REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
March
31, 2007
(Unaudited)
Note
1. Redwood Trust
Redwood
Trust, Inc., together with its subsidiaries (Redwood, we, or us), invests
in,
finances, and manages real estate assets. We invest in residential and
commercial real estate loans and in asset-backed securities backed by real
estate loans. Our primary focus is credit-enhancing residential and commercial
real estate loans. We credit-enhance loans by acquiring and managing the
first-loss and other credit-sensitive securities that bear the bulk of
the
credit risk of securitized loans.
We
seek
to invest in assets that have the potential to generate high long-term
cash flow
returns to help support our goal of distributing an attractive level of
dividends per share to shareholders over time. For tax purposes, we are
structured as a real estate investment trust (REIT).
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.
Note
2. Summary of
Significant Accounting Policies
Basis
of Presentation
The
consolidated financial statements presented herein are at March 31, 2007
and
December 31, 2006 and for the three months ended March 31, 2007 and 2006.
The
accompanying consolidated financial statements are unaudited. The unaudited
interim consolidated financial statements have been prepared on the same
basis
as the annual consolidated financial statements and, in our opinion, reflect
all
adjustments necessary for a fair statement of our financial position, results
of
operations, and cash flows. These consolidated financial statements and
notes
thereto should be read in conjunction with our audited consolidated financial
statements included in our Annual Report on Form 10-K for the year ended
December 31, 2006. The results for the three months ended March 31, 2007
are not
necessarily indicative of the expected results for the year ended December
31,
2007. Certain amounts for prior years have been reclassified to conform
to the
March 31, 2007 presentation.
These
consolidated financial statements include the accounts of Redwood Trust,
Inc.
(Redwood Trust) and its direct and indirect wholly-owned subsidiaries
(collectively, Redwood). All inter-company balances and transactions have
been
eliminated in consolidation. A number of Redwood Trust’s subsidiaries are
qualifying REIT subsidiaries and the remainder are taxable subsidiaries.
References to the Redwood REIT mean Redwood Trust and its qualifying REIT
subsidiaries, excluding taxable subsidiaries.
We
currently operate two securitization programs. Our Sequoia program is used
for
the securitization of residential mortgage loans. References to Sequoia
refer
collectively to all the Sequoia securitization entities. Our Acacia program
involves the resecuritization of mortgage-backed securities and other types
of
financial assets through the issuance of collateralized debt obligations
(CDOs).
References to Acacia refer collectively to all of the Acacia CDO issuing
entities.
Under
the
provisions of Statement of Financial Accounting Standards No. 140, Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities (FAS
140), we treat the securitizations we sponsor as financings, as under these
provisions we have retained effective control over these loans and securities.
Control is maintained through our active management of the assets in the
securitization entities, our retained asset transfer discretion, our ability
to
direct certain servicing decisions, or a combination of the foregoing.
Accordingly, the underlying loans and securities owned by these securitization
entities are shown on our consolidated balance sheets under real estate
loans,
real estate securities, and the asset-back securities (ABS) issued to third
parties are shown on our consolidated balance sheets under ABS issued.
In our
consolidated statements of income, we record interest income on the loans
and
securities and interest expense on the ABS issued. Any Sequoia ABS acquired
by
Redwood or Acacia from Sequoia entities and any Acacia ABS acquired by
Redwood
for its own portfolio are eliminated in consolidation
and thus are not shown separately on our consolidated balance sheets and
the
associated income and expense are not shown separately on our consolidated
statements of income.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Use
of Estimates
The
preparation of financial statements in conformity with Generally Accepted
Accounting Principles in the United States of America (GAAP) requires us
to make
a significant number of estimates. These include fair market value of certain
assets, amount and timing of credit losses, prepayment assumptions, and
other
items that affect the reported amounts of certain assets and liabilities
as of
the date of the consolidated financial statements and the reported amounts
of
certain revenues and expenses during the reported period. It is likely
that
changes in these estimates (e.g., market values due to changes in supply
and
demand, credit performance, prepayments, interest rates, or other reasons;
yields due to changes in credit outlook and loan prepayments) will occur
in the
near term. Our estimates are inherently subjective in nature and actual
results
could differ from our estimates and the differences may be
material.
Real
Estate Loans
Residential
and
Commercial Real Estate Loans: Held-for-Investment
Real
estate loans include residential and commercial real estate loans. Currently,
all our real estate loans are held-for-investment as we have the ability
and
intent to hold these loans to maturity. Real estate loans held-for-investment
are carried at their unpaid principal balances adjusted for net unamortized
premiums or discounts and net of any allowance for credit losses.
Coupon
interest is recognized as revenue when earned and deemed collectible. We
accrue
interest on loans until they are more than 90 days past due at which point
they
are placed on nonaccrual status. Purchase discounts and premiums related
to real
estate loans are amortized into interest income over their estimated lives
to
generate an effective yield, considering the actual and future estimated
prepayments of the loans pursuant to the provisions discussed below. Gains
or
losses on the sale of real estate loans are based on the specific identification
method.
