Redwood Trust, Inc. — Q3 2014 Form 10-Q
Business context and reporting period. Unaudited results cover the quarter and nine months ended September 30, 2014, compared with the same periods in 2013. Redwood invests in mortgage and real-estate-related assets and conducts residential and commercial mortgage banking through three segments. It is a REIT; mortgage banking and mortgage servicing rights (MSRs) are generally held in taxable subsidiaries. Financial amounts below are in U.S. dollars; unless stated otherwise, figures are in millions.
Financial and operating results
| Metric | Q3 2014 | Q3 2013 | Nine months 2014 | Nine months 2013 |
|---|---|---|---|---|
| Interest income | $63.4 | $57.4 | $176.8 | $168.7 |
| Net interest income | $40.0 | $35.7 | $113.3 | $107.2 |
| Noninterest income, net | $28.5 | $5.3 | $25.3 | $117.4 |
| Net income | $45.1 | $21.9 | $73.4 | $148.1 |
| Diluted EPS | $0.50 | $0.25 | $0.84 | $1.65 |
| Operating expenses | $21.4 | $22.3 | $63.7 | $66.9 |
| Regular dividend per share | $0.28 | $0.28 | $0.84 | $0.84 |
- Q3 interest income yield was 4.96%; interest expense yield was 2.26%. The filing does not present a single consolidated net interest margin figure.
- At September 30, total assets were $5.61 billion, total liabilities $4.35 billion, and equity $1.27 billion. Cash and cash equivalents were $149.6 million.
- Debt and securitization balances included $1.89 billion short-term debt, $1.66 billion of asset-backed securities (ABS), and $696.9 million long-term debt. ABS are obligations of consolidated securitization entities payable from their collateral, not general Redwood obligations. Some short-term facilities are uncommitted and subject to margin calls.
- For the first nine months, operating cash flow was negative $1.53 billion, investing cash flow was positive $629.3 million, and financing cash flow was positive $880.4 million. Cash declined $23.6 million to $149.6 million. Management attributed negative operating cash flow mainly to loan purchases and sales associated with mortgage banking; much of the loan-purchase funding is reflected in financing cash flows.
Material changes versus comparable periods
- Q3 net income and diluted EPS rose year over year, supported by higher mortgage banking income and net interest income. Residential mortgage banking swung to $11.4 million of income from a $12.2 million loss in Q3 2013, partly reflecting timing differences in loan-pipeline and hedge valuations.
- For the first nine months, net income fell to $73.4 million from $148.1 million. Mortgage banking income declined to $24.0 million from $85.6 million, and MSR income fell to $4.7 million from $14.7 million. Management cited lower residential loan-sale margins, a larger conforming-loan mix, lower industry originations and mortgage-rate-related MSR valuation declines.
- Net interest income increased in both comparison periods, principally from higher average investment balances. Q3 noninterest income was also higher year over year, while nine-month noninterest income was substantially lower, reflecting much lower mortgage banking and realized-gain income.
- Assets increased from $4.61 billion at year-end 2013 to $5.61 billion at September 30, 2014. Short-term debt rose from $862.8 million to $1.89 billion. A commercial borrowing facility was reclassified from long-term to short-term because its remaining term was under one year.
- Residential securities declined to $1.39 billion from $1.68 billion at year-end, following sales and principal payments. MSRs increased to $135.2 million from $64.8 million, reflecting substantial additions, particularly conforming MSRs.
Outlook, management commentary, risks and unusual items
- Management reported Q3 residential loan acquisitions of $3.4 billion, up 89% from Q2; commercial senior loan originations were a record $340 million. It expects commercial originations to exceed $900 million for 2014, versus $805 million in 2013, and expects commercial refinancing opportunities to expand beginning in 2015.
- Management expected at least one additional Sequoia securitization in Q4 2014 and expected whole-loan sales to remain the principal jumbo-loan distribution channel for the rest of 2014. The filing identifies a long-term residential loan-sale profit-margin target of 25–50 basis points; jumbo margins were above that range, while conforming margins had turned positive.
- Redwood entered a Fannie Mae risk-sharing arrangement covering $1.1 billion of conforming loans planned for Q4 2014, committing to absorb the first 1% of credit losses. Its FHLBC loan-purchase initiative was in pilot rollout. Management also reported $597 million of purchases completed through November 2 from a $1.3 billion identified jumbo-loan pipeline; further purchases were subject to availability and delivery.
- Management estimated investment capacity at approximately $145 million and said it expected to need additional capital for sustained longer-term investment. It was considering external funding, including convertible or other medium- or long-term debt. The regular dividend was $0.28 per share per quarter; the board determines future dividends based on earnings, cash flows, capital and liquidity, among other factors.
- Risk factors include dependence on short-term, often uncommitted financing; collateral-value declines and same- or next-day margin calls; interest-rate, prepayment, credit and liquidity risks; and reliance on subjective Level 3 fair-value assumptions. Proposed FHFA rules could restrict the captive insurance subsidiary’s FHLBC membership and borrowing flexibility. Redwood stated that the proposal would not affect its separate FHLBC loan-purchase program.
- Litigation reserves were $10.4 million at September 30, including a confidential settlement agreed in October and paid after quarter-end. Other legacy RMBS litigation and indemnity exposure remained; actual losses could exceed recorded reserves. Residential repurchase reserves were $3.8 million, up from $1.8 million at year-end.
- Q3 included a $1.6 million other-income benefit from reducing litigation reserves. Other-than-temporary impairment recognized through income was $188,000 for Q3 and $565,000 for the nine months. Management noted expected tax-credit losses of approximately $36 million on securities, with timing uncertain.
Most important facts for investors to verify
- Whether Q3 mortgage banking gains, including pipeline/hedge timing effects, are repeatable and whether loan-sale margins and acquisition volumes hold up.
- How the $1.89 billion short-term debt balance, uncommitted facilities, collateral coverage and margin-call exposure evolve as the loan and investment platforms grow.
- Whether management secures additional capital while sustaining the $0.28 quarterly dividend and meeting investment needs.
- Progress and economics of the Fannie Mae risk-sharing arrangement, FHLBC programs, planned Sequoia issuance and commercial origination outlook, including regulatory developments affecting captive membership.
- Changes in Level 3 asset valuations, credit-loss assumptions, delinquencies, MSR prepayment sensitivity and the $74 million AFS securities credit reserve.
- Updates to litigation and repurchase claims, including whether additional reserves are needed beyond the recorded $10.4 million litigation reserve and $3.8 million residential repurchase reserve.