REDWOOD TRUST INC quarterly report, Q3 FY2011

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Redwood Trust, Inc. — Q3 2011 Form 10-Q

Business context and reporting period

Redwood Trust invests in and finances residential and commercial real estate loans and securities backed by real estate assets. It operates as a REIT. This unaudited quarterly report covers the three and nine months ended September 30, 2011; comparisons are to the corresponding 2010 periods unless noted.

Financial performance and condition

  • Q3 earnings: Interest income was $53.4 million and net interest income was $29.1 million. Net income attributable to Redwood was $1.3 million, or $0.01 per share, versus $19.9 million, or $0.25 per share, in Q3 2010.
  • Nine-month earnings: Interest income was $160.7 million and net interest income was $90.8 million. Net income attributable to Redwood was $28.9 million, or $0.35 per share, versus $95.3 million, or $1.19 basic EPS, in the first nine months of 2010.
  • Key Q3 expenses and adjustments: Loan-loss provision was $4.0 million; net market valuation adjustments were negative $13.4 million; operating expenses were $11.5 million. For the nine months, these were $8.4 million, negative $30.3 million, and $35.1 million, respectively.
  • Dividends: The company declared $0.25 per share for Q3, unchanged from Q3 2010, and $0.75 per share for the first nine months of both years.
  • Cash flow: Operating activities provided $15.5 million in the first nine months, compared with $13.0 million used in the same 2010 period. Investing activities used $307.9 million and financing activities provided $378.9 million. Cash increased $86.5 million to $133.4 million.
  • Balance sheet and liquidity: At September 30, total assets were $5.55 billion, total liabilities $4.60 billion, and stockholders’ equity $959 million. Cash was $133.4 million; restricted cash was $17.0 million. Management estimated investment capacity at $206 million.
  • Debt: Redwood had no short-term debt outstanding at quarter-end and had $139.5 million of long-term debt. Consolidated asset-backed securities (ABS) were $4.29 billion; these are principally obligations of securitization entities, whose creditors generally have no recourse to Redwood. Debt and liquidity measures should be read with this distinction in mind.
  • Book value: GAAP book value was $12.22 per share, down $0.82 from June 30. Accumulated other comprehensive income fell to $32.3 million from $112.3 million at December 31, 2010, reflecting unrealized losses on securities and hedges.

The filing does not provide a clearly defined consolidated operating-margin or net-interest-margin figure.

Material changes versus comparable periods

  • Q3 net income attributable to Redwood fell to $1.3 million from $19.9 million. Management cited lower market values of risk-management derivatives amid falling rates, lower average securities holdings, and a higher legacy loan-loss provision.
  • For the first nine months, net income fell to $28.9 million from $95.3 million. Net interest income declined to $90.8 million from $111.3 million, while net realized gains on sales and calls dropped to $10.8 million from $62.0 million.
  • Residential loans increased to $4.16 billion from $3.80 billion at year-end 2010, while real estate securities declined to $1.03 billion from $1.15 billion. Commercial real estate loans increased to $110.6 million from $50.4 million.
  • Cash rose to $133.4 million from $46.9 million at year-end 2010. Short-term debt declined from $44.1 million to zero.
  • Redwood completed a residential securitization and a July resecuritization. The latter transferred $365 million of residential securities into a structure that issued ABS to third parties; Redwood retained subordinate exposure, so its credit risk was largely unchanged.
  • The Redwood Opportunity Fund was deconsolidated after distributing its remaining cash; the company recognized a $256,000 loss on deconsolidation.

Outlook, management commentary, and risks

  • Management said it was dissatisfied with Q3 results but encouraged by business progress, while acknowledging that it needed to deploy more capital at attractive returns and improve operating leverage.
  • The company expected its next residential securitization in late Q4 2011 or Q1 2012. At October 31, loans held for future securitization and planned purchases totaled $570 million.
  • Management expected commercial loan originations of approximately $25 million to $50 million per quarter in the near term. The commercial loan portfolio was $113 million at October 31; management reported an average yield above 10%, average origination LTV of 73%, and average origination debt-service coverage ratio of 1.15x.
  • Management did not expect to need equity capital over the next couple of quarters, but said this could change in 2012. It was negotiating warehouse facilities to finance residential loan acquisitions.
  • Management described challenging and illiquid credit markets, wider bid-ask spreads, and market volatility. It noted that derivative accounting can create timing mismatches with the loans being hedged, making reported earnings volatile even when hedges are intended to manage economic risk.
  • Key exposures include mortgage credit losses, prepayments, interest-rate and fair-value movements, margin calls and counterparty performance, access to short-term financing, and reliance on significant management estimates for illiquid Level 3 valuations. Residential loans held for investment had a $64.0 million allowance; serious delinquencies at consolidated Sequoia entities were $133 million, or 3.37% of outstanding loan balances.
  • Three investor lawsuits involving Sequoia RMBS were pending: claims by the Federal Home Loan Banks of Seattle and Chicago and Charles Schwab. Redwood said it believed the claims were without merit, but could not estimate potential losses; indemnities to underwriters could also result in costs. The SEC had requested information on past CDO activities and the NCUA had issued a subpoena concerning RMBS transactions; Redwood had responded, and neither request was stated to be an allegation of wrongdoing.
  • The SEC’s review of the Investment Company Act exclusion Redwood relies on could lead to regulatory changes affecting its business model or access to capital. The company also cited uncertainty around securitization rules, including proposed risk-retention requirements.

Important facts for investors to verify

  • Whether derivative-related losses and accounting timing mismatches persist, and how hedge performance compares with the underlying economic exposure.
  • Trends in loan delinquencies, charge-offs, loss severity, credit reserves, and the performance of legacy Sequoia assets and subordinate securities.
  • Whether planned securitizations and warehouse financing are completed on the expected timing and terms, and whether capital deployment generates the anticipated returns.
  • Liquidity available to Redwood itself, including the effect of margin requirements and any short-term financing needs; distinguish these from non-recourse securitization liabilities.
  • Developments in the RMBS litigation, related indemnity exposure, SEC and NCUA matters, and potential changes to Redwood’s Investment Company Act exemption.
  • The sustainability of the $0.25 quarterly dividend relative to REIT taxable income, cash flows, and future credit losses.