REDWOOD TRUST INC quarterly report, Q3 FY2016

Redwood Trust, Inc. — Q3 2016 Form 10-Q

Reporting period: Three and nine months ended September 30, 2016; filed November 7, 2016. Redwood invests in mortgage and real-estate-related assets and conducts mortgage banking through Residential Investments, Residential Mortgage Banking, and Commercial segments.

Financial performance and position

Metric	Q3 2016	Q3 2015	Nine months 2016	Nine months 2015
Interest income	$60.9 million	$63.5 million	$190.0 million	$190.6 million
Net interest income	$39.3 million	$39.6 million	$122.0 million	$119.8 million
Net income	$52.6 million	$19.2 million	$105.9 million	$61.0 million
Diluted EPS	$0.58	$0.22	$1.23	$0.69
Regular dividend declared per share	$0.28	$0.28	$0.84	$0.84

Q3 non-interest income was $33.7 million versus a $3.4 million loss a year earlier, including $11.9 million of positive investment fair-value changes, $9.8 million of mortgage banking income, and $6.6 million of realized gains. Nine-month investment fair-value changes remained negative at $18.7 million.
Operating expenses were $20.4 million in Q3 and $71.0 million for nine months. The nine-month total included $10.5 million of restructuring charges.
At September 30, total assets were $5.87 billion, cash and equivalents $221.4 million, equity $1.13 billion, and total liabilities $4.74 billion. Earning assets were $5.61 billion.
Debt included $1.12 billion short-term debt, $819.9 million asset-backed securities, and $2.62 billion long-term debt. Long-term debt included $2.00 billion of FHLB Chicago advances, at a 0.57% weighted-average rate and approximately nine-year weighted-average maturity.
For the first nine months, operating cash flow was negative $756.1 million, investing cash flow positive $1.149 billion, and financing cash flow negative $391.7 million. Cash increased $1.1 million to $221.4 million. Management said operating cash flow excluding purchases, sales, and principal payments of held-for-sale loans was positive $75 million.
Book value was $14.74 per share at quarter-end, up from $14.20 at June 30. Management estimated approximately $300 million of capital available for investments; a separate capital-allocation table showed $337.6 million of available capital, including liquidity-management capital.

Material changes and management commentary

Q3 earnings improved from Q3 2015, principally because of stronger fair-value marks and jumbo mortgage banking margins; net interest income was broadly flat. Nine-month net income rose to $105.9 million from $61.0 million.
Redwood discontinued conforming-loan acquisition and commercial-loan origination in 2016. It sold most of its commercial mezzanine portfolio in Q3, generating $5 million of gains; management expected to settle the sale of approximately $27 million of remaining loans in Q4.
Q3 jumbo loan purchases were $1.25 billion; loan sales totaled $774 million, including $416 million of whole-loan sales and $358 million securitized. The identified-purchase pipeline was $1.11 billion at quarter-end. Q3 jumbo gross margins were 126 basis points, above management’s stated long-term expectation of 50–75 basis points.
Management reported investment of $76 million in new assets during Q3 and described two 2016 Portfolio Risk Transfer investments, with further transactions under consideration. Redwood’s third 2016 jumbo securitization closed in late October at tighter spreads than its July transaction; management said the Redwood Choice expanded-prime program was continuing to gain traction.
Management characterized the environment as favorable for selling selected lower-yielding or non-core investments, but challenging for redeploying capital. It warned that spread widening and volatility could return. The filing does not provide a general earnings forecast; management’s stated normalized quarterly MSR income expectation was $3–4 million.
The board declared a Q4 regular dividend of $0.28 per share, payable December 29, 2016. Redwood reported $1.9 million of litigation reserves for the FHLB-Seattle and Schwab matters, rounded to $2 million in the filing’s discussion; indemnity exposure could exceed reserves. Risk-sharing obligations had a $44 million maximum potential payment, fully collateralized, with no losses incurred to date.

Risks, contingencies, and unusual items

Funding depends partly on uncommitted warehouse and repo facilities, which lenders may decline to renew or extend. These borrowings are subject to collateral valuation, margin calls, and liquidity risk. Redwood reported compliance with its debt covenants at quarter-end.
Fair-value measurements rely substantially on Level 3 inputs and estimates, including credit losses, prepayments, discount rates, and spreads; changes in assumptions can materially affect reported earnings and asset values.
Long-term debt derivatives had a cumulative unrealized loss of approximately $70 million in accumulated other comprehensive income. The associated debt is carried at amortized cost, so its offsetting fair-value change is not reflected in book value.
Commercial operations were being wound down; one remaining commercial loan had a technical default and a $0.3 million valuation adjustment. Five of six remaining commercial loans were pending sale, subject to conditions.
Legacy securitization litigation and related indemnities may produce additional losses. Redwood also disclosed possible future litigation and regulatory exposure associated with prior securitizations.
Management cautioned that 2016 tax results were estimates, taxable income can differ substantially from GAAP income, and it expected approximately $22 million of additional tax credit losses over an estimated three-to-five-year period.

Important facts for investors to verify

Whether expected Q4 commercial-loan sales and the approximately $25 million conforming MSR sale subsequently settled, and at what proceeds or gain.
Whether available capital was redeployed at returns consistent with management’s expectations, given the stated difficulty finding attractive investments.
Whether short-term funding remained available on acceptable terms and whether collateral, margin-call, or FHLB membership requirements changed.
Subsequent performance of the jumbo and Choice mortgage channels, including realized margins versus the stated 50–75 basis-point long-term expectation.
Changes in litigation, indemnity, loan-repurchase, and risk-sharing exposures, and whether any additional reserves were recorded.
Final 2016 taxable income and dividend tax characterization, which the filing describes as estimates or expectations.