Redwood Trust, Inc. — Second-Quarter 2012 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2012. Redwood is a REIT that invests in residential and commercial real estate loans and mortgage-backed securities. Unless otherwise noted, amounts are in U.S. dollars; financial statements are unaudited.
Financial performance and position
| Metric | Q2 2012 | Q2 2011 | Six months 2012 | Six months 2011 |
|---|---|---|---|---|
| Interest income | $59.5M | $53.0M | $118.3M | $107.3M |
| Net interest income | $30.6M | $29.3M | $58.7M | $61.7M |
| Net income attributable to Redwood | $19.5M | $9.4M | $50.0M | $27.6M |
| Diluted earnings per share | $0.24 | $0.11 | $0.61 | $0.34 |
| Operating expenses | $15.2M | $12.1M | $29.8M | $23.6M |
| Mortgage banking activities, net | $1.8M | — | $6.0M | — |
| Realized gains, net | $7.0M | $5.8M | $20.6M | $9.7M |
| Regular dividend declared per share | $0.25 | $0.25 | $0.50 | $0.50 |
- At June 30, total assets were $5.25B, total liabilities $4.30B, and stockholders’ equity $951M. Assets and liabilities include consolidated securitization entities; much of their debt is nonrecourse to Redwood and is payable only from those entities’ assets.
- Cash and cash equivalents were $69.5M, down from $267.2M at December 31, 2011. Six-month operating cash flow was negative $219.6M; investing cash flow was positive $368.9M and financing cash flow negative $346.9M.
- Redwood-level short-term debt was $455.4M and long-term debt $139.5M. Short-term debt averaged 1.90% and had a 60-day weighted-average remaining maturity at quarter-end. The filing reports covenant compliance.
- Residential loans held for investment were $3.22B; commercial loans were $259.0M; real estate securities were $1.31B. The residential loan allowance was $55.4M and the commercial loan allowance $1.3M.
- Book value was $12.00 per share, down from $12.22 at March 31; management’s estimated non-GAAP economic value was $12.87 per share. The filing cautions that this estimate relies on assumptions and is not a liquidation or market-value estimate.
Material changes and notable items
- Year-over-year Q2 net income more than doubled, while net interest income rose modestly. For the first half, net interest income declined despite higher interest income, as interest expense increased substantially.
- Management attributed improved Q2 results versus the prior-year quarter to higher investment activity, less negative market valuation adjustments, and a reversal of loan-loss provisions. Q2 included a $1.3M loan-loss reversal, versus a $1.6M provision in Q2 2011.
- First-half realized gains included a $7.0M gain from deconsolidating five Sequoia securitization entities. The transactions removed about $307M of assets and liabilities from the consolidated balance sheet.
- Q2 included a $5M decline in residential interest-only security values as mortgage rates fell. Management said this was generally offset economically by increased loan values, but those gains were not recognized under the accounting elections used; it expected to realize them as loans were sold or securitized.
- Other market valuation adjustments remained negative: $5.4M for Q2 and $6.0M for the first half. First-half comprehensive income was $91.4M, including $41.4M of other comprehensive income, principally unrealized securities gains.
- Operating expenses increased 25% year over year in Q2, mainly from higher headcount and variable compensation. The quarterly dividend remained $0.25 per share.
Outlook, management commentary, and risks
- Management said it was on track to invest at least $400M of equity capital in 2012 and purchase at least $2B of residential loans. It targeted $200M–$250M of commercial loan originations, with no more than $300M of equity allocated to the commercial business.
- Redwood expected another Sequoia securitization in Q3 2012 and hoped to become an active seller of conforming loans to Fannie Mae and Freddie Mac by Q4. It planned to expand its loan-seller network and reported 37 sellers at quarter-end, with a year-end goal of 50.
- At June 30, management estimated available investment capacity of $90M. It planned to purchase up to $476M of residential loans; $119M had settled by August 1. Management said further settlements were subject to availability and delivery.
- Key risks include credit deterioration and defaults, prepayment and interest-rate volatility, illiquid or model-valued assets, short-term uncommitted funding, collateral margin calls, and counterparties’ ability to perform. Most securities and financial instruments measured at fair value use Level 3 inputs.
- Three RMBS-related investor cases were disclosed (FHLB-Seattle, Schwab, and FHLB-Chicago). Redwood said it would defend them; outcomes and potential losses could not be estimated, and indemnities to underwriters could create additional exposure. The FHLB-Seattle case against Redwood and its subsidiary was dismissed for lack of personal jurisdiction, but the claimant might file elsewhere.
- The filing added risk concerning possible municipal use of eminent domain to acquire underwater mortgage loans from securitization trusts, which could reduce the value of Redwood’s interests and impair future securitizations. It also disclosed an Acacia entity’s swap-payment default and a subsequent termination event at another Acacia entity; these obligations are not Redwood’s legal obligations.
- Management identified the slowing U.S. economy and European fiscal crisis as uncertainties. It also warned of potential earnings and taxable-income volatility. Estimated additional future tax credit losses on securities were $130M, with timing difficult to predict.
Most important facts for investors to verify
- Whether loan purchases, securitizations, and the stated residential and commercial investment targets were achieved after quarter-end, and how transaction margins developed.
- Cash availability, short-term facility renewals, collateral requirements, and compliance with lender covenants, particularly given uncommitted financing and $294.8M of short-term debt maturing within 30 days.
- Realized credit performance versus reserve assumptions, including serious delinquencies, residential loan-loss allowances, and the expected $130M of future tax credit losses.
- Fair-value assumptions and sensitivity for Level 3 securities, derivatives, Acacia liabilities, and mortgage servicing rights.
- Developments in RMBS litigation and indemnification exposure, and any implementation of municipal eminent-domain proposals affecting securitization assets.