Redwood Trust, Inc. — Q1 2017 Form 10-Q
Reporting period: Three months ended March 31, 2017; balance-sheet comparisons are to December 31, 2016. Redwood invests in mortgage and real estate-related assets and conducts residential mortgage banking. It reports Investment Portfolio and Residential Mortgage Banking segments. Results are unaudited; management cautions that quarterly results are not necessarily indicative of full-year performance.
Key financial metrics
| Metric | Q1 2017 | Comparable period / change |
|---|---|---|
| Interest income | $54.6 million | $62.3 million in Q1 2016 |
| Net interest income | $33.6 million | $38.4 million in Q1 2016 |
| Non-interest income | $27.8 million | $4.5 million in Q1 2016 |
| Net income | $37.0 million | $12.1 million in Q1 2016 |
| Diluted EPS | $0.43 | $0.15 in Q1 2016 |
| Annualized GAAP return on equity | 13% | — |
| Operating cash flow | $253.6 million | $106.0 million in Q1 2016 |
| Investing / financing cash flows | $62.3 million / $(307.0) million | Net cash increased $8.9 million |
| Cash and cash equivalents | $221.8 million | $212.8 million at December 31, 2016 |
| Total assets / total equity | $5.21 billion / $1.17 billion | $5.48 billion / $1.15 billion at December 31, 2016 |
| Short-term debt / long-term debt | $563.8 million / $2.62 billion | $791.5 million / $2.62 billion at December 31, 2016 |
Operating cash flow included substantial loan purchases and sales associated with mortgage banking. Excluding cash flows from held-for-sale loan purchases, sales, and principal payments, operating cash flow was negative $4 million in Q1 2017. Redwood’s quarterly common dividend was $0.28 per share. Book value rose to $15.13 per share from $14.96 at year-end.
Material changes versus Q1 2016
- Net income increased $24.9 million. Non-interest income improved by $23.3 million, including mortgage banking income of $17.6 million (up from $7.2 million) and investment fair-value changes of positive $1.6 million versus a $19.5 million loss.
- Net interest income declined $4.8 million, primarily reflecting the 2016 sale of commercial mezzanine loans; higher residential investment income partly offset the decrease.
- Operating expenses fell $12.2 million to $18.2 million. Q1 2016 included $10.7 million of restructuring charges associated with winding down conforming and commercial mortgage banking operations.
- The income-tax provision increased to $6.2 million from $28,000, primarily due to taxable-subsidiary income and the prior-year deferred-tax valuation allowance.
- Redwood reorganized reporting segments: commercial investments moved into Investment Portfolio, while the former commercial mortgage banking business had been wound down in 2016.
Outlook, management commentary, and risks
- Management described the quarter as a strong start, citing $158 million deployed into investments, three Sequoia securitizations, and stronger mortgage banking results. Capital available for investment was estimated at approximately $160 million at quarter-end, down from $270 million at December 31, 2016.
- Management expects private-label RMBS issuance to remain elevated in 2017 and sees continued opportunities in agency credit-risk-transfer and multifamily securities. It aims to deploy excess capital prudently while controlling leverage and interest-rate exposure.
- Mortgage banking margins exceeded management’s long-term expectation of 75–100 basis points per loan; management expects near-term competition and loan pricing to bring margins back toward that range. Redwood Choice expanded-prime loans represented 19% of Q1 acquisition volume, and management said it had begun accumulating most Choice loans for investment.
- Management intended to pay a regular dividend of $0.28 per share per quarter in 2017. It expected the sale of substantially all remaining conforming MSRs to close in Q2 2017; proceeds were intended for higher-yielding REIT-eligible investments.
- Market and business risks include interest-rate and credit-spread changes, prepayments, asset valuations, housing and borrower performance, liquidity, and counterparty risk. Management said it does not actively hedge widening credit spreads. Most short-term facilities are uncommitted and secured; lenders may decline funding, and collateral declines can trigger margin requirements. Recourse debt-to-equity leverage was about 2.7x.
- The $2.0 billion FHLB borrowing balance carried a weighted-average rate of 0.82% and was secured by residential loans with a $2.34 billion fair value. Regulatory changes concerning captive-insurer FHLB membership remain a risk; the existing advances are permitted to remain outstanding to stated maturity under the described transition rules.
- Risk-sharing arrangements with the agencies had a maximum potential future payment of $44 million, fully collateralized; Redwood reported no losses incurred under these arrangements. Litigation reserves were $2 million, and the company cautioned that indemnity-related or other litigation losses could exceed reserves.
- Reported results include significant fair-value estimates and market-sensitive items. Q1 fair-value changes were positive $1.6 million, compared with a $19.5 million loss in Q1 2016; management expects quarter-to-quarter GAAP earnings volatility.
Important facts for investors to verify
- Whether mortgage banking margins normalize toward management’s 75–100 basis-point long-term range as loan pricing and securitization competition change.
- Whether the expected Q2 sale of most remaining conforming MSRs closes as planned, and how the proceeds are redeployed.
- Liquidity and refinancing exposure from uncommitted warehouse and repo facilities, collateral haircuts, and potential margin calls; verify the $160 million estimated investment capital and $221.8 million cash balance in context.
- Performance and valuation sensitivity of securities, loans, and MSRs to credit spreads, prepayments, defaults, and interest rates, particularly given substantial Level 3 fair-value assets.
- Potential losses under litigation indemnities and agency risk-sharing arrangements relative to the stated $2 million litigation reserve and $44 million maximum risk-sharing payment.
- The sustainability of earnings and the $0.28 quarterly dividend, including the difference between GAAP net income, estimated REIT taxable income per share ($0.22), and diluted EPS ($0.43).