Pursuant
to Statement of Financial Accounting Standards No. 91, Accounting
for Nonrefundable Fees and Costs Associated with Originating or Acquiring
Loans
and Initial Direct Cost of Leases
(FAS
91), we use the interest method to determine an effective yield and amortize
the
premium or discount on loans. For loans acquired prior to July 1, 2004,
we use
coupon interest rates as they change over time and anticipated principal
payments to determine an
effective yield to amortize the premium or discount. For loans acquired
after
July 1, 2004, we use the initial coupon interest rate of the loans (without
regard to future changes in the underlying indices) and anticipated principal
payments to calculate an effective yield to amortize the premium or
discount.
We
may
exercise our right to call ABS issued by entities sponsored by us and may
subsequently sell the underlying loans to third parties. For balance sheet
purposes, we reclassify held-for-investment loans to held-for-sale loans
once we
determine which loans will be sold to third parties. In our consolidated
statements of cash flows, sales of loans are reported as sales of loans
held-for-investment as the acquisition of loans were reported as purchases
of
loans held-for-investment.
Residential
and Commercial Real Estate Loans: Held-for-Sale
Residential
and commercial real estate loans that we are marketing for sale are classified
as real estate loans held-for-sale. These are carried at the lower of cost
or
fair market value on a loan-by-loan basis. Any market valuation adjustments
on
these loans are recognized in valuation adjustments net, in our consolidated
statements of income.
Real
Estate Loans - Reserve for Credit Losses
For
consolidated real estate loans held-for-investment, we establish and maintain
credit reserves based on estimates of credit losses inherent in these loan
portfolios as of the reporting date. To calculate the credit reserve, we
assess
inherent losses by determining loss factors (defaults, the timing of defaults,
and loss severities upon defaults) that
can
be specifically applied to each of the consolidated loans, loan pools,
or
individual loans. See Note
7
for a
discussion of the levels of reserves for credit losses.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
We
follow
the guidelines of Staff Accounting Bulletin No. 102, Selected
Loan Loss Allowance Methodology and Documentation
(SAB
102), Statement of Financial Accounting Standards No. 5, Accounting
for Contingencies
(FAS 5),
and Statement of Financial Accounting Standards No. 114, Accounting
by Creditors for Impairment of a Loan
(FAS
114), and Statement of Financial Accounting Standards No. 118, Accounting
by Creditors for Impairment of a Loan-Income Recognition and
Disclosures
(FAS
118) in setting credit reserves for our real estate loans.
The
following factors are considered and applied in such
determinations:
|
·
|
Ongoing
analyses of loans — including, but not limited to, the age of loans,
underwriting standards, business climate, economic conditions,
geographical considerations, and other observable
data;
|
|
·
|
Historical
loss rates and past performance of similar
loans;
|
|
·
|
Relevant
environmental factors;
|
|
·
|
Relevant
market research and publicly available third-party reference
loss
rates;
|
|
·
|
Trends
in delinquencies and charge-offs;
|
|
·
|
Effects
and changes in credit
concentrations;
|
|
·
|
Information
supporting the borrowers’ ability to meet
obligations;
|
|
·
|
Ongoing
evaluations of fair market values of collateral using current
appraisals
and other valuations; and
|
|
·
|
Discounted
cash flow analyses.
|
Once
we
determine applicable default amounts, the timing of the defaults, and severity
of losses upon the defaults, we estimate expected losses for each pool
of loans
over its expected life. We then estimate the timing of these losses and
the
losses probable to occur over an effective loss confirmation period. This
period
is defined as the range of time between the probable occurrence of a credit
loss
(such as the initial deterioration of the borrower’s financial condition) and
the confirmation of that loss (the actual impairment or charge-off of the
loan).
The losses expected
to occur within the estimated loss confirmation period are the basis of
our
credit reserves because we believe those losses exist as of the reported
date of
the financial statements. We re-evaluate the level of our credit reserves
on at
least a quarterly basis, and we record provision, charge-offs, and recoveries
monthly.
We
do not
maintain a loan repurchase reserve, as any risk of loss due to loan repurchases
(i.e., due to breach of representations) would normally be covered by recourse
to the companies from whom we acquired the loans.
Real
Estate Securities
Real
estate securities include residential, commercial, and CDO securities.
Real
estate securities are classified as available-for-sale (AFS) and are carried
at
their estimated fair market values. Cumulative unrealized gains and losses
are
reported as a component of accumulated other comprehensive income (loss)
in our
consolidated statements of stockholders’ equity. Upon sale this accumulated
other comprehensive income (loss) is reclassified into earnings on the
specific
identification method.
Coupon
interest is recognized as revenue when earned and deemed collectible. Purchase
discounts and premiums related to the securities are amortized into interest
income over their estimated lives to generate an effective yield, considering
the actual and future estimated prepayments of the securities pursuant
to the
provisions discussed below. Gains or losses on the sale of securities are
based
on the specific identification method.
When
recognizing revenue on AFS securities, we employ the interest method to
account
for purchase premiums, discounts, and fees associated with these securities.
