Redwood Trust, Inc. — Q1 2014 Form 10-Q
Reporting period: Three months ended March 31, 2014; balance-sheet comparisons are with December 31, 2013. Unless noted otherwise, financial statement amounts below are in U.S. dollars. The company is a mortgage-focused specialty finance company with residential mortgage banking, residential investments, and commercial mortgage banking and investments businesses, and is structured as a REIT.
Financial results and position
| Metric | Q1 2014 / March 31, 2014 | Comparable / prior date |
|---|---|---|
| Interest income | $55.5 million | $53.5 million, Q1 2013 |
| Net interest income | $36.4 million | $35.3 million, Q1 2013 |
| Provision for loan losses | $1.3 million | $2.0 million, Q1 2013 |
| Net interest income after provision | $35.1 million | $33.2 million, Q1 2013 |
| Noninterest income (loss), net | $(5.1) million | $58.0 million, Q1 2013 |
| Operating expenses | $19.5 million | $19.7 million, Q1 2013 |
| Net income | $12.3 million | $60.6 million, Q1 2013 |
| EPS | $0.14 basic and diluted | $0.72 basic / $0.69 diluted, Q1 2013 |
| Dividend declared per common share | $0.28 | $0.28, Q1 2013 |
| Total assets / equity | $5.007 billion / $1.251 billion | $4.609 billion / $1.246 billion, Dec. 31, 2013 |
| Cash and cash equivalents | $150.0 million | $173.2 million, Dec. 31, 2013 |
| Short-term debt | $1.289 billion | $862.8 million, Dec. 31, 2013 |
| Long-term debt | $513.2 million | $476.5 million, Dec. 31, 2013 |
Interest income yield was 5.11% versus 4.85% in Q1 2013; the reported interest expense yield was 2.27% versus 2.09%. Management attributed higher net interest income after provision principally to increased investment balances. No consolidated operating margin was reported as a single metric; mortgage banking profit margins are discussed separately below.
Cash flow: Operating activities used $401.7 million; investing activities provided $29.4 million; financing activities provided $349.0 million. Cash decreased $23.2 million to $150.0 million. Management said operating cash use largely reflected loan purchases and sales in the mortgage banking conduits and timing of loans held for sale; excluding loan purchase and sale cash flows, operating cash use was $6 million.
Debt and liquidity: Short-term debt was mainly secured by residential loans ($512 million), commercial loans ($68 million), and real estate securities ($708 million). Its weighted-average rate was 1.54%, with a weighted-average 73 days to maturity; $791 million matured within 30 days. The company reported $920 million of additional uncommitted borrowing capacity under existing residential and commercial loan warehouse facilities, as well as a $10 million committed line with no borrowings. Management estimated approximately $110 million of current investment capacity and said available capital and liquidity should fund business and investment objectives for most or all of 2014. Uncommitted facilities can be withdrawn or declined, and collateral declines may trigger margin calls.
Asset-backed securities issued were $1.854 billion. These are obligations of consolidated securitization entities, not legal obligations of Redwood; creditors generally have recourse only to the relevant entity’s assets. Redwood’s reported long-term debt included $287.5 million principal of 4.625% convertible notes due 2018 and $140 million of trust preferred securities and subordinated notes.
Material changes and operating developments
- Net income fell to $12.3 million from $60.6 million in Q1 2013. The prior-year quarter included $45.0 million of mortgage banking income and $12.3 million of realized gains; Q1 2014 had a $0.7 million mortgage banking loss and $1.1 million of realized gains.
- Net interest income after provision increased by $1.9 million year over year, while noninterest income declined by $63.1 million. Negative market valuation adjustments were $6.1 million in Q1 2014 versus $0.3 million negative in Q1 2013.
- Residential loan purchases were $1.1 billion, up 66% from Q4 2013, despite a reported 23% industry decline over that period. Purchases comprised $794 million of jumbo and $299 million of conforming loans. The company completed $722 million of whole-loan sales and identified $347 million of jumbo loans for a securitization that settled in early April.
- Residential securities increased to $1.743 billion from $1.683 billion at year-end. Mortgage servicing rights (MSRs) were $65.0 million, associated with approximately $6.0 billion of loans; Q1 net MSR income was $0.6 million.
- Commercial loans totaled $491 million, including $414 million held for investment. Redwood originated $119 million of senior commercial loans and $2 million of mezzanine loans, and sold $65 million of senior loans. Commercial segment contribution was $5.0 million, down from $8.8 million in Q1 2013.
- GAAP book value per share rose to $15.14 from $15.10 despite the $0.28 dividend. The filing attributes the increase to net positive portfolio valuation changes, partly offset by hedge losses and dividends.
Outlook, commentary, and risks
- Management expected U.S. residential mortgage originations to contract to about $1.2 trillion in 2014 from $1.8 trillion in 2013, with loan-sale margins under pressure. It estimated a further six to nine months of industry-capacity adjustment. The company planned to grow residential market share, add sellers, expand conforming-loan purchases, and consider non-QM loans and MSR acquisitions.
- Management maintained its goal of originating $1 billion of commercial loans in 2014. It cited about $250 billion of commercial mortgage maturities annually in 2014 and each of the following three years, while noting increased competition and lower origination margins.
- Management said Q1 residential loan-sale profit margins, net of hedges, were within its long-term target of 25–50 basis points, although reported results were affected by interest-rate volatility and timing differences between loan and hedge marks. This is management’s characterization, not a separately reported GAAP measure.
- Q1 fair-value changes were sensitive to interest rates, credit performance, prepayments, and market liquidity. Most real estate securities, MSRs, and certain loans were valued using Level 3 inputs and management assumptions. AFS securities had $13.6 million of gross unrealized losses. Q1 other-than-temporary impairments totaled $1.7 million, of which $0.1 million was recognized in earnings and $1.6 million in other comprehensive income.
- Residential and commercial loan-loss allowances were $25.6 million and $8.0 million, respectively. Commercial loans included $42 million on watch list, although those loans were current; no commercial loans were classified as impaired. Serious delinquencies in legacy consolidated Sequoia residential loans were $81.7 million, or 4.79% of outstanding balances.
- Three RMBS-related lawsuits and associated indemnity exposure remained outstanding. Redwood had a $12.0 million litigation reserve and a $1.9 million residential repurchase reserve. Management cautioned that actual litigation losses could materially exceed the established reserve; the FHLB-Seattle claims against Redwood itself had been dismissed for lack of personal jurisdiction, but claims against underwriters remained pending.
- The company estimated $11.2 million of Q1 taxable income, including $15.5 million of REIT taxable income and a $4.3 million taxable REIT subsidiary loss. It anticipated approximately $46 million of additional tax credit losses on residential securities over an estimated three-to-five-year period, with timing uncertain. Taxable and GAAP earnings can differ materially.
Important facts for investors to verify
- Whether subsequent-quarter mortgage banking margins, loan purchase volumes, and the stated $1 billion commercial origination goal were achieved.
- How much of the $1.289 billion short-term debt balance was refinanced or repaid as near-term maturities came due, and whether uncommitted facilities and collateral remained available without material margin calls.
- Whether the $110 million investment-capacity estimate and management’s liquidity outlook remained valid after the identified loan pipeline was purchased.
- How changes in interest rates, prepayments, credit losses, and Level 3 valuation assumptions affected portfolio values, hedges, MSRs, and earnings.
- Developments in RMBS litigation, indemnification obligations, and repurchase claims, including whether the $12.0 million litigation reserve remained adequate.
- Actual credit performance and losses in legacy residential loans and commercial watch-list loans, and the timing and amount of projected taxable credit losses.