REDWOOD TRUST INC annual report, FY2018

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Redwood Trust, Inc. — FY2018 Form 10-K

Reporting period: Fiscal year ended December 31, 2018; filing dated February 28, 2019. Redwood is a specialty finance company investing in residential and multifamily mortgage credit and operating a mortgage banking conduit. Its segments are Investment Portfolio and Mortgage Banking. It is taxed as a REIT.

Financial performance and position

  • Income: Interest income was $378.7 million, up from $248.1 million; interest expense rose to $239.0 million from $108.8 million. Net interest income was $139.7 million, nearly unchanged from $139.2 million. Net non-interest income declined to $73.8 million from $90.1 million.
  • Profit and returns: Net income was $119.6 million, down 14.8% from $140.4 million. Diluted EPS fell to $1.34 from $1.60; GAAP return on equity was 9.3% versus 11.9%. Fourth-quarter 2018 reported a net loss of $0.9 million, or $0.02 per diluted share, compared with net income of $30.9 million, or $0.35 per diluted share, in fourth-quarter 2017.
  • Margins and segment results: The filing reports a 4.9% average yield on interest-earning assets and a 3.5% average cost of interest-bearing liabilities for 2018; it does not provide a single consolidated net interest margin figure. Investment Portfolio segment contribution was $156.2 million, down from $185.7 million; Mortgage Banking contribution rose to $48.2 million from $44.3 million.
  • Cash flow: Operating cash flow was negative $1.61 billion, largely reflecting mortgage-loan purchases and sales; excluding held-for-sale loan purchase, sale, and principal-payment flows, operating cash flow was positive $100 million. Investing cash flow was negative $12.8 million and financing cash flow positive $1.68 billion. Year-end cash and cash equivalents were $175.8 million, with $29.3 million of restricted cash.
  • Capital and debt: Total assets were $11.94 billion, up from $7.04 billion, and stockholders’ equity was $1.35 billion, up from $1.21 billion. Book value per share increased to $15.89 from $15.83. Total consolidated liabilities were $10.59 billion, including $5.71 billion of liabilities of consolidated VIEs that are not Redwood’s legal obligations; Redwood reported $4.88 billion of liabilities excluding those VIE obligations. Short-term debt was $2.40 billion, including $201 million of exchangeable notes classified as short-term, and long-term debt was $2.57 billion, including $2.00 billion of FHLB advances.
  • Liquidity and dividends: Management estimated $85 million of capital available for investment at year-end and approximately $115 million of borrowing capacity under mortgage warehouse facilities. The 2018 declared dividend totaled $1.18 per share, versus $1.12 in 2017. Estimated REIT taxable income was $1.38 per share, above the dividend; 2018 distributions were expected to be 69% ordinary income and 31% long-term capital gains.

Material changes versus 2017

  • Credit-spread widening in the fourth quarter drove negative investment fair-value changes; management estimated the effect reduced fourth-quarter net income by more than $30 million. Credit spreads tightened in early 2019, recovering some of the portfolio and book-value decline, according to management.
  • Capital deployed increased to $810 million from $511 million. Residential loan purchases rose to $7.13 billion from $5.74 billion, while sales rose to $5.43 billion from $3.98 billion.
  • Portfolio expansion and accounting consolidation materially increased reported assets and liabilities. New consolidated interests included Freddie Mac SLST residential loans and Freddie Mac K-Series multifamily loans, alongside expanded Sequoia Choice activity. Consolidated VIE assets and liabilities are generally ring-fenced from Redwood’s own obligations.
  • Redwood issued $200 million of convertible notes and approximately $142 million net proceeds from common-stock issuance in 2018; it also repaid $250 million of 2018-maturing convertible notes. In January 2019, it raised approximately $177 million in a common-stock offering.
  • Fourth-quarter volatility left annual GAAP earnings lower despite increased portfolio deployment and stronger mortgage banking activity. Management attributed the overall decline chiefly to valuation changes and higher expenses, including loan-acquisition costs and costs of new initiatives.

Outlook, risks, and contingencies

  • Management expected industry mortgage volumes to remain pressured in 2019, particularly refinancing, and identified loan-purchase competition and lower origination volumes as risks to mortgage banking volume and margins. It planned to improve workflow, capital turnover, and loan-distribution channels while shifting some capital from mortgage banking to investments.
  • Management’s stated strategic focus was growing durable investment cash flows to support sustainable dividends. It highlighted new investment areas and the planned acquisition of the remaining 80% of 5 Arches for $40 million in cash and stock, subject to closing conditions; part of the consideration depends on future origination volumes. The acquisition was expected to close in first-quarter 2019.
  • Key exposures include credit and prepayment risk, interest-rate and spread volatility, fair-value estimation for illiquid Level 3 assets, reliance on short-term and generally uncommitted funding, collateral and margin calls, refinancing and counterparty risk, and geographic concentration. California is a significant concentration in residential and business-purpose loans.
  • FHLB advances were at the $2.00 billion maximum, and management did not expect the facility to grow. Federal rules place limits on the captive-insurance subsidiary’s future FHLB membership and financing flexibility; alternative financing could be less attractive or unavailable.
  • At year-end, Redwood had a $4 million residential loan/MSR repurchase reserve and a $2 million litigation reserve. The FHLB-Seattle claims were dismissed and Schwab dismissed its claim against Redwood’s subsidiary, but indemnity obligations and other litigation-related losses could remain. Management cautioned that ultimate litigation losses could exceed reserves.
  • Redwood reported compliance with its financing covenants through the filing date. The independent auditor issued unqualified opinions on the financial statements and internal control over financial reporting; management also concluded controls were effective.

Most important facts for investors to verify

  • Whether early-2019 credit-spread tightening persisted and translated into a sustained recovery in book value and portfolio marks.
  • Whether investment income and credit performance support the $0.30 quarterly dividend and whether taxable income continues to cover distributions.
  • How much of the 2018 earnings decline was temporary mark-to-market volatility versus ongoing funding-cost, expense, or operating pressure.
  • The scale, returns, funding needs, and integration results of the 5 Arches acquisition and newer multifamily, servicing, and re-performing-loan investments.
  • Near-term refinancing and liquidity needs, particularly the $201 million exchangeable notes due in 2019, repo and warehouse renewals, and the availability of alternative financing to FHLB advances.
  • The extent to which reported assets and liabilities reflect consolidated non-recourse VIEs rather than obligations or economic exposure directly attributable to Redwood.