 million, investing activities provided $723.3 million, and financing activities used $459.2 million; cash decreased by $186.1 million overall. Operating cash flow included substantial loan purchases for resale, so it should be viewed alongside the financing and investing flows.
- Debt and liquidity: Year-end short-term debt was $551.9 million, up from $428.1 million; long-term debt was $139.5 million. Asset-backed securities issued totaled $2.53 billion, compared with $4.14 billion. Most ABS relates to consolidated securitization entities and is not a direct legal obligation of Redwood. Management estimated $130 million of investment capacity at year-end and reported compliance with debt covenants and margin calls.
- Margins: The filing does not provide a single comparable consolidated operating-margin measure. Redwood said residential loan sale margins remained elevated, above its expected long-run range of 25–50 basis points.
Material changes versus the prior period
- Net income rose sharply from 2011, supported by mortgage banking income, lower loan-loss provisions and less-negative market valuation adjustments. Net interest income declined as interest expense increased.
- Redwood acquired $2.3 billion of residential loans in 2012, completed six Sequoia securitizations, and expanded its active seller network to 62. It retained $150 million of securities from new Sequoia transactions.
- Commercial loans held or securitized increased: year-end commercial loans were $313 million versus $170 million in 2011. A November 2012 securitization financed $291 million of mezzanine loans, issued $172 million of ABS, and released $168 million of cash for reinvestment.
- Redwood sold its remaining interests in legacy Acacia and certain Sequoia entities and deconsolidated them. The Q4 accounting effects included an approximately $4 million net non-recurring earnings increase after reclassification; the company also reported a $15 million GAAP deconsolidation gain and an $11 million accelerated hedging-cost expense.
- Residential securities rose in fair value to $1.11 billion from $750.7 million. The portfolio remained exposed to credit and valuation risk: reported serious delinquencies in underlying senior residential pools were 10.44% at year-end.
Outlook, risks and contingencies
- 2013 targets: Management aimed to acquire and securitize approximately $7 billion of residential loans; add sellers, loan products and capital sources; originate $1 billion of senior commercial loans for sale; and originate $150 million of mezzanine commercial loans for investment. It also anticipated potential conforming-loan sales to the Agencies and further MSR acquisitions. These were goals, not guarantees.
- Dividend: The board stated its intention to pay a regular dividend of $0.28 per share per quarter in 2013, compared with $0.25 per quarter in 2012. The filing cautions that dividends are discretionary and depend on earnings, taxable income, liquidity and other factors. The expected 2012 tax characterization was 77% ordinary income and 23% return of capital.
- Liquidity and financing risks: Much of Redwood’s warehouse and repurchase financing is short-term and uncommitted, with collateral margin requirements and covenant triggers. A decline in collateral values, lender non-renewal or reduced access to funding could require cash, asset sales or reduced activity. Management expected to need additional capital during 2013 and was considering debt or equity issuance.
- Business and market risks: Results are sensitive to credit losses, mortgage prepayments, interest rates, asset valuations, securitization economics and liquidity. Regulatory changes, Agency competition, reduced refinancing volumes, servicing obligations, and reliance on counterparties and sub-servicers may also affect results.
- Legal matters: The filing describes RMBS-related litigation involving the Federal Home Loan Banks of Seattle and Chicago and Schwab, as well as related indemnification exposures. Redwood said it would defend the cases; it could not reasonably estimate possible losses and had not established reserves for these matters. Separate SEC and NCUA information requests were described as not indicating that violations had occurred.
- Unusual accounting and tax factors: Fair-value estimates rely substantially on management judgments and Level 3 inputs. GAAP income and REIT taxable income differ materially; 2012 estimated taxable income was $55.2 million versus GAAP net income of $131.8 million. Redwood reported expected additional tax-basis credit losses of $111 million over time, with timing uncertain.
Important facts for investors to verify
- Whether 2013 residential and commercial origination and securitization targets were achieved, and whether elevated residential gain-on-sale margins were sustainable.
- Current cash, investment capacity, short-term debt maturities, lender renewals, collateral haircuts and covenant headroom.
- Credit performance and reserve adequacy across residential securities, Sequoia loans and commercial loans, including the effect of California and other geographic concentrations.
- Actual dividend payments and tax characterization, compared with the board’s stated 2013 intention and the company’s taxable income.
- Developments in RMBS litigation, indemnity obligations and any subsequent loss estimates or reserves.
- Changes in fair-value assumptions, realized losses, securitization accounting and the distinction between Redwood obligations and liabilities of consolidated entities.