RWT

Business Context and Reporting Period

Company: Redwood Trust, Inc. (RWT)
Filing Type: Form 10-K (Annual Report)
Period Ended: December 31, 2005
Business Model: Redwood is a specialty finance company and Real Estate Investment Trust (REIT) that invests in, credit-enhances, and securitizes residential and commercial real estate loans. Its primary strategy involves acquiring first-loss and second-loss credit-enhancement securities (CES) to partially guarantee the credit performance of underlying loans. The company sponsors securitization programs (Sequoia for residential loans and Acacia for CDOs) and maintains a portfolio of "permanent assets" funded primarily with equity to generate long-term cash flows for dividends.

Key Financial Metrics (Year Ended Dec 31, 2005)

Note: Dividends included $2.80 regular and $3.00 special in 2005, compared to $2.68 regular and $6.00 special in 2004.

Material Changes vs. Prior Period

• Net Income Decline: GAAP net income decreased by approximately $33 million (14%) from 2004 to 2005. This was driven by a $14 million decrease in net interest income, an $11 million increase in operating expenses, and a $10 million increase in income tax provisions.
• Balance Sheet Contraction: Total assets decreased by roughly $8 billion, primarily due to a significant reduction in consolidated residential real estate loans (from $22.5 billion to $13.9 billion) and asset-backed securities issued (from $23.6 billion to $15.6 billion). This reflects a strategic shift away from high-volume securitization activity.
• Securitization Volume: Residential loan securitization activity dropped significantly. Sequoia entities issued $1.5 billion in ABS in 2005, compared to $10.0 billion in 2004, due to a flatter yield curve reducing the attractiveness of LIBOR-indexed adjustable-rate mortgages and increased competition.
• Prepayment Rates: Prepayment rates (CPR) on consolidated residential ARM loans surged from an average of 17% in 2004 to 43% in 2005, accelerating premium amortization expenses and reducing net interest income.
• Portfolio Restructuring: The company sold $207 million of residential loan CES in 2005 (generating $40 million in gains) to reduce credit risk and raise cash, compared to only $22 million sold in 2004.

Guidance, Outlook, and Risks

Management Commentary and Outlook

• 2006 Expectations: Management expects per-share earnings and special dividends in 2006 to be lower than 2005 levels. Factors include higher cash balances, a newer portfolio with lower yields, fewer gains from sales, and continued high premium amortization.
• Investment Strategy: Redwood plans to invest its excess capital ($189 million at year-end) steadily over the next two to three years. The company anticipates that a potential weakening in housing fundamentals will create attractive asset acquisition opportunities.
• Conduit Business: The residential conduit business is expected to break-even economically in 2006 while serving as a source of assets for the permanent portfolio.

Risks and Contingencies

• Credit Risk: The company assumes concentrated credit risk through CES. While delinquencies remain historically low (0.27% for residential loans), a deterioration in the housing market or economy could increase losses. Approximately 46% of residential loans underlying CES are secured by properties in California.
• Interest Rate and Prepayment Risk: A flattening yield curve has increased prepayment speeds, negatively impacting net interest income in the short term. The company is biased toward faster prepayments for long-term economic benefit but faces GAAP earnings volatility.
• REIT Status: Failure to qualify as a REIT would subject the company to corporate income taxes, adversely affecting dividends and stock value.
• Accounting Error Correction: The company corrected a misclassification of cash flows in Q3 2005 related to loan sales, which was deemed immaterial to earnings but indicated a significant deficiency in internal controls.

Key Facts for Investor Verification

• Dividend Sustainability: Verify the company's ability to maintain the $0.70 quarterly regular dividend given the projected decline in 2006 earnings and the variability of special dividends.
• Credit Loss Assumptions: Review the assumptions used for credit reserves and discount amortization, as actual credit performance significantly impacts GAAP yields and net income.
• Reinvestment Rate: Monitor the yield on new assets acquired with the $189 million excess cash, as lower yields on new investments will pressure future earnings per share.
• Securitization Pipeline: Assess the volume and profitability of future Sequoia and Acacia securitizations, which are critical for generating gains on sale and managing inventory.
• Internal Controls: Confirm the implementation of corrective actions regarding the internal control deficiency identified in Q3 2005.