For
securities rated AAA or AA, we use the interest method as prescribed under
FAS
91, while for securities rated A or lower we use the interest method as
prescribed under the Emerging Issues Task Force of the Financial Accounting
Standards Board 99-20, Recognition
of Interest Income and Impairment on Purchased and Retained Beneficial
Interests
in Securitized Financial Assets (EITF
99-20). The use of these methods requires us to project cash flows over
the
remaining life of each asset. These projections include assumptions about
interest rates, prepayment rates, the timing and amount of credit losses,
and
other factors. We review and make adjustments to our cash flow projections
on an
ongoing basis and monitor these projections based on input and analyses
received
from external sources, internal models, and our own judgment and experience.
Actual maturities of AFS securities are generally shorter than stated
contractual maturities. All of our stated maturities are greater than ten
years.
Actual maturities of the AFS securities are affected by the contractual
lives of
the underlying mortgages, periodic payments of principal, and prepayments
of
principal. There can be no assurance that our assumptions used to estimate
future cash flows or the current period’s yield for each asset would not change
in the near term, and the change could be material.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
For
determining other-than-temporary impairment on our real estate securities,
we
use the guidelines prescribed under EITF 99-20, Statement of Financial
Accounting Standards No. 115, Accounting
for Certain Investments in Debt and Equity Securities
(FAS
115), and Staff Accounting Bulletin No. 5(m), Other-Than-Temporary
Impairment for Certain Investments in Debt and Equity Securities
(SAB
5(m)). Any other-than-temporary impairments are reported under market valuation
adjustments, net in our consolidated statements of income. For real estate
securities subject to Emerging Issues Task Force of the Financial Accounting
Standards Board 03-1, The
Meaning of Other-Than-Temporary Impairment and Its Application to Certain
Investments (EITF
03-1), we assess whether a drop in fair market value below the cost of
the real
estate security should be deemed as other-than-temporary impairment. If
we have
the ability and intent to hold a real estate security for a reasonable
period of
time sufficient for a forecasted recovery of fair market value up to (or
beyond)
the cost of the investment, we do not deem that unrealized loss an
other-than-temporary impairment.
In
the
footnotes to the consolidated financial statements, we disclose information
on
our real estate securities portfolio based on the underlying residential,
commercial, and CDO assets. We also provide a further breakdown of these
securities by investment-grade securities (IGS, those rated BBB to AAA)
and
credit-enhancement securities (CES, those rated non-rated to BB, also referred
to as first-loss, second-loss, and third-loss securities) based on their
current
credit rating.
Other
Real Estate Investments
Other
real estate investments include interest-only certificates (IOs), net interest
margin securities (NIMs), and residual securities (residuals). At the conclusion
of the first quarter of 2007, we classified these investments as trading
securities. With the adoption of Statement
of Financial Accounting Standards
No. 155,
Accounting
for Certain Hybrid Financial Investments,
(FAS
155) IOs, NIMs and residuals may contain embedded derivatives which would
require bifurcation and separate valuation through the income statement.
We have
elected to treat these investments as trading securities under FAS 115
rather
than bifurcate the embedded derivative component. Trading securities are
reported on our consolidated balance sheet at their estimated fair market
values
with changes in fair market values reported through our consolidated statements
of income through market valuation adjustments.
Total
income recognized in current period earnings on these investments equals
coupon
interest earned plus the change in fair market value. Interest income is
equal
to the instruments’ yield based on market expectations.
Cash
and Cash Equivalents
Cash
and
cash equivalents include cash on hand and highly liquid investments with
original maturities of three months or less.
Derivative
Financial Instruments
All
derivative financial instruments are reported at fair market value on our
consolidated balance sheets. Those with a positive value to us are reported
as
an asset and those with a negative value to us are reported as a liability.
Whether changes in the fair market value of these instruments are reported
through our income statement depends on the type of derivative it is and
the
accounting treatment chosen. See Note
6
for a
discussion on the value of our derivative financial instruments.
We
currently enter into interest rate agreements to help manage some of our
interest rate risks. We report our interest rate agreements at fair market
value. We may elect hedge accounting treatment under Statement of Financial
Accounting Standards No. 133, Accounting
for Derivative Instruments and Hedging Activities
(FAS
133), or we may account for these as trading instruments. Net purchases
and
proceeds from interest rate agreements are classified within cash flows
from
financing activities within the consolidated statement of cash flows together
with the items the interest rate agreements hedge.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
We
designate an interest rate agreement as (1) a hedge of the fair market
value of
a recognized asset or liability or of an unrecognized firm commitment (fair
value hedge), (2) a hedge of a forecasted transaction or of the variability
of
cash flows to be received or paid related to a recognized asset or liability
(cash flow hedge), or (3) held for trading (trading instrument).
In
a cash
flow hedge, the effective portion of the change in the fair market value
of the
hedging derivative is recorded in accumulated other comprehensive income
(loss)
and is subsequently reclassified into earnings when the hedging relationship
is
terminated. The ineffective portion of the cash flow hedge is recognized
immediately in earnings. We use the dollar-offset method to determine the
amount
of ineffectiveness, and we anticipate having some ineffectiveness in our
hedging
program, as not all terms of our hedges and not all terms of our hedged
items
match perfectly.
