Redwood Trust, Inc. — Q3 2017 Form 10-Q
Reporting period: Three and nine months ended September 30, 2017; unaudited. Redwood invests in mortgage and other real-estate-related assets and conducts residential mortgage banking. It reports Investment Portfolio and Residential Mortgage Banking segments and is taxed as a REIT.
Financial results and position
| Metric | Q3 2017 | Q3 2016 | Nine months 2017 | Nine months 2016 |
|---|---|---|---|---|
| Net interest income | $35.3 million | $39.3 million | $103.9 million | $122.0 million |
| Non-interest income | $26.1 million | $33.7 million | $79.1 million | $49.1 million |
| Operating expenses | $19.9 million | $20.4 million | $56.8 million | $71.0 million |
| Net income | $36.2 million | $52.6 million | $109.5 million | $105.9 million |
| Diluted EPS | $0.41 | $0.58 | $1.26 | $1.23 |
- Q3 mortgage banking income was $21.2 million, up from $9.8 million a year earlier; higher loan volume and gross margins contributed. Investment fair-value changes were $0.3 million, versus $11.9 million in Q3 2016. Realized gains were $1.7 million, versus $6.6 million.
- Nine-month net income rose modestly despite lower net interest income. Mortgage banking income increased to $50.9 million from $24.7 million, and investment fair-value changes improved to a $10.0 million gain from an $18.7 million loss. The prior-year period included a $7.1 million reversal of loan-loss provisions and $11 million of restructuring charges.
- Q3 interest expense increased to $27.4 million from $21.6 million, contributing to lower net interest income. Management attributed the year-over-year NII decline mainly to the 2016 sale of commercial mezzanine loans, partly offset by higher residential investment income.
- At September 30, total assets were $6.13 billion, liabilities $4.92 billion, and equity $1.21 billion. Cash and cash equivalents were $257.6 million. Book value was $15.67 per share, up from $15.29 at June 30 and $14.96 at year-end 2016. Annualized GAAP return on equity was 12% for both Q3 and the year-to-date period.
- Short-term debt totaled $1.24 billion, including $988 million under secured facilities and $250 million of 2018 convertible notes. Long-term debt was $2.57 billion, including $2.00 billion of FHLB advances. Management estimated available capital at approximately $330 million.
- Operating cash flow was negative $629 million for nine months, largely reflecting mortgage-loan purchases and sales; excluding held-for-sale loan purchase, sale, and principal-payment cash flows, operating cash flow was positive $13 million. Investing cash flow was positive $205 million and financing cash flow positive $468 million. Cash increased $44.8 million.
- Regular dividends were $0.28 per share per quarter; $0.84 per share was declared for the first nine months. The board declared a further $0.28 dividend for Q4, payable December 28, 2017.
Changes, outlook, and material items
- Redwood completed its first expanded-prime Sequoia Choice securitization, backed by $318 million of loans, and two traditional Sequoia securitizations in Q3. It reported $839 million of loans in the traditional transactions and $212 million of whole-loan sales during the quarter. Management expected Choice securitizations to recur as the program grew.
- Loan purchase commitments adjusted for expected fallout were $1.6 billion in Q3, compared with $1.4 billion in Q2 and $1.1 billion in Q1. Mortgage banking margins remained at or above management’s long-term expectation of 75–100 basis points. Management said current operating metrics were in line with expectations for Q4; no formal earnings guidance was provided.
- Redwood issued $245 million of 4.75% convertible notes due 2023, receiving approximately $238 million net proceeds. It also had $250 million of convertible notes due April 2018; management was evaluating alternatives and said early retirement at then-current prices was unattractive relative to other cash uses.
- In October 2017, the FHLB increased the capital requirement on Redwood’s borrowing facility. Management said this would require more equity relative to debt for the associated loan portfolio and reduce returns on capital. Redwood stated it did not expect to increase FHLB borrowings above the existing $2.00 billion limit.
- Management reported no realized hurricane-related losses to date and said most of the portfolio was not affected; it continued to assess potential impacts. It reported that credit-spread tightening generally outweighed adverse hurricane-related pricing effects during the quarter.
- Key risks include market value and credit deterioration, interest-rate and prepayment changes, derivative and counterparty exposure, and liquidity or margin calls. Many warehouse and repo facilities are uncommitted and may be unavailable on request. The company reported compliance with debt covenants at quarter-end.
- Litigation-related reserves were $2 million; the filing cautions actual losses, including under indemnities, could exceed reserves. Risk-sharing arrangements with the Agencies had a maximum potential future payment of $44 million, fully collateralized; no losses had been incurred under those arrangements.
- A proposed federal tax bill released November 2, 2017 would restrict mortgage-interest deductions on certain new mortgages. The company said enactment and effects were uncertain, but changes could affect housing, jumbo mortgage demand, and asset values.
Investor verification points
- Track whether mortgage banking margins and Choice loan volumes remain sustainable, and confirm subsequent securitization execution and retained exposure.
- Review refinancing or repayment plans for the $250 million April 2018 convertible maturity, and monitor the effect of the FHLB capital-requirement change on portfolio returns and available capital.
- Assess exposure to uncommitted short-term financing, collateral haircuts, margin calls, and the gap between reported cash and management’s available-capital estimate.
- Monitor fair-value assumptions and credit performance in Level 3 loans, securities, and servicing rights, as well as litigation, indemnity, and repurchase claims beyond recorded reserves.
- Confirm Q4 dividend payment and subsequent tax characterization; the 2017 taxable-income figures were estimates, and management expected most or nearly all 2017 dividends to be ordinary income.