Redwood Trust, Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018; filed November 8, 2018. Redwood is a mortgage-focused specialty finance company operating Investment Portfolio and Mortgage Banking segments and taxed as a REIT.
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Interest income | $99.4 million | $62.7 million | $259.0 million | $176.6 million |
| Net interest income | $35.0 million | $35.3 million | $104.9 million | $103.9 million |
| Non-interest income | $32.3 million | $26.1 million | $91.5 million | $79.1 million |
| Operating expenses | $21.5 million | $19.9 million | $63.5 million | $56.8 million |
| Net income | $40.9 million | $36.2 million | $120.5 million | $109.5 million |
| Diluted EPS | $0.42 | $0.41 | $1.30 | $1.26 |
| Dividends declared per share | $0.30 | $0.28 | $0.88 | $0.84 |
- Q3 annualized GAAP return on equity was 12%; book value was $16.42 per share, up from $16.23 at June 30. Economic return on book value was 3.0% for Q3 and 9.3% year to date.
- At September 30, total assets were $9.14 billion, total liabilities $7.78 billion, and equity $1.36 billion. Cash and cash equivalents were $173.5 million; restricted cash was $27.3 million.
- Short-term debt was $1.42 billion. Long-term debt was $2.77 billion, including $2.00 billion of FHLB advances. Asset-backed securities (ABS) issued were $3.41 billion, largely obligations of consolidated securitization entities that are nonrecourse to Redwood.
- For the nine months, operating cash flow was negative $1.36 billion, reflecting the timing and scale of loan purchases and sales; investing cash flow was positive $354.6 million and financing cash flow positive $1.06 billion. Cash, cash equivalents and restricted cash ended at $200.8 million.
- Management reported $2.13 billion of total capital, including $1.36 billion of equity and $0.77 billion of corporate long-term debt capital; $150 million was available for investment. Q3 interest income yield was 5.0% and interest expense rate 3.7%; net interest income was nearly flat year over year.
Material changes versus comparable periods
- Q3 net income increased $4.7 million year over year. Higher investment fair-value gains and realized gains offset lower mortgage banking income, slightly lower net interest income, and higher operating expenses.
- Nine-month net income increased $11.0 million. Interest income grew with larger average investment balances, but interest expense more than doubled, mainly reflecting greater ABS financing, increased short-term borrowing and higher borrowing rates. Net interest income rose only $1.0 million.
- Mortgage banking income declined to $11.2 million in Q3 from $21.2 million, primarily due to lower gross margins. Nine-month mortgage banking income was $48.4 million, down from $50.9 million.
- The investment portfolio expanded substantially. Redwood consolidated two Freddie Mac K-Series multifamily securitization trusts in Q3, adding $942 million of multifamily loans and $876 million of ABS liabilities. Sequoia Choice residential loans held for investment rose to $2.18 billion from $620 million at year-end 2017.
- In July, Redwood raised $117 million net in its first follow-on common stock offering since 2009. It also issued $200 million of 5.625% convertible notes due 2024 and repaid $250 million of convertible notes that matured in April.
- Book value per share increased for a tenth consecutive quarter, according to management. Unrealized AFS-security gains declined $0.07 per share during Q3, while a reduction in unrealized losses on long-term debt hedges added $0.06 per share.
Outlook, management commentary and risks
- Management said Q3 earnings exceeded the recently increased dividend and described record quarterly capital deployment of $281 million, bringing year-to-date deployment to $575 million. It cited proprietary sourcing, platform growth and potential operating leverage as strategic priorities.
- Management noted higher mortgage rates, refinance activity at a 14-year low, home-affordability pressures and aggressive pricing competition among lenders. It said mortgage banking margins remained strong but that challenging market conditions would continue.
- After quarter-end, credit spreads widened; management estimated a modestly negative effect on portfolio value and book value. No specific earnings or revenue guidance was provided.
- The board declared a regular $0.30-per-share Q4 dividend, payable December 28, 2018 to holders of record December 14, 2018. Management expected 2018 REIT taxable income to exceed dividend distributions and anticipated using part of a $55 million federal REIT NOL carryforward.
- Redwood expected to fund approximately $180 million in Q4 to complete a Freddie Mac re-performing-loan securities purchase, following a $58 million deposit. It also had up to $14 million of additional potential funding under its loan warehouse participation commitment.
- Key risks include fair-value estimation and market volatility; credit, prepayment and interest-rate risk; margin calls and reliance on short-term, largely uncommitted financing; and potential changes in FHLB access. Management reported compliance with debt covenants at quarter-end, with more than $200 million headroom on specified equity/net-worth tests and capacity for at least $600 million additional recourse debt under a specified leverage covenant.
- Litigation-related loss reserves were $2 million. Management cautioned that indemnity obligations and unresolved claims could lead to additional reserves or materially higher losses. Residential loan and MSR repurchase reserves were approximately $5 million; eight repurchase requests were received in the first nine months, with no loans repurchased.
- Management stated disclosure controls were effective and there were no material Q3 changes in internal control over financial reporting.
Investor verification priorities
- Assess whether portfolio growth and new multifamily/business-purpose investments can sustain earnings as funding costs rise and spreads move.
- Reconcile consolidated debt and liquidity with nonrecourse VIE obligations, collateral requirements, maturities, and the availability of uncommitted facilities.
- Evaluate the durability of mortgage banking margins and the sensitivity of reported earnings and book value to fair-value assumptions, interest rates and credit spreads.
- Track Q4 completion and financing of the re-performing-loan investment, and subsequent-quarter effects of post-quarter spread widening.
- Confirm dividend coverage against REIT taxable income, the expected use of NOLs and final 2018 tax characterization.
- Review developments in litigation, indemnities, repurchase claims, and risk-sharing guarantees, including whether current reserves remain adequate.