We
will
discontinue hedge accounting when (1) we determine that the derivative
is no
longer expected to be effective in offsetting changes in the fair market
value
or cash flows of the designated hedged item; (2) the derivative expires
or is
sold, terminated, or exercised; (3) the derivative is de-designated as
a fair
value or cash flow hedge; or (4) it is probable that the forecasted transaction
will not occur by the end of the originally specified time period.
As
of
each period end, we may also have outstanding commitments to purchase real
estate loans. These commitments are accounted for as derivatives under
Statement
of Financial Accounting Standards No. 149, Amendment
of Statement 133 on Derivative Instruments and Hedging Activities
(FAS
149), when applicable. These are classified as trading instruments and
changes
in fair market value of the purchase commitments are recorded through valuation
adjustments in the consolidated statements of income.
Beginning
in the first quarter of 2007, we entered into
credit default swap agreements. A credit default swap is an agreement to
provide
(receive) credit event protection based on a financial index or specific
security in exchange for receiving (paying) a fixed rate fee or premium
over the
term of the contract. Under FAS 133, credit default swaps are accounted
for as
trading instruments.
Restricted
Cash
Restricted
cash includes principal and interest payments from real estate loans and
securities owned by consolidated securitization entities that are collateral
for, or payable to, owners of ABS issued by those entities and cash pledged
as
collateral on interest rate agreements. Restricted cash may also include
cash
retained in Acacia or Sequoia securitization trusts prior to purchase of
real
estate loans and securities or the redemption of outstanding ABS
issued.
Accrued
Interest Receivable
Accrued
interest receivable represents interest that is due and payable to us.
This is
generally received within the next month.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Deferred
Tax Assets
Income
recognition for GAAP and tax differ in material respects. As a result,
we may
recognize taxable income in periods prior to recognizing the income for
GAAP.
When this occurs, we pay the tax liability and establish a deferred tax
asset
for GAAP. When the income is then realized under GAAP in future periods,
the
deferred tax asset is recognized as an expense. Our deferred tax assets
are
generated by differences in GAAP and tax income at our taxable
subsidiaries.
Deferred
Asset-Backed Securities Issuance Costs
ABS
issuance costs are costs associated with the issuance of ABS from securitization
entities we sponsor. These costs typically include underwriting, rating
agency,
legal, accounting, and other fees. Deferred ABS issuance costs are reported
on
our consolidated balance sheets as deferred charges and are amortized as
an
adjustment to consolidated interest expense using the interest method based
on
the actual and estimated repayment schedules of the related ABS issued
under the
principles prescribed in Accounting Practice Bulletin 21, Interest
on Receivables and Payables
(APB
21).
Other
Assets
Other
assets on our consolidated balance sheets include real estate owned (REO),
fixed
assets, purchased interest, principal receivable, and other prepaid expenses.
REO is reported at the lower of cost or fair market value.
Redwood
Debt
Redwood
debt is currently all short-term debt collateralized by loans and securities.
We
report this debt at its unpaid principal balance.
Asset-Backed
Securities Issued
The
majority of the liabilities reported on our consolidated balance sheets
represent ABS issued by bankruptcy-remote securitization entities sponsored
by
Redwood. These ABS issued are carried at their unpaid principal balances
net of
any unamortized discount or premium. Our exposure to loss from consolidated
securitization entities (such as Sequoia and Acacia) is limited (except,
in some
circumstances, for limited loan repurchase obligations) to our net investment
in
securities we have acquired from these entities. Sequoia and Acacia assets
are
held in the custody of trustees. Trustees collect principal and interest
payments (less servicing and related fees) from the assets and make
corresponding principal and interest payments to the issued ABS. ABS obligations
are payable solely from the assets of these entities and are non-recourse
to
Redwood.
Junior
Subordinated Notes
Junior
subordinated notes (trust preferred securities) are unsecured debt, requiring
quarterly interest payments at a floating rate equal to LIBOR plus a spread
until they are redeemed in whole, or mature at a future date. These notes
contain an earlier optional redemption date without penalty.
Earnings
per Share
Basic
earnings per share are computed by dividing net income by the weighted
average
number of common shares outstanding during the period. Diluted earnings
per
share are computed by dividing net income by the weighted average number
of
common shares and potential common shares outstanding during the period.
Potential common shares outstanding are calculated using the treasury stock
method, which assumes that all dilutive common stock equivalents are exercised
and the funds generated by the exercises are used to buy back outstanding
common
stock at the average market price of the common stock during the reporting
period.
The
following table provides reconciliation of denominators of the basic and
diluted
earnings per share computations.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Basic
and Diluted Earnings
per Share
(In
thousands, except share data)
|
|
Three
Months Ended March 31,
|
|
|
|
2007
|
|
2006
|
|
Denominators:
|
|
|
|
|
|
|
|
Denominator
for basic earnings per share is equal to the weighted average
number of
common shares outstanding during the period
|
|
|
26,855,681
|
|
|
25,201,525
|
|
Adjustments
for diluted earnings per share are:
|
|
|
|
|
|
|
|
Net
effect of dilutive stock options
|
|
|
828,348
|
|
|
501,205
|
|
Denominator
for diluted earnings per share
|
|
|
27,684,029
|
|
|
25,702,730
|
|
|
|
|
|
|
|
|
|
Basic
Earnings Per Share
|
|
$
|
0.68
|
|
$
|
1.11
|
|
|
|
|
|
|
|
|
|
Diluted
Earnings Per Share
|
|
$
|
0.66
|
|
$
|
1.09
|
|
Pursuant
to EITF 03-6, Participating
Securities and the Two — Class Method
under
FASB
No. 128
(EITF
03-6), we determined that there was no allocation of income for our outstanding
stock options as they were antidilutive for the three months ended March
31,
2007 and 2006. There were no other participating securities, as defined
by EITF
03-6, during for the three months ended March 31, 2007 and 2006. For the
three
months ended March 31, 2007 and 2006, the number of outstanding stock options
that were antidilutive totaled 61,042, and 466,755, respectively.
