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| RWT > SEC Filings for RWT > Form 10-Q on 4-Nov-2009 | All Recent SEC Filings |
4-Nov-2009
Quarterly Report
Redwood Trust, Inc., together with its subsidiaries, is a financial institution that seeks to invest in real estate related assets that have the potential to provide attractive cash flows over a long period of time and support our goal of distributing attractive levels of dividends to our stockholders. For tax purposes, we are structured as a real estate investment trust, or REIT. We are able to pass through substantially all of our earnings generated at our REIT to our stockholders without paying income tax at the corporate level. We pay income tax on the REIT taxable income we retain and on the income we earn at our taxable subsidiaries. Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. Our executive offices are located at One Belvedere Place, Suite 300, Mill Valley, California 94941.
References herein to "Redwood," the "company," "we," "us," and "our" include Redwood Trust, Inc. and its consolidated subsidiaries, unless the context otherwise requires. Financial information concerning our business is set forth in "Management's Discussion and Analysis of Financial Condition and Results of Operations," the consolidated financial statements and the notes thereto, and the supplemental financial information, which is included in Part I, Items 1 and 2 of this Quarterly Report on Form 10-Q.
Our website can be found at www.redwoodtrust.com. We make available, free of charge through the investor information section of our website, access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the U.S. Securities Exchange Act of 1934, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission (SEC). We also make available, free of charge, access to our Corporate Governance Standards, charters for our Audit Committee, Compensation Committee, and Corporate Governance and Nominating Committee, our Corporate Governance Standards, and our Code of Ethics governing our directors, officers, and employees. Within the time period required by the SEC and the New York Stock Exchange, we will post on our web site any amendment to the Code of Ethics and any waiver applicable to any executive officer, director, or senior officer (as defined in the Code). In addition, our web site includes information concerning purchases and sales of our equity securities by our executive officers and directors, as well as disclosure relating to certain non generally accepted accounting principles (GAAP) and financial measures (as defined in the SEC's Regulation G) that we may make public orally, telephonically, by webcast, by broadcast, or by similar means from time to time. The information on our website is not part of this Quarterly Report on Form 10-Q.
Our Investor Relations Department can be contacted at One Belvedere Place, Suite 300, Mill Valley, CA 94941, Attn: Investor Relations, telephone (866) 269-4976.
Cautionary Statement
This Quarterly Report on Form 10-Q and the documents incorporated by reference herein contain forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve numerous risks and uncertainties. Our actual results may differ from our beliefs, expectations, estimates, and projections and, consequently, you should not rely on these forward-looking statements as predictions of future events. Forward-looking statements are not historical in nature and can be identified by words such as "anticipate," "estimate," "will," "should," "expect," "believe," "intend," "seek," "plan" and similar expressions or their negative forms, or by references to strategy, plans, or intentions. These forward-looking statements are subject to risks and uncertainties, including, among other things, those described in our 2008 Annual Report on Form 10-K and in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2009, in each case set forth under the caption "Risk Factors." Other risks, uncertainties, and factors that could cause actual results to differ materially from those projected are described below and may be described from time to time in reports we file with the SEC, including reports on Forms 10-Q and 8-K. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Statements regarding the following subjects, among others, are forward-looking by their nature: (i) the future cash flows and investment returns we expect to receive from our investments and the timing of the receipt of such cash flows, including, without limitation, whether we will realize investment returns consistent with our base case, stress case, or upside case for any particular assets or group of assets; (ii) our beliefs about the future direction of housing market fundamentals, including, without limitation, home prices, mortgage delinquencies, inventory of homes for sale, percentage of voluntary and involuntary home sales, and mortgage interest rates; (iii) our views on the sustainability of government interventions into various financial markets and the possible future effects of the government's withdrawal from such interventions; (iv) statements regarding our future investment strategy and our strategy for managing various risks, including, without limitation, interest rate risk and our statements regarding our ability to find and create attractive investments in the future, including, without limitations, statements about our ability to participate in future securitization transactions and credit risk transfers; (v) our characterizations of the performance of investments that remain outstanding, which performance, therefore, remains subject to change in the future; (vi) statements about the possible future direction of any economic recovery, the future direction of market prices for assets we invest in, and future trends relating to our pace of acquiring or selling assets; (vii) our views about the future direction of the commercial real estate sector and our potential future investment activity in this sector, and the attractiveness of any future investment in this sector; (viii) our statements regarding future capital raising activity and our belief that we have sufficient resources to meet our capital needs for the foreseeable future; (ix) our expectations regarding future credit losses and impairments on our investments; (x) our statements regarding future operating expenses; (xi) our views regarding the drivers of interest income in future periods; (xii) our statement that we do not anticipate calling any Sequoia securitizations in 2009 or 2010; (xiii) our expectations relating to tax accounting that we will report a taxable loss in 2009 and that all 2009 dividends will characterized as a return of capital, our anticipation of additional losses for tax accounting purpose (and our statements regarding likely future trends in this regard), and our statement that our quarterly taxable income will remain volatile; and (xiv) statements relating to our board of directors' intention to pay a regular dividend of $0.25 per share per quarter in 2009 and that we do not expect to pay a special dividend in 2009.
