Redwood Trust, Inc. — 2017 Form 10-K
Reporting period: Fiscal year ended December 31, 2017. This annual filing includes quarterly results; it is not a filing limited to the fourth quarter. Redwood is a mortgage REIT investing in residential and other real-estate-related assets and conducting residential mortgage banking through two segments: Investment Portfolio and Residential Mortgage Banking.
Financial performance and position
| Metric | 2017 | 2016 |
|---|---|---|
| Interest income | $248.1 million | $246.4 million |
| Net interest income | $139.2 million | $157.8 million |
| Non-interest income, net | $90.1 million | $58.8 million |
| Operating expenses | $77.2 million | $88.8 million |
| Net income | $140.4 million | $131.3 million |
| Diluted EPS | $1.60 | $1.54 |
| GAAP return on equity | 11.9% | 11.8% |
| Book value per share, year-end | $15.83 | $14.96 |
| Regular dividends per share | $1.12 | $1.12 |
- Net interest income declined 12%, chiefly reflecting the 2016 sale of commercial mezzanine loans and higher FHLB borrowing costs. Fourth-quarter net income was $30.9 million, versus $25.4 million in fourth-quarter 2016; diluted EPS was $0.35 versus $0.31.
- Mortgage banking income rose to $53.9 million from $38.7 million, alongside residential loan purchases of $5.74 billion, up more than 20%. Net investment fair-value changes improved to a gain of $10.4 million from a loss of $28.6 million; realized gains were $13.4 million, down from $28.0 million.
- Interest income yield was 4.6% and average interest expense rate was 2.4%. Redwood does not present these figures as a single consolidated net interest margin.
- Total assets were $7.04 billion and stockholders’ equity was $1.21 billion at year-end. Cash and cash equivalents were $144.7 million. Management estimated approximately $280 million of capital available for investment or debt repayment.
- Year-end short-term debt was $1.94 billion, including $250 million of convertible notes due April 2018; secured warehouse and repo borrowings were $1.69 billion. Long-term debt, net, was $2.58 billion. Total liabilities were $5.83 billion, including $1.16 billion of asset-backed securities issued by consolidated securitization entities; those entities’ obligations are nonrecourse to Redwood. Management separately described $4.66 billion of liabilities excluding those ABS obligations.
- Operating cash flow was negative $1.71 billion, primarily reflecting cash used in mortgage-loan purchases and sales. Excluding held-for-sale loan purchase, sale, and principal-payment flows, operating cash flow was positive $37 million. Investing cash flow was positive $286.9 million; financing cash flow was positive $1.36 billion.
Material changes versus the prior year
- Net income increased 7%, while net interest income fell and non-interest income increased. The improvement in non-interest income was led by mortgage banking results and more favorable investment fair-value changes.
- Book value per share increased $0.87, supported by earnings exceeding dividends and higher unrealized gains on securities.
- The Investment Portfolio expanded, including $620 million of loans in newly consolidated Sequoia Choice securitizations. Redwood’s retained economic investment in those entities was approximately $78 million.
- Redwood completed nine Sequoia securitizations and sold $1.35 billion of jumbo loans to third parties. It also sold substantially all of its conforming MSRs; MSR fair value fell to $63.6 million from $118.5 million.
- During 2017, Redwood issued $245 million of 4.75% convertible notes due 2023 and repurchased $37 million principal of its 2018 notes. The remaining principal due in April 2018 was $250 million.
Outlook, risks and unusual items
- Management’s 2018 priorities were to grow Redwood Choice loan purchases, maintain long-term gross margins, and pursue financing for single-family housing investors and additional capital solutions for loan sellers. No specific earnings or revenue guidance was provided.
- The board stated its intention to pay a regular dividend of $0.28 per share per quarter in 2018; the filing emphasizes that this is not a commitment. The board declared the first-quarter 2018 dividend at that rate.
- Management said it had sufficient capital to repay the April 2018 convertible notes and would consider portfolio optimization and capital-markets funding for future investments. The FHLB-financed subsidiary was at its $2.00 billion borrowing limit; federal rules constrain future increases and could require alternative financing after the transition period.
- The Tax Cuts and Jobs Act reduced the corporate tax rate to 21%; Redwood recorded an $8 million fourth-quarter benefit from remeasuring deferred tax liabilities. Management viewed the tax changes as favorable to its taxable subsidiaries but said housing-market effects were uncertain and could weigh on jumbo mortgage demand.
- Key exposures include credit and prepayment risk, interest-rate and fair-value volatility, margin calls, illiquid assets, and dependence on uncommitted short-term financing. Redwood reported compliance with financing covenants and margin calls through the filing date. Its prime held-for-investment loans at Redwood had weighted-average FICO of 770 and original LTV of 65%; none were over 90 days delinquent or in foreclosure at year-end. Legacy Sequoia loans included $25 million over 90 days delinquent.
- Litigation and indemnification exposure remains relevant. The FHLB-Seattle matter was resolved and Schwab dismissed its claim against Redwood’s subsidiary, but indemnity obligations and other securitization-related claims may still create losses. The company recorded $2 million of litigation reserves; actual losses could exceed reserves. Legacy RMBS trustee litigation reduced portfolio security values by approximately $0.5 million in 2017.
- Other notable items: CEO Martin Hughes announced retirement effective May 22, 2018, with President Christopher Abate expected to become CEO. The company reported effective disclosure controls and internal control over financial reporting; the auditor gave unqualified opinions on the financial statements and internal controls.
Important facts for investors to verify
- Whether Redwood repaid or refinanced the $250 million convertible notes due April 2018, and the resulting effect on liquidity and capital allocation.
- Whether mortgage banking growth, especially Redwood Choice, can be sustained without weakening margins or underwriting standards.
- How rising funding costs and interest rates affect net interest income, asset values, hedges, and margin requirements.
- Whether the $0.28 quarterly dividend remains supported by REIT taxable income and cash generation; 2017 estimated REIT taxable income was $1.15 per share versus dividends of $1.12 per share.
- Developments in FHLB membership and financing rules, securitization-related litigation and indemnities, and the CEO transition.