Other
Comprehensive Income
(Loss)
Current
period net unrealized gains and losses on real estate securities
available-for-sale, and interest rate agreements classified as cash flow
hedges
are reported as components of other comprehensive income (loss) on our
consolidated statements of comprehensive income (loss). Net unrealized
gains and
losses on securities and interest rate agreements held by our taxable
subsidiaries that are reported in other comprehensive income (loss) are
adjusted
for the effects of tax and may create deferred tax assets or
liabilities.
Stock-Based
Compensation
As
of
March 31, 2007 and December 31, 2006, we had one stock-based employee
compensation plan and one employee stock purchase plan. These plans, and
associated stock options and other equity awards, are described more fully
in
Note
15.
We
adopted Statement of Financial Accounting Standards No. 123R, Share-Based
Payment (FAS
123R), on January 1, 2006. With the adoption of FAS 123R, the grant date
fair
market value of all remaining unvested stock compensation awards (stock
options,
deferred stock units, and restricted stock) are expensed on the consolidated
statements of income over the remaining vesting period. At January 1, 2006,
upon
adoption of FAS 123R, we had $19.3 million of unamortized costs related
to
unvested equity awards (stock options, restricted stock, and deferred stock
units). At March 31, 2007, the unamortized costs totaled $17.7 million
and will
be expensed over the next six years, over half of which will be recognized
over
the next twelve months.
The
Black-Scholes option-pricing model was used in determining fair market
values of
option grants accounted for under FAS 123R. The model requires the use
of inputs
such as strike price, and assumptions such as expected life, risk free
rate of
return, and stock price volatility. Options are generally granted over
the
course of the calendar year. The stock price volatility assumption is based
on
the historical volatility of our common stock. Certain options have dividend
equivalent rights (DERs) and, accordingly, the assumed dividend yield was
zero
for these options. Other options granted have no DERs and the assumed dividend
yield was 10%. The following table describes the weighted average of assumptions
used for calculating the value of options granted for the three months
ended
March 31, 2007 and 2006.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Weighted
Average Assumptions used for Valuation of Options under FAS 123R Granted
during
period
|
|
Three
Months Ended
March
31,
|
|
|
|
2007
|
|
2006
|
|
Stock
price volatility
|
|
|
25.5
|
%
|
|
25.7
|
%
|
Risk
free rate of return (5 yr Treasury Rate)
|
|
|
4.58
|
%
|
|
4.75
|
%
|
Average
life
|
|
|
6
years
|
|
|
5
years
|
|
Dividend
yield
|
|
|
10.00
|
%
|
|
10.00
|
%
|
Recent
Accounting Pronouncements
In
February 2007, the FASB issued Statement of Financial Accounting Standards
No. 159, The
Fair Value Option for Financial Assets and Financial Liabilities, including
an
amendment of FASB Statement No. 115,
(“SFAS
159”). SFAS 159 permits fair value accounting to be irrevocably elected for
certain financial assets and liabilities at the time of acquisition on
an
individual contract basis or at a remeasurement event date. Upon adoption
of
SFAS 159, fair value accounting may also be elected for existing financial
assets and liabilities. For those instruments for which fair value accounting
is
elected, changes in fair value will be recognized in earnings and fees
and costs
associated with origination or acquisition will be recognized as incurred
rather
than deferred. SFAS 159 is effective January 1, 2008, with early adoption
permitted as of January 1, 2007. We have determined that we will adopt SFAS
159 concurrent with the adoption of FASB issued Statement 157, Fair Value
Measurements (“SFAS 157”), on January 1, 2008, but we have not yet
determined the financial impact, if any, upon adoption.
Note
3. Real Estate Loans
We
acquire residential real estate loans from third party originators. A portion
of
these loans are sold to securitization entities sponsored by us under our
Sequoia program which, in turn, issue ABS. The remainder of the loans we
invest
in are held and financed with Redwood debt and equity. The following tables
summarize the carrying value of the residential and commercial real estate
loans, as reported on our consolidated balance sheets at March 31, 2007
and
December 31, 2006.
