Redwood Trust, Inc. — Q1 2015 Form 10-Q
Reporting period: Three months ended March 31, 2015; balance-sheet comparisons are with December 31, 2014, and operating results with Q1 2014 unless stated otherwise. Redwood invests in mortgage and other real-estate-related assets and conducts residential and commercial mortgage banking. It is taxed as a REIT.
Key financial results and position
- Income: Interest income was $63.7 million and interest expense $24.0 million, producing net interest income of $39.8 million, up from $36.4 million. After a $0.2 million loan-loss provision, non-interest loss of $5.0 million, and operating expenses of $25.1 million, net income was $14.8 million versus $12.3 million. The $5.3 million income-tax benefit contributed to reported net income.
- Per-share results and dividend: Diluted EPS was $0.16 versus $0.14 in Q1 2014. Management also compared Q1 EPS of $0.16 with $0.31 in Q4 2014, citing lower jumbo-loan sale margins and MSR valuation losses. The regular dividend declared was $0.28 per share.
- Margins and valuation: No single consolidated operating-margin measure is provided. Net interest income increased, while mortgage servicing rights (MSR) income was a $10.9 million loss, including $19.5 million of negative MSR fair-value adjustments. Total other market valuation adjustments were negative $1.1 million; realized gains were $4.3 million.
- Cash flow: Operating cash flow was negative $119.1 million, including cash used in held-for-sale loan purchases and sales; excluding those loan flows, operating cash flow was negative $30 million. Investing cash flow was positive $194.1 million and financing cash flow negative $40.9 million. Cash increased $34.1 million to $303.8 million.
- Balance sheet and liquidity: Total assets were $5.82 billion, total liabilities $4.56 billion, and equity $1.26 billion. GAAP book value was $15.01 per share, down from $15.05 at year-end. Management estimated investment capacity at approximately $198 million.
- Debt: Short-term debt was $1.50 billion, down from $1.79 billion; long-term debt was $1.55 billion, up from $1.19 billion. Long-term debt included $851 million of FHLB Chicago advances, $493 million of convertible/exchangeable notes, and other debt. The FHLB advances carried a 0.27% weighted-average rate and 9.2-year weighted-average maturity, with rates resetting every 13 weeks.
- Portfolio: Earning assets totaled $5.57 billion, including residential loans of $3.40 billion, commercial loans of $460 million, real-estate securities of $1.29 billion, and MSRs of $120 million. Residential loans held for investment at Redwood were $1.00 billion; commercial held-for-investment loans at amortized cost had a $7.7 million allowance.
Material changes versus comparable periods
- Net interest income rose $3.4 million year over year, supported by higher average residential loan balances, including loans financed through the FHLB facility. Operating expenses increased $5.1 million to $25.1 million, mainly from higher compensation and growth in staffing.
- MSR income shifted from positive $0.6 million to a $10.9 million loss as declining mortgage rates and prepayment assumptions reduced MSR values. Net income nevertheless rose year over year, aided by a larger tax benefit and improved mortgage-banking results.
- Residential mortgage banking activity benefited from higher conforming-loan volume, but jumbo sale margins were pressured by volatile rates and wider spreads. Commercial mortgage-banking results weakened amid competition, spread widening, and seasonal softness.
- Residential securities fell to $1.29 billion from $1.38 billion, and MSRs to $120 million from $139 million. Redwood sold $91 million of available-for-sale securities and recorded $4.3 million of related realized gains.
- Redwood early-adopted ASU 2014-13 on January 1, 2015, applying fair-value measurement to consolidated Sequoia entities. The adoption produced a $9.7 million cumulative-effect increase to equity; management reported the fair value of its retained Sequoia interests at $72 million at quarter-end. This accounting change affects comparability with prior periods.
Outlook, management commentary, and risks
- Management said Q1 conditions were difficult, particularly due to interest-rate volatility, but considered its hedging efforts economically effective. Accounting treatment split effects between earnings and equity, so reported earnings did not fully reflect the hedge economics.
- For Q2, management expected to sell most Q1 jumbo pipeline and inventory at or above March 31 accounting valuations. It reported $480 million of Q2-to-date jumbo loan sales at prices significantly above those valuations and expected loan-sale margins on more recent acquisitions to return to its 25–50 basis-point long-term target range. These are forward-looking expectations, not guarantees.
- Management cited a $275 million commercial senior-loan pipeline at April 30 and expected loan demand to improve later in Q2 as maturities create refinancing opportunities. It also planned commercial senior-loan securitizations in Q2 and was exploring distribution channels beyond CMBS conduits.
- The board’s stated intention was to pay a regular $0.28-per-share quarterly dividend in 2015. Management said near-term investment capacity was sufficient but additional capital might be needed in coming quarters.
- Key risks include volatile rates and prepayments, credit and asset-valuation changes, illiquid mortgage markets, refinancing and margin-call exposure, and reliance on largely uncommitted short-term facilities. At March 31, $428 million of short-term debt matured within 30 days and $269 million within 31–90 days. Redwood reported compliance with debt covenants and more than $200 million of equity-covenant headroom, but facility funding may be declined or collateral requirements may rise.
- Litigation: Redwood reported a $2 million reserve for legacy RMBS matters and possible indemnification exposure; it cautioned that actual losses could materially exceed the reserve. Schwab’s claim against Redwood’s subsidiary was dismissed with prejudice, but claims against other defendants and related indemnity exposure remained. The FHLB-Seattle claims against Redwood and its subsidiary had been dismissed for lack of personal jurisdiction, while claims against underwriters remained.
- Other items: The Fannie Mae risk-sharing arrangement exposed Redwood to the first 1% of losses on a reference pool, with maximum potential payments of $10 million fully collateralized at quarter-end. No allowance for contingent losses was recorded. Management estimated $30 million of additional tax credit losses on owned securities over three to five years. Disclosure controls were reported effective; no material change in internal control over financial reporting was reported.
Most important facts for investors to verify
- Whether jumbo and commercial loan sale margins, volumes, and Q2 pipeline expectations were realized, and how much of the reported valuation improvement was retained.
- MSR valuation sensitivity to interest rates and prepayments, and the degree to which securities and hedges offset MSR losses economically and in reported results.
- Availability and terms of short-term funding, collateral haircuts and margin calls, debt maturities, and continued access to FHLB financing.
- Credit performance and valuation assumptions for residential securities, legacy Sequoia loans, and commercial loans, including the $25 million watch-list loan and the $7.7 million commercial allowance.
- Potential litigation and indemnity losses relative to the $2 million reserve, and the performance and collateral sufficiency of the Fannie Mae risk-sharing arrangement.
- Effects of the Sequoia fair-value accounting adoption on period-to-period earnings, equity, and the stated $72 million retained interest value.
- Whether estimated taxable income, REIT distribution requirements, investment capacity, and the announced $0.28 quarterly dividend remain sustainable.