Redwood Trust, Inc. — Q1 2012 Form 10-Q
Reporting period: Three months ended March 31, 2012; balance-sheet comparisons are to December 31, 2011. Redwood invests in and finances residential and commercial real estate loans and securities and is organized as a REIT. Unless noted, financial statement amounts below are in millions.
Financial performance and position
- Earnings: Net income attributable to Redwood was $30.5 million, versus $18.2 million in Q1 2011. Diluted EPS was $0.37, versus $0.22; basic EPS was $0.38. Net income included $13.6 million of realized gains, including a $7.0 million gain from deconsolidating five legacy Sequoia entities and approximately $6.3 million net gains on securities sales and calls.
- Interest income and expense: Interest income rose to $58.7 million from $54.3 million, but interest expense increased to $30.7 million from $22.0 million. Net interest income therefore declined to $28.1 million from $32.4 million. After loan-loss provision and other market valuation adjustments, net interest income was $27.2 million versus $23.8 million.
- Other income and costs: Mortgage banking activities contributed $4.3 million, including $7.4 million of securitization gains offset by $3.1 million of economic-hedge valuation losses. Operating expenses rose to $14.6 million from $11.5 million, mainly due to higher headcount and compensation.
- Cash flow: Cash and equivalents ended at $149.6 million, down from $267.2 million. Operating activities used $233.7 million, investing activities provided $305.0 million, and financing activities used $189.0 million. Cash use reflected loan purchases and investment activity; cash receipts from securitizations and borrowings helped fund those uses.
- Capital and leverage: Total assets were $5.37 billion and stockholders’ equity was $962.3 million, up from $892.6 million at year-end. Short-term debt was $441.0 million, compared with $428.1 million; long-term debt remained $139.5 million. Asset-backed securities (ABS) were $3.70 billion on the balance sheet. Most ABS relate to consolidated, bankruptcy-remote entities and are not Redwood’s direct legal obligations.
- Liquidity: Redwood reported $183 million of estimated available investment capacity and said it expected this to cover anticipated investment activity for the next two quarters. Short-term facilities are generally uncommitted; $227.0 million of short-term debt matured within 30 days of quarter-end. Redwood reported compliance with its short-term debt covenants.
- Dividend and book value: The declared regular dividend was $0.25 per share, unchanged from Q1 2011. GAAP book value rose to $12.22 per share from $11.36, principally reflecting earnings and unrealized gains on securities and hedges. Management estimated non-GAAP economic value at $13.18 per share; this is a management estimate, not GAAP book value. Estimated REIT taxable income was $0.13 per share.
Material changes versus the prior comparable period
- Net income and diluted EPS improved year over year, while net interest income declined as financing expense rose. Lower loan-loss provisions and less-negative market valuation adjustments, together with mortgage banking income and higher realized gains, more than offset the NII decline.
- Other market valuation adjustments improved to a net loss of $0.6 million from $5.7 million. Redwood reported $55.0 million of other comprehensive income, including net unrealized gains on securities and interest-rate agreements; accumulated other comprehensive income moved from a $13.2 million deficit to $41.9 million positive.
- Real estate securities increased to $1.26 billion from $981.8 million, while residential loans held-for-investment declined to $3.35 billion from $3.80 billion. Cash decreased by $117.6 million.
- The company completed two Sequoia residential securitizations, transferring $743 million of loans in aggregate and recognizing the transfers as sales. Redwood also deconsolidated five legacy Sequoia entities, removing about $307 million of assets and liabilities and recognizing a $7.0 million gain.
- The residential loan-loss allowance declined to $59.2 million from $66.9 million, reflecting charge-offs and the deconsolidation adjustment. The filing says delinquencies and defaults appeared to be stabilizing, but this remains management’s assessment.
Guidance, management commentary, risks and contingencies
- Residential plans: Management targeted approximately $400 million of equity investment in third-party RMBS, new Sequoia RMBS and commercial loans during 2012; purchases of $2 billion of residential loans; and four to six securitizations. It expected the next securitization in late Q2 or early Q3, subject to market and execution conditions. Whole-loan sales were also planned, with management expecting modest gains on hybrid ARM loan sales in Q2.
- Commercial plans: Management expected commercial investment activity to increase later in Q2, targeted $200–$300 million of commercial originations in 2012, and said the portfolio’s gross yield exceeded 10% before credit costs. The 19-loan portfolio had $178 million carrying value and was funded entirely with equity at quarter-end.
- Market outlook: Management described Q1 market conditions as generally favorable, with narrower credit spreads and recovery in securities values. It noted competition from banks for high-quality jumbo loans, continued government involvement in mortgage finance, uncertainty about the future mortgage market, and dependence on liquidity and securitization markets.
- Funding and valuation risks: Short-term recourse borrowing exposes Redwood to refinancing, margin-call and collateral-value risks. Many securities, loans and related liabilities rely on Level 3 fair-value estimates in illiquid markets; actual values may differ materially. Credit losses, prepayments, interest rates, hedging, counterparties and securitization accounting may cause earnings and book-value volatility.
- Credit and tax: Residential securities and legacy loans remain exposed to delinquencies and losses, with California concentrations in certain underlying pools. Management estimated $130 million of additional future tax-basis credit losses on securities, but said timing is difficult to predict. Taxable income can differ materially from GAAP earnings.
- Litigation and inquiries: A Washington court entered final judgment dismissing the FHLB-Seattle claims against Redwood and its subsidiary for lack of personal jurisdiction; appeal or a new claim remained possible, and related underwriter indemnities could still create exposure. Schwab litigation and FHLB-Chicago litigation remained pending; Redwood said it could not estimate potential losses. The company also disclosed prior SEC and NCUA information requests concerning CDO valuation/trading and RMBS, respectively; it had responded, and the agencies’ requests did not themselves indicate a violation.
- Other unusual item: One Acacia entity had an early termination event under an ISDA agreement after failing to make a required swap payment; the obligation is not a legal obligation of Redwood. A subsequent event at another Acacia entity was also reported.
Important facts for investors to verify
- Whether planned 2012 loan purchases, securitizations and commercial originations were completed on expected timing and economics.
- How much reported earnings depended on realized gains, deconsolidations, securitization accounting and fair-value estimates, versus recurring interest and operating income.
- Changes in short-term financing availability, maturities, collateral requirements, liquidity capacity and the company’s use of recourse leverage.
- Trends in loan delinquencies, charge-offs, securities credit reserves, underlying collateral performance and management’s allowance assumptions.
- Progress and potential exposure in Schwab and FHLB-Chicago litigation, underwriter indemnities, and any developments in the SEC/NCUA matters.
- Whether taxable income and REIT distribution requirements support the dividend over time; Q1 taxable REIT income was below the $0.25-per-share dividend.
- The assumptions underlying non-GAAP economic value and Level 3 marks, including management’s stated estimates for long-term debt and securitization investments.