Real
Estate Loans Composition
(In
thousands)
|
|
March
31,
2007
|
|
December
31,
2006
|
|
Residential
real estate loans
|
|
$
|
8,680,487
|
|
$
|
9,323,935
|
|
Commercial
real estate loans
|
|
|
25,883
|
|
|
28,172
|
|
Total
real estate loans
|
|
$
|
8,706,370
|
|
$
|
9,352,107
|
|
Real
Estate Loans Carrying Value
March
31, 2007
(In
thousands)
|
|
Residential
Real Estate Loans
|
|
Commercial
Real
Estate
Loans
|
|
Total
|
|
Current
face
|
|
$
|
8,582,964
|
|
$
|
38,394
|
|
$
|
8,621,358
|
|
Unamortized
premium (discount)
|
|
|
117,477
|
|
|
(2,022
|
)
|
|
115,455
|
|
Discount
designated as credit reserve
|
|
|
—
|
|
|
(8,141
|
)
|
|
(8,141
|
)
|
Amortized
cost
|
|
|
8,700,441
|
|
|
28,231
|
|
|
8,728,672
|
|
Reserve
for credit losses
|
|
|
(19,954
|
)
|
|
(2,348
|
)
|
|
(22,302
|
)
|
Carrying
value
|
|
$
|
8,680,487
|
|
$
|
25,883
|
|
$
|
8,706,370
|
|
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Real
Estate Loans Carrying Value
December
31, 2006
(In
thousands)
|
|
Residential
Real Estate Loans
|
|
Commercial
Real
Estate
Loans
|
|
Total
|
|
Current
face
|
|
$
|
9,212,002
|
|
$
|
38,360
|
|
$
|
9,250,362
|
|
Unamortized
premium (discount)
|
|
|
132,052
|
|
|
(2,047
|
)
|
|
130,005
|
|
Discount
designated as credit reserve
|
|
|
—
|
|
|
(8,141
|
)
|
|
(8,141
|
)
|
Amortized
cost
|
|
|
9,344,054
|
|
|
28,172
|
|
|
9,372,226
|
|
Reserve
for credit losses
|
|
|
(20,119
|
)
|
|
—
|
|
|
(20,119
|
)
|
Carrying
value
|
|
$
|
9,323,935
|
|
$
|
28,172
|
|
$
|
9,352,107
|
|
Of
the
$8.6 billion of face and $117 million of unamortized premium on our residential
real estate loans at March 31, 2007, $4.5 billion of face and $95 million
of
unamortized premium relates to residential loans acquired prior to July
1, 2004.
At December 31, 2006, the residential loans acquired prior to July 1, 2004
had
face and unamortized premium balances of $5.2 billion and $104 million,
respectively. For these residential loans, we use coupon interest rates
as they
change over time and anticipated principal payments to determine an effective
yield to amortize the premium or discount. During the first quarter of
2007, 13%
of these residential loans prepaid and we amortized 9% of the premium.
For
residential loans acquired after July 1, 2004, the face and unamortized
premium
was $4.1 billion and $22 million at March 31, 2007 and $4.0 billion and
$28
million at December 31, 2006, respectively. For these residential loans,
we use
the initial coupon interest rate of the loans (without regard to future
changes
in the underlying indices) and anticipated principal payments to calculate
an
effective yield to amortize the premium or discount.
Residential
real estate loans are either sold to securitization entities sponsored
by us
under our Sequoia program which, in turn, issue ABS or are held and financed
with Redwood debt. The table below presents information regarding real
estate
loans pledged under our borrowing agreements.
Real
Estate Loans Pledged and Unpledged
(In
thousands)
|
|
March
31, 2007
|
|
December
31, 2006
|
|
|
|
Face
Value
|
|
Carrying
Value
|
|
Face
Value
|
|
Carrying
Value
|
|
Unpledged
|
|
$
|
106,987
|
|
$
|
94,119
|
|
$
|
120,578
|
|
$
|
111,231
|
|
Pledged
for Redwood debt:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Repurchase
(repo) agreements
|
|
|
900,142
|
|
|
909,230
|
|
|
978,713
|
|
|
982,629
|
|
Commercial
paper
|
|
|
252,897
|
|
|
253,430
|
|
|
301,827
|
|
|
302,615
|
|
Owned
by securitization entities, financed through the issuance of
ABS
|
|
|
7,361,332
|
|
|
7,449,591
|
|
|
7,849,244
|
|
|
7,955,632
|
|
Carrying
value
|
|
$
|
8,621,358
|
|
$
|
8,706,370
|
|
$
|
9,250,362
|
|
$
|
9,352,107
|
|
Note
4. Real Estate Securities
The
real
estate securities shown on our consolidated balance sheets include residential,
commercial, and CDO securities acquired from securitizations sponsored
by
others. The table below presents the carrying value (which equals fair
market
value as these are available-for-sale securities (AFS)) of our securities
that
are included in our consolidated balance sheets as of March 31, 2007 and
December 31, 2006, by type of securities, and by credit rating of
investment-grade (IGS) and below investment-grade (CES).