Important factors, among others, that may affect our actual results include:
changes in interest rates; changes in mortgage prepayment rates; the timing of
credit losses within our portfolio; our exposure to adjustable-rate and negative
amortization mortgage loans; the state of the credit markets and other general
economic conditions, particularly as they affect the price of earning assets and
the credit status of borrowers; the concentration of the credit risks we are
exposed to; the ability of counterparties to satisfy their obligations to us;
legislative and regulatory actions, including those affecting the mortgage
industry or our business; the availability of high quality assets for purchase
at attractive prices; declines in home prices and commercial real estate prices;
increases in mortgage payment delinquencies; changes in the level of liquidity
in the capital markets which may adversely affect our ability to finance our
real estate asset portfolio; changes in liquidity in the market for real estate
securities, the re-pricing of credit risk in the capital markets, inaccurate
ratings of securities by rating agencies, rating agency downgrades of
securities, and increases in the supply of real estate securities
available-for-sale, each of which may adversely affect the values of securities
we own; the extent of changes in the values of securities we own and the impact
of adjustments reflecting those changes on our income statement and balance
sheet, including our stockholders' equity; our ability to maintain our status as
a real estate investment trust for tax purposes; our ability to generate the
amount of cash flow we expect from our investment portfolio; changes in our
investment, financing, and hedging strategies and the new risks that those
changes may expose us to; changes in the competitive landscape within our
industry, including changes that may affect our ability to retain or attract
personnel; our failure to manage various operational risks associated with our
business; our failure to maintain appropriate internal controls over financial
reporting; our failure to properly administer and manage our securitization
entities; risks we may be exposed to if we expand our business activities, such
as risks relating to significantly increasing our direct holdings of loans;
limitations imposed on our business due to our REIT status and our status as
exempt from registration under the Investment Company Act of 1940; our ability
to successfully deploy excess capital into attractive investment opportunities,
and raise additional capital to fund our investing activity; and other factors
not presently identified. Fair values for our securities and asset-backed
securities (ABS) issued are dependent upon a number of market-based assumptions
including future interest rates, prepayment rates, discount rates, credit
loss rates, and the timing of credit losses. We use these assumptions to generate cash flow estimates and internal values for each individual security.
This Quarterly Report on Form 10-Q may contain statistics and other data that in some cases have been obtained from or compiled from information made available by servicers and other third-party service providers.
Our Business
Redwood is a financial institution focused on investing in, financing, and managing residential and commercial real estate loans and securities. Our primary source of income is net interest income, which consists of the interest income we earn from our investments less the interest expenses we incur on our borrowed funds and other liabilities. We assume a range of risks in our investments and the level of risk is influenced by the manner in which we finance our purchases of, and derive income from, our investments. Our primary real estate investments include investments in real estate loans and securities, an investment in a private fund that we sponsor - Redwood Opportunity Fund, LP (the Fund) - and investments in securitization entities that we sponsor - Sequoia and Acacia.
