REDWOOD TRUST INC quarterly report, Q3 FY2019

Full document

Redwood Trust, Inc. — Q3 2019 Form 10-Q

Reporting period: Three and nine months ended September 30, 2019. Redwood is a specialty finance company focused on residential and multifamily mortgage investments and mortgage banking, operating through Investment Portfolio and Mortgage Banking segments. Figures below are in U.S. dollars; financial statement amounts are in millions unless stated otherwise.

Financial performance and position

  • Q3 earnings: Net income was $34.3 million, down from $40.9 million a year earlier. Diluted EPS was $0.31 versus $0.42; basic EPS was $0.33 versus $0.49.
  • First nine months: Net income was $120.0 million, approximately flat with $120.5 million in 2018. Diluted EPS declined to $1.09 from $1.30, reflecting a higher weighted-average share count as well as lower net income.
  • Interest and other income: Q3 interest income was $150.1 million and interest expense was $116.6 million, producing net interest income of $33.5 million, down 4% year over year. Nine-month net interest income fell to $97.6 million from $104.9 million. Non-interest income was $27.5 million in Q3 and $101.8 million for the nine months.
  • Expenses and returns: Q3 operating expenses rose to $26.8 million from $21.5 million, primarily reflecting 5 Arches operations and CoreVest transaction costs. Q3 annualized GAAP return on equity was 9%; nine-month return was 10%. Book value per share was $15.92, down $0.09 during Q3. Economic return on book value was 1.3% for Q3 and 5.9% for the nine months.
  • Assets and equity: Total assets were $15.48 billion, up from $11.94 billion at year-end 2018; total equity was $1.79 billion, up from $1.35 billion. Growth included larger residential and multifamily loan balances and consolidated securitization entities.
  • Cash flow and liquidity: Nine-month operating cash flow was negative $1.20 billion, largely reflecting loan purchases and originations in mortgage banking. Investing cash flow was positive $915.5 million and financing cash flow positive $586.9 million. Cash and restricted cash totaled $506.1 million at September 30, including $394.6 million of cash and equivalents. Management estimated $590 million available for investment, plus $201 million reserved for November note repayment.
  • Debt: Reported short-term debt was $1.98 billion, including $201 million of exchangeable notes due November 2019; long-term debt was $2.95 billion. Asset-backed securities issued were $8.35 billion, largely obligations of consolidated securitization entities whose creditors generally have no recourse to Redwood. Corporate capital included $1.79 billion of equity and approximately $0.77 billion of unsecured corporate debt. Redwood reported compliance with debt covenants.
  • Dividends: Dividends declared were $0.30 per share in Q3 and $0.90 per share for the nine months. In November, the board declared a further $0.30 per share dividend, payable December 30, 2019.

Material changes versus comparable periods

  • Q3 net income decreased $6.6 million year over year. Lower net interest income, mortgage banking income, realized gains, and higher operating expenses were partly offset by higher investment fair-value gains and a lower tax provision.
  • Nine-month net income was nearly unchanged, but diluted EPS declined. Net interest income fell $7.3 million; investment fair-value gains increased to $34.7 million from $12.8 million, while operating expenses rose $12.7 million.
  • Portfolio expansion and securitization activity materially increased reported assets and ABS. Multifamily loans held for investment rose to $3.79 billion from $2.14 billion, and business-purpose residential loans rose to $336.0 million from $141.3 million.
  • Common shares outstanding increased to 112.1 million from 84.9 million at year-end 2018, including public offerings that raised approximately $405 million net in January and September, plus ATM and dividend-reinvestment issuances.

Outlook, commentary, risks and unusual items

  • Management attributed Q3 pressure on net interest income to higher financing costs and increased undeployed capital; mortgage banking margins were affected by lower rates and weaker securitization execution during the quarter. Management said execution improved in an October Sequoia securitization and expected residential loan volumes to remain stable, with margins normalizing toward long-term expectations. These are forward-looking statements, not guarantees.
  • Redwood completed its acquisition of 5 Arches in March 2019. The acquisition added business-purpose lending capacity and $49.1 million of goodwill and intangible assets; 5 Arches reported $12 million of mortgage banking income and a $3 million net loss from March through September, including $4 million of intangible amortization.
  • Subsequent event: Redwood acquired CoreVest on October 15, 2019 for estimated consideration of approximately $492 million, including its operating platform and about $900 million of business-purpose loans and securities. After the acquisition and other activity, management estimated approximately $100 million of capital remained available for investment at October-end.
  • Key exposures include interest-rate and credit-spread movements, prepayments, loan credit performance, fair-value estimates based on significant unobservable inputs, and derivative and margin-call volatility. Q3 included substantial derivative valuation losses; management linked the $0.09 per-share book-value decline principally to hedges on long-term debt.
  • Many warehouse and repo facilities are uncommitted and may be unavailable when needed; collateral value declines can trigger margin requirements. Management cited rent-control and rent-stabilization changes as potential risks to collateral values, including legislation in New York, California and Oregon.
  • Litigation-related indemnity exposure remains possible. The filing reports $2 million of reserves for identified litigation matters and cautions that actual losses could exceed reserves. Other commitments include $67 million to fund residential bridge loans, $49 million remaining for a multifamily loan partnership, and up to $39 million for shared home appreciation options. A Freddie Mac partnership guarantee had a stated maximum exposure of $135 million, with management assessing performance as remote.
  • Management provided no specific earnings or EPS forecast. It identified the expected expiration of the CFPB “QM Patch” as a potential opportunity for private non-QM lending. It also noted that 2019 estimated taxable income and dividend tax characterization remained subject to change.

Most important facts for investors to verify

  • Whether CoreVest integration, purchase accounting, and the estimated $492 million consideration support the expected business-purpose lending returns and reported post-acquisition liquidity.
  • How much of available capital is deployed, and whether funding remains accessible given reliance on uncommitted facilities, collateral haircuts, and potential margin calls.
  • Whether net interest income and mortgage banking margins recover as undeployed capital is invested and securitization execution develops.
  • How fair-value assumptions, hedging results, prepayments, and credit performance affect earnings and book value—particularly in re-performing residential loans and servicing-related investments.
  • Progress on the November 2019 exchangeable-note repayment, dividend coverage and sustainability, and any changes to litigation, repurchase, guarantee, or other contingent exposures.