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Securities
(AFS) — Underlying Collateral Characteristics
March
31, 2007
(In
thousands)
|
|
CES
|
|
IGS
|
|
Total
AFS
Securities
|
|
|
|
|
|
|
|
|
|
Residential
securities:
|
|
|
|
|
|
|
|
|
|
|
Prime
|
|
$
|
571,149
|
|
$
|
789,492
|
|
$
|
1,360,641
|
|
Alt-a
|
|
|
171,987
|
|
|
765,840
|
|
|
937,827
|
|
Subprime
|
|
|
9,141
|
|
|
470,518
|
|
|
479,659
|
|
Total
residential securities
|
|
|
752,277
|
|
|
2,025,850
|
|
|
2,778,127
|
|
Commercial
securities
|
|
|
435,382
|
|
|
116,494
|
|
|
551,876
|
|
CDO
securities
|
|
|
16,152
|
|
|
254,307
|
|
|
270,459
|
|
Total
securities
|
|
$
|
1,203,811
|
|
$
|
2,396,651
|
|
$
|
3,600,462
|
|
December
31, 2006
(In
thousands)
|
|
CES
|
|
IGS
|
|
Total
AFS
Securities
|
|
|
|
|
|
|
|
|
|
Residential
securities:
|
|
|
|
|
|
|
|
|
|
|
Prime
|
|
$
|
555,369
|
|
$
|
723,247
|
|
$
|
1,278,616
|
|
Alt-a
|
|
|
156,859
|
|
|
455,550
|
|
|
612,409
|
|
Subprime
|
|
|
9,303
|
|
|
518,453
|
|
|
527,756
|
|
Total
residential securities
|
|
|
721,531
|
|
|
1,697,250
|
|
|
2,418,781
|
|
Commercial
securities
|
|
|
448,060
|
|
|
119,613
|
|
|
567,673
|
|
CDO
securities
|
|
|
21,964
|
|
|
224,349
|
|
|
246,313
|
|
Total
securities
|
|
$
|
1,191,555
|
|
$
|
2,041,212
|
|
$
|
3,232,767
|
|
The
table
below presents the components comprising the carrying value of
available-for-sale IGS reported on our consolidated balance sheets at March
31,
2007 and December 31, 2006.
Investment-Grade
Securities (AFS)
March
31, 2007
(In
thousands)
|
|
Residential
|
|
Commercial
|
|
CDO
|
|
Total
IGS
|
|
|
|
|
|
|
|
|
|
|
|
Current
face
|
|
$
|
2,094,494
|
|
$
|
121,737
|
|
$
|
263,237
|
|
$
|
2,479,468
|
|
Unamortized
discount, net
|
|
|
(19,617
|
)
|
|
(3,172
|
)
|
|
(945
|
)
|
|
(23,734
|
)
|
Amortized
cost
|
|
|
2,074,877
|
|
|
118,565
|
|
|
262,292
|
|
|
2,455,734
|
|
Gross
unrealized gains
|
|
|
5,376
|
|
|
211
|
|
|
1,440
|
|
|
7,027
|
|
Gross
unrealized losses
|
|
|
(54,403
|
)
|
|
(2,282
|
)
|
|
(9,425
|
)
|
|
(66,110
|
)
|
Carrying
value
|
|
$
|
2,025,850
|
|
$
|
116,494
|
|
$
|
254,307
|
|
$
|
2,396,651
|
|
December
31, 2006
(In
thousands)
|
|
Residential
|
|
Commercial
|
|
CDO
|
|
Total
IGS
|
|
|
|
|
|
|
|
|
|
|
|
Current
face
|
|
$
|
1,708,607
|
|
$
|
122,869
|
|
$
|
222,413
|
|
$
|
2,053,889
|
|
Unamortized
discount, net
|
|
|
(16,382
|
)
|
|
(3,367
|
)
|
|
(238
|
)
|
|
(19,987
|
)
|
Amortized
cost
|
|
|
1,692,225
|
|
|
119,502
|
|
|
222,175
|
|
|
2,033,902
|
|
Gross
unrealized gains
|
|
|
14,622
|
|
|
980
|
|
|
2,638
|
|
|
18,240
|
|
Gross
unrealized losses
|
|
|
(9,597
|
)
|
|
(869
|
)
|
|
(464
|
)
|
|
(10,930
|
)
|
Carrying
value
|
|
$
|
1,697,250
|
|
$
|
119,613
|
|
$
|
224,349
|
|
$
|
2,041,212
|
|
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
The
table
below presents the components comprising the carrying value of
available-for-sale CES reported on our consolidated balance sheets at March
31,
2007 and December 31, 2006.