Our direct investments in residential, commercial, and collateralized debt obligations (CDO) securities are currently financed with equity and long-term debt, although we may use short-term debt financing to acquire securities and loans from time to time. These investments are primarily senior and subordinate mortgage-backed securities backed by high-quality residential and commercial real estate loans. "High-quality" real estate loans are loans that typically have low loan-to-value ratios, borrowers with strong credit histories, and other indications of quality relative to the range of loans within U.S. real estate markets as a whole. The long term focus of our operations is to invest in subordinate securities (often below investment grade) that have concentrated structural credit risk. More recently, we have been investing in senior securities (often investment-grade) at distressed prices, which have the first right to cash flows in a securitization and therefore less concentrated credit risk than subordinate securities.
The entities that we sponsor - the Fund, Sequoia, and Acacia - invest in real estate assets. Assets held at the Fund include senior securities backed by non-prime residential and CDO collateral, which were funded through the sale of limited partnership interests to us and to third party investors. The offer and sale of these interests were privately placed and were not registered under the federal securities laws in reliance on an exemption from registration. Assets held at the Sequoia entities include residential real estate loans, which are funded through the issuance of ABS to us and to third party investors. Assets held at the Acacia entities include real estate securities, and some loans and other mortgage related investments, which are funded through the issuance of ABS and equity to us and to third party investors.
Our investments in each of these entities are currently financed with equity and long-term debt. Our capital at risk is limited to these investments as each entity is independent of Redwood and of each other and the assets and liabilities are not owned by and are not obligations of Redwood. For financial reporting purposes, we are generally required to consolidate these entities' assets, liabilities, and noncontrolling interests.
Recent Developments
Earlier this year, when there was substantial fear in the financial markets and prices for MBS had fallen to historic lows without a commensurate decrease in projected cash flows, we saw a buying opportunity. We raised capital in the first and second quarters of 2009 to capitalize on what we expected to be an extraordinary investment opportunity to acquire senior non-agency residential mortgage-backed securities (RMBS) at distressed prices. At that time we were extremely bearish on the underlying fundamentals for housing and employment. Yet even after factoring in that outlook, our target investments were projected to generate attractive base case returns, well-protected stress case returns, and exceptional upside returns if prepayments and credit outperformed our expectations. The securities that best fit our investment criteria were seasoned RMBS (issued in 2005 or earlier), backed by prime or near-prime borrowers.
In hindsight, we were right - it was an extraordinary opportunity - and during the third quarter there was an increase in RMBS prices that has been good news for the overall value of our existing portfolio. Our earnings and book value are moving in the right direction, and our cash flows are strong, as shown in the Summary of Results of Operations, Financial Condition, Capital Resources and Liquidity.
• GAAP earnings were $27 million, or $0.35 per share in the third quarter, up from $7 million, or $0.10 per share in the second quarter.
• GAAP book value per share was $11.68 at quarter-end, up $1.33, or 13% in the third quarter over the prior quarter, while our non-GAAP estimate of economic value per share was $12.28 at quarter-end, up $0.98 or 9% in the third quarter over the prior quarter.
• During the quarter, investment cash flow increased to $78 million, up $14 million from the second quarter, and business cash flow (after cash operating expenses) increased to $68 million, up $13 million from the second quarter.
• We started the third quarter with $337 million of cash and ended it with $217 million of cash.
The increase in RMBS prices, however, has also had the effect of diminishing our ability to invest additional capital to acquire senior non-agency RMBS at distressed prices. Predictably, this unprecedented investment opportunity for senior mortgage securities attracted lots of investors, and numerous competitors followed after us, raising a substantial amount of capital to invest in the sector. This new pool of capital and other technical factors contributed to the upward movement of residential and commercial mortgage-backed security prices in the second and third quarters, as shown in the following chart.
