Business context and reporting period
Redwood Trust, Inc. filed this Form 10-K for the fiscal year ended December 31, 2014. The mortgage-focused REIT operates residential mortgage banking, residential investments, and commercial mortgage banking and investments. Earnings come mainly from investment net interest income and mortgage loan acquisition, origination, sale, and securitization activity.
Financial and operating highlights
| Metric | 2014 | 2013 |
|---|---|---|
| Interest income | $242.1 million | $226.2 million |
| Net interest income | $154.6 million | $145.2 million |
| Mortgage banking income | $34.9 million | $102.5 million |
| MSR income (loss) | $(4.3) million | $20.3 million |
| Total noninterest income, net | $36.0 million | $142.4 million |
| Operating expenses | $90.1 million | $86.6 million |
| Net income | $100.6 million | $173.2 million |
| Diluted EPS | $1.15 | $1.94 |
| Return on equity | 8.0% | 14.4% |
| Book value per share, year-end | $15.05 | $15.10 |
For Q4 2014, net income was $27.1 million and diluted EPS was $0.31; the quarterly dividend was $0.28 per share. Full-year dividends were $1.12 per share. 2014 net income exceeded dividends, but book value per share declined slightly year over year.
Residential acquisitions totaled $9.0 billion, comprising $5.0 billion jumbo and $4.0 billion conforming loans, versus $7.1 billion in 2013. Redwood completed four private-label residential securitizations in 2014, compared with 12 in 2013. Commercial originations were approximately $1.0 billion, including $904 million of senior loans and $87 million of subordinate loans. Management reported no delinquencies or credit losses on more than $420 million of mezzanine investments.
At year-end, assets were $5.92 billion, including $5.75 billion of earning assets; total stockholders’ equity was $1.26 billion. Cash and cash equivalents were $269.7 million, and management estimated readily available investment capacity at approximately $198 million. Operating cash flow was negative $1.79 billion, investing cash flow was positive $740.6 million, and financing cash flow was positive $1.15 billion; cash increased $96.5 million over the year. Management attributes the large operating cash outflow in part to mortgage loan purchases and year-end held-for-sale inventory.
Consolidated liabilities were $4.66 billion, including $1.79 billion of short-term debt, $1.19 billion of long-term debt, and $1.55 billion of asset-backed securities. Some securitization liabilities are payable only from securitized assets and are not Redwood’s direct obligations. Short-term debt was largely under uncommitted facilities and was backed by loans and securities. The company reported $496 million of FHLB Chicago advances, with a 0.29% weighted-average rate and 9.4-year weighted-average maturity. It also issued $205 million of 5.625% exchangeable notes due 2019.
Changes versus the prior comparable period
- Net income fell $72.7 million, and diluted EPS declined from $1.94 to $1.15. Management attributed the decline chiefly to a $67 million reduction in mortgage banking income, lower MSR valuations, and higher operating costs as platforms expanded.
- Net interest income increased $9.4 million, reflecting higher average earning-asset balances, partly offset by higher interest expense.
- MSR income shifted from $20.3 million of income to a $4.3 million loss. Lower mortgage rates increased expected prepayments and reduced MSR fair values; market valuation changes were negative $21.1 million in 2014.
- Residential loan acquisitions rose about 27%, but mortgage banking margins were pressured by lower industry origination volumes, competition, and a larger share of lower-margin conforming loans.
- Operating expenses increased $3.5 million; year-end headcount rose to 221 from 141 as Redwood expanded its mortgage banking platforms.
- Short-term debt increased to $1.79 billion from $862.8 million, while year-end assets rose to $5.92 billion from $4.61 billion.
Outlook, commentary, risks, and contingencies
- For 2015, management expected to acquire $8 billion of conforming and $7 billion of jumbo residential loans, targeting loan-sale margins of 25–50 basis points. It also expected to expand conforming purchases through the FHLB Chicago mortgage partnership program and pursue additional Fannie Mae and Freddie Mac risk-sharing transactions.
- Management targeted $1.5 billion of commercial originations in 2015 at average margins of 150 basis points. It cited anticipated refinancing demand and potential CMBS issuance of up to $120 billion, while noting that origination volume would not ramp evenly.
- Management stated an intention to maintain the regular dividend at $0.28 per share per quarter in 2015. The board retains discretion, and dividends depend on taxable income, liquidity, financial condition, and other factors.
- A proposed FHFA rule could restrict the captive insurance subsidiary’s FHLB membership and access to financing. Redwood had $496 million of FHLB advances outstanding at year-end; the proposal’s eventual effect was uncertain.
- Key exposures include interest-rate and prepayment changes, mortgage and commercial real estate credit losses, valuation uncertainty in illiquid Level 3 assets, short-term funding renewal and margin-call risk, counterparty performance, securitization-market conditions, regulation, and REIT qualification and distribution requirements.
- Residential mortgage securities and loans have geographic concentration, including California exposure. Commercial investments also carry refinancing and maturity risk; much of the portfolio is subordinate or does not fully amortize.
- Litigation reserves were $2.0 million for the FHLB-Seattle and Schwab matters. Redwood and its subsidiary were dismissed from the FHLB-Seattle case, but claims against underwriters remained and indemnity obligations could still create losses. Schwab’s claim against the subsidiary was dismissed with prejudice; an Illinois case against Redwood entities was settled on confidential terms.
- The filing reports effective disclosure controls and internal control over financial reporting, and the auditor issued unqualified opinions on the financial statements and internal controls.
Important facts for investors to verify
- Whether residential and commercial mortgage banking margins and transaction volumes meet management’s 2015 targets.
- How lower rates, prepayments, and any subsequent rate changes affect MSR valuations, hedge results, earnings, and book value.
- Liquidity, collateral headroom, short-term facility renewals, and compliance with debt covenants, particularly as short-term borrowings increased.
- The outcome of the proposed FHFA rules and the subsidiary’s continued access to FHLB Chicago financing.
- Credit performance and valuation assumptions for residential securities, commercial loans, and other illiquid assets; the filing relies substantially on management estimates for fair value.
- Progress and potential losses from litigation, loan repurchase obligations, and the Fannie Mae risk-sharing arrangement.
- Whether taxable income, cash availability, and REIT requirements support the stated quarterly dividend intention.