Redwood Trust, Inc. — Q1 2016 Form 10-Q
Reporting period: Three months ended March 31, 2016; balance-sheet comparisons are to December 31, 2015. Redwood invests in mortgage and real-estate assets and conducts mortgage banking; it reports Residential Investments, Residential Mortgage Banking, and Commercial segments.
Financial results and key metrics
| Metric | Q1 2016 | Comparable period / change |
|---|---|---|
| Interest income | $62.3 million | $63.7 million in Q1 2015 |
| Net interest income | $38.4 million | $39.8 million in Q1 2015 |
| Net income | $12.1 million; $0.15 diluted EPS | $14.8 million; $0.16 diluted EPS in Q1 2015 |
| Non-GAAP core earnings | $37.1 million; $0.44 per diluted share | $40.5 million; $0.45 per share in Q4 2015 |
| Total comprehensive income (loss) | ($23.2 million) | $9.8 million in Q1 2015 |
| Operating expenses | $30.5 million | $25.1 million in Q1 2015; includes $10.7 million restructuring charges |
| Cash from operating / investing / financing activities | $106.0 million / $473.0 million / ($494.1 million) | Cash and cash equivalents ended at $305.1 million |
Net income before tax was $12.1 million; the income-tax provision was $0.03 million, versus a $5.3 million tax benefit in Q1 2015. The company declared a regular dividend of $0.28 per common share. GAAP book value was $14.17 per share, down from $14.67 at year-end.
At March 31, total assets were $5.73 billion, total liabilities $4.64 billion, and equity $1.09 billion. Short-term debt was $804.2 million, down from $1.86 billion at year-end; long-term debt was $2.68 billion, up from $2.03 billion. The $2.00 billion FHLB of Chicago advances were at a 0.58% weighted-average rate and approximately nine-year weighted-average maturity. Management estimated about $200 million of capital available for future investment; the filing’s capital-allocation table reports $252.9 million as available capital, a broader category that includes liquidity risk capital.
Residential mortgage banking jumbo-loan sale margins were 147 basis points, which management said was well above normalized expectations. Residential Investments segment contribution was $31.8 million; Residential Mortgage Banking contributed $8.5 million; Commercial contributed $2.5 million.
Material changes versus comparable periods
- GAAP net income declined 18% year over year, while net interest income decreased $1.4 million. Management attributed the latter partly to lower average conforming and commercial loan balances, offset by increased residential loans held for investment.
- Non-interest income improved to $4.5 million from a $5.0 million loss in Q1 2015. Higher mortgage banking income, MSR income, and realized gains were partly offset by a $19.5 million net investment fair-value loss.
- Fair-value movements were significant: the investment fair-value line was a $19.5 million loss, principally reflecting derivatives and market movements; MSR income was $6.3 million, including $41.1 million of gains on associated hedges against $44.6 million of MSR valuation losses.
- Residential loans held for investment at Redwood rose to $2.34 billion from $1.79 billion, while real-estate securities fell to $919.9 million from $1.23 billion and MSRs declined to $126.6 million from $192.0 million.
- Management reported Q1 GAAP results included $0.14 per share of restructuring and severance charges and $0.19 per share of negative market valuation adjustments. Core earnings exclude specified fair-value movements, taxes, and restructuring charges; management cautions that this non-GAAP measure supplements, not replaces, GAAP results.
Outlook, management commentary, risks and unusual items
- Redwood announced it would discontinue conforming-loan acquisition and aggregation for Agency resale and commercial loan originations. It said these operations were substantially wound down during Q1; it expected restructuring activities to be substantially complete in Q2 2016. The President was expected to depart effective July 1, 2016.
- The company shifted focus to jumbo lending and launched the Redwood Choice expanded-credit prime loan program in April. Management expected a ramp-up period and said future volumes remained uncertain. It expected most acquired jumbo loans to be sold to third-party aggregators or securitized.
- No Sequoia residential securitization closed in Q1 because of private-label market conditions. Management expected a transaction in the next few months, while noting limited market liquidity, wide and volatile credit spreads, and subdued participation by major issuers and investors.
- Management expected residential-loan investment net interest income to stabilize over the remainder of 2016 because FHLB borrowing capacity was fully utilized. It stated an intention to pay a regular $0.28 quarterly dividend during 2016, subject to the risks described in the filing.
- Redwood targeted reducing securities repurchase financing to below $300 million in the next few months; the balance was $435 million at quarter-end. Much short-term financing was uncommitted, subject to collateral and margin requirements, and could be unavailable when needed. The company reported compliance with debt covenants.
- Other risks include interest-rate, credit-spread, prepayment, fair-value and liquidity volatility; reliance on FHLB financing and regulatory developments affecting FHLB membership; and valuation sensitivity in Level 3 assets and liabilities. Management noted that FHLB advances reset every 13 weeks and are hedged in part with derivatives.
- Legal contingencies: Redwood and its subsidiary were dismissed for lack of personal jurisdiction from the FHLB-Seattle claims, and the Schwab claim against the subsidiary was dismissed with prejudice. Related claims against underwriters remain pending, and Redwood could face losses under indemnities. A $2 million litigation reserve was recorded; actual losses could exceed it.
- Other notable items: $9.5 million realized gains, primarily from AFS securities sales; $21 million of share repurchases and $4 million par value of exchangeable-note repurchases; and a $49 million credit reserve on AFS securities. No OTTI losses were recognized on AFS securities in Q1.
Most important facts for investors to verify
- Reconcile Q1 GAAP earnings and book-value decline with restructuring costs, fair-value changes, derivative hedges, realized gains, and the non-GAAP core-earnings adjustments.
- Track execution and costs of the conforming and commercial wind-downs, the jumbo Choice program’s loan volumes and margins, and the expected Sequoia securitization.
- Assess liquidity and refinancing exposure: uncommitted short-term facilities, collateral haircuts and margin calls, the repo-reduction target, and the $2.00 billion FHLB borrowing cap and membership conditions.
- Review whether the $0.28 quarterly dividend and planned investment and repurchase activity remain supported by available capital and cash generation.
- Monitor credit performance and valuation assumptions for residential securities, MSRs, commercial mezzanine loans, and consolidated Sequoia assets, as well as potential litigation-indemnity exposure beyond the recorded reserve.