We believe the primary drivers of the upward movement in RMBS prices have been the deluge of new liquidity into the secondary mortgage markets and the positive effects of government initiatives. Liquidity has come from renewed buying by traditional banks as well as new entrants into the RMBS space such as hedge funds and newly formed REITs. Liquidity has also come from a market shift away from lower-risk, lower-yielding instruments and into higher-risk, higher-yielding instruments. The Federal Reserve and Treasury Department have undertaken extraordinary steps to introduce liquidity and leverage into the capital markets as a strategy to increase the value of financial assets; these programs have included the zero interest rate policy, direct government purchases of RMBS, TALF (Term Asset-Backed Securities Loan Facility), and PPIF (Public-Private Investment Fund).
Although price appreciation on securities has increased the value of our existing portfolio of securities, it has generally reduced the potential returns we believed we could generate from new investments. As a result, during the third quarter we began reducing our acquisition activity of RMBS, and increased our focus on
other investment opportunities. The increase in prices has also given us an exceptional opportunity to cull our portfolio. We have been selling our weakest performing assets from a credit standpoint to investors that are either willing to accept lower returns, have a more bullish view on housing and prepayment fundamentals, or are enhancing yields by employing leverage. To that end, we sold $57 million of RMBS during the second quarter of 2009, $74 million in the third quarter, and another $34 million in October.
Our decision to acquire senior RMBS at steep discounts was an investment opportunity for Redwood, not a long-term business plan. We quickly took advantage of that opportunity and began stepping aside when the potential rewards were no longer apparent to us based upon our analysis of current market prices and expected returns. Our success at Redwood has been driven in part by our history of being patient and disciplined investors. This includes pulling back from investment strategies when appropriate. And so while we have slowed our RMBS investment pace for now, we remain hard at work developing other ways to invest our capital to the benefit of our shareholders. For instance, we continue to work with our business partners to fashion customized credit solutions for large institutional investors such as banks and insurance companies.
With respect to the fundamentals underlying our investments, from a credit standpoint, serious delinquencies on prime mortgages have risen significantly since the beginning of the year, consistent with the scenarios we modeled and well within our range of expectations. On the prepayment side, prime and higher quality non-prime loans have generally paid down at a rate on the higher end of our expectations, due to seasonal factors and the low mortgage rates available to borrowers who conform to the underwriting guidelines of Fannie Mae, Freddie Mac, and the Federal Housing Administration (collectively referred to as government sponsored enterprises, or GSEs). Overall, this is good news - credit performance has been tracking in line with our expectations and prepayments have been somewhat faster than we expected.
Outlook
There are varying opinions on the outlook for residential and commercial real estate investments. If prices continue to remain elevated, it will be more challenging to find senior RMBS investments that both meet our investment criteria and exceed our risk-adjusted return requirements. This is consistent with our long-standing view that the senior RMBS opportunity was just that - a limited opportunity created by unprecedented market conditions. We do not intend to react to these market conditions by accepting lower yields, changing our investment risk criteria, or trying to enhance yields with repo or other callable financing. Accordingly, our recent investment pace has slowed, from $341 million in the second quarter, to $246 million in third quarter, and to $6 million in October. It is possible that the trend towards higher prices could reverse if investors' perception of credit risk heightens or if government programs do not work as the market expects. If this happens, senior RMBS may once again be an attractive investment opportunity.
Looking forward, our goal is to create our own investments and to minimize our dependence on market liquidity cycles, which at the end of the day are out of anyone's control. To this end, we are engaged with originators, triple-A investors, rating agencies, industry trade groups, and government representatives to restart the private securitization markets for mortgage loans. In the long run, we believe that it is important and necessary for the residential mortgage market to have a non-government, non-GSE securitization alternative, especially because it is inefficient to return to the day when mortgages were only financed through bank portfolio lending. Ultimately, when the private securitization markets begin to function again, we believe we will have an opportunity to resume our leading role in credit enhancing jumbo mortgages while generating long-term cash flows from credit investments we either created or acquired.
Unlike some forecasters, we are not calling a bottom to the decline in home prices - in fact, we are modeling a further overall decline in home prices nationwide. We expect downward price pressure on housing to be caused by a mounting oversupply of homes for sale, stubbornly high unemployment, and a higher percentage of foreclosures and other involuntary transactions in the fall and winter. We believe these negative factors will trump the often-touted positive impact from increased borrower affordability.
We believe that the unprecedented level of government intervention in the mortgage markets is most likely unsustainable and are watching and preparing for the eventual withdrawal of government support. The government is currently supporting essentially the entire mortgage market, as Fannie Mae, Freddie Mac, and the Federal Housing Administration (FHA) collectively guaranteed over 90% of the $995 billion of industry-wide loan originations in the first half of 2009, up from an average of 50% over the last 20 years. Through late October 2009, the Federal Reserve has also purchased nearly $1 trillion out of a planned $1.25 trillion of agency MBS in an attempt to lower mortgage rates and enable borrowers to refinance and lower their mortgage payments. Once the government withdraws this support (assuming all other things remain unchanged), we will likely see mortgage rates move higher. Unfortunately, this will require a highly complex and lengthy unwinding process that we believe will likely take much longer than most people expect and may have long term lingering effects on large parts of the economy.
As the government pulls back from supporting the mortgage market, triple-A investors of private capital such as pension funds, insurance companies, and banks, along with other credit investors such as Redwood, will be watching for many needed improvements in the mortgage securitization process. To rebuild investor trust, we believe that (among other things) originators must demonstrate that the loan underwriting process has improved, rating agencies must reform their methodologies, and the sanctity of contract law must be preserved, despite recent challenges pertaining to the agreements governing securitizations.
The commercial mortgage sector has historically represented a strategic area of growth for Redwood. We began making commercial investments in 1998, but it has been nearly three years since we last made a new commercial investment, as we have patiently waited for the risk/return balance to tip back in our favor. As we discuss below, we feel that the time to re-enter this sector is nearing. To that end, in September we hired Scott Chisholm to oversee our commercial mortgage activities. Mr. Chisholm was most recently a Managing Director and Head of the New York office for Prudential Mortgage Capital Company.
As we look at the commercial sector we see the significant and growing imbalance in the supply and demand for commercial loan financing. Most traditional lenders, with the exception of the GSEs, are largely inactive and internally focused on their own credit and capital issues. The volume of new lending has slowed dramatically, commercial mortgage financing is becoming increasingly scarce, and there is approximately $1.4 trillion of commercial mortgage debt maturing over the next three years. Given these factors, we are confident that there will be opportunities to deploy capital in the not too distant future on high quality commercial assets at attractive risk-adjusted yields.
With respect to any plans for raising capital, our philosophy since Redwood was founded has been to ask for capital only if we have a use for it. It seems unlikely that we would seek additional equity capital in the near term. Our management team is compensated based on the results we generate for shareholders, not the amount of equity we manage. We believe our current cash position, projections of future cash flows, and our ability to free up capital internally is sufficient to meet our capital needs for the foreseeable future. We would reevaluate our capital needs if there was a significant unforeseen change in the level of attractive investment opportunities.
Looking forward, our future GAAP earnings will largely be driven by our recently acquired residential senior and re-REMIC securities, which currently comprise 68% of our total earning assets. The predominance of senior cash flows in our portfolio makes our future returns less sensitive to credit risk than in the past, although we are still exposed to significant credit risk. Future earnings will also be impacted by how we deploy our remaining cash balances, which currently comprise 20% of our total earning assets, and future cash flows. As we noted above, our earnings are moving in the right direction, but our goal is to increase them above the current level. In order to accomplish that goal we will need to invest more of our cash balances in order to reduce the earnings drag from carrying high levels of cash. However, we will remain patient investors, as we believe that it is more important to make the right investment, than make investments quickly.
To the extent our loss expectations do not significantly change and we continue to hold fewer subordinate securities, we expect impairments to remain at or below current period levels. We continue to observe our GAAP results and the economics of our business moving more in-line with each other. Having said that, we may engage in complex transactions where GAAP accounting and our business economics once again diverge.
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