Credit-Enhancement
Securities
(AFS)
March
31, 2007
(In
thousands)
|
|
Residential
|
|
Commercial
|
|
CDO
|
|
Total
CES
|
|
|
|
|
|
|
|
|
|
|
|
Current
face
|
|
$
|
1,259,446
|
|
$
|
792,240
|
|
$
|
23,731
|
|
$
|
2,075,417
|
|
Unamortized
discount, net
|
|
|
(158,669
|
)
|
|
(71,455
|
)
|
|
(7,004
|
)
|
|
(237,128
|
)
|
Discount
designated as credit reserve
|
|
|
(392,763
|
)
|
|
(294,466
|
)
|
|
─
|
|
|
(687,229
|
)
|
Amortized
cost
|
|
|
708,014
|
|
|
426,319
|
|
|
16,727
|
|
|
1,151,060
|
|
Gross
unrealized gains
|
|
|
71,323
|
|
|
18,767
|
|
|
527
|
|
|
90,617
|
|
Gross
unrealized losses
|
|
|
(27,060
|
)
|
|
(9,704
|
)
|
|
(1,102
|
)
|
|
(37,866
|
)
|
Carrying
value
|
|
$
|
752,277
|
|
$
|
435,382
|
|
$
|
16,152
|
|
$
|
1,203,811
|
|
December
31, 2006
(In
thousands)
|
|
Residential
|
|
Commercial
|
|
CDO
|
|
Total
CES
|
|
|
|
|
|
|
|
|
|
|
|
Current
face
|
|
$
|
1,180,605
|
|
$
|
793,743
|
|
$
|
28,731
|
|
$
|
2,003,079
|
|
Unamortized
discount, net
|
|
|
(144,842
|
)
|
|
(71,424
|
)
|
|
(6,889
|
)
|
|
(223,155
|
)
|
Discount
designated as credit reserve
|
|
|
(372,247
|
)
|
|
(295,340
|
)
|
|
─
|
|
|
(667,587
|
)
|
Amortized
cost
|
|
|
663,516
|
|
|
426,979
|
|
|
21,842
|
|
|
1,112,337
|
|
Gross
unrealized gains
|
|
|
71,134
|
|
|
23,235
|
|
|
516
|
|
|
94,885
|
|
Gross
unrealized losses
|
|
|
(13,119
|
)
|
|
(2,154
|
)
|
|
(394
|
)
|
|
(15,667
|
)
|
Carrying
value
|
|
$
|
721,531
|
|
$
|
448,060
|
|
$
|
21,964
|
|
$
|
1,191,555
|
|
At
March
31, 2007, our residential CES provided credit-enhancement on $237 billion
of
residential real estate loans and our commercial CES provided credit-enhancement
on $57 billion of commercial real estate loans. At December 31, 2006, our
residential CES provided credit-enhancement on $210 billion of residential
real
estate loans and our commercial CES provided credit-enhancement on $58
billion
of commercial real estate loans.
The
amount of designated credit reserve equals the estimate of credit losses
within
the underlying loan pool on the CES that we expect to incur over the life
of the
loans. This estimate is determined based upon various factors affecting
these
assets, including economic conditions, characteristics of the underlying
loans,
delinquency status, past performance of similar loans, and external credit
reserves. We use a variety of internal and external credit risk cash flow
modeling and portfolio analytical tools to assist in our assessments. We
review
our assessments on each individual underlying loan pool and determine the
appropriate level of credit reserve required for each security we own at
least
quarterly. The designated credit reserve is specific to each security.
The
following table presents the aggregate changes in our unamortized discount
and
the portion of the discount designated as credit reserve for the three
months
ended March 31, 2007 and 2006.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Changes
In Unamortized Discount and Designated Credit Reserves on Residential,
Commercial, and CDO CES
(In
thousands)
Three
months ended March 31, 2007
|
|
Residential
|
|
Commercial
|
|
CDO
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
Beginning
balance of unamortized discount, net
|
|
$
|
144,842
|
|
$
|
71,424
|
|
$
|
6,889
|
|
$
|
223,155
|
|
Amortization
of discount
|
|
|
(18,892
|
)
|
|
9
|
|
|
─
|
|
|
(18,883
|
)
|
Calls,
sales, and other
|
|
|
2,370
|
|
|
─
|
|
|
─
|
|
|
2,370
|
|
Re-designation
between credit reserve and discount
|
|
|
22,312
|
|
|
(397
|
)
|
|
─
|
|
|
21,915
|
|
Upgrades
to investment-grade securities
|
|
|
─
|
|
|
160
|
|
|
115
|
|
|
275
|
|
Purchased
discount
|
|
|
8,037
|
|
|
259
|
|
|
─
|
|
|
8,296
|
|
Ending
balance of unamortized discount, net
|
|
$
|
158,669
|
|
$
|
71,455
|
|
$
|
7,004
|
|
$
|
237,128
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Beginning
balance of designated credit reserve
|
|
$
|
372,247
|
|
$
|
295,340
|
|
|
─
|
|
$
|
667,587
|
|
Realized
credit losses
|
|
|
(3,805
|
)
|
|
(1,271
|
)
|
|
─
|
|
|
(5,076
|
)
|
Calls,
sales, and other
|
|
|
(1,516
|
)
|
|
─
|
|
|
─
|
|
|
(1,516
|
)
|
Re-designation
between credit reserve and discount
|
|
|
(22,312
|
)
|
|
397
|
|
|
─
|
|
|
(21,915
|
)
|
Purchased
discount designated as credit reserve
|
|
|
48,149
|
|
|
─
|
|
|
─
|
|
|
48,149
|
|
Ending
balance of designated credit reserve
|
|
$
|
392,763
|
|
$
|
294,466
|
|
|
─
|
|
$
|
687,229
|
|
(In
thousands)
Three
months ended March 31, 2006
|
|
Residential
|
|
Commercial
|
|
CDO
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
Beginning
balance of unamortized discount, net
|
|
$
|
121,824
|
|
$
|
28,993
|
|
$
|
8,004
|
|
$
|
158,821
|
|
Amortization
of discount
|
|
|
(12,391
|
)
|
|
564
|
|
|
44
|
|
|
(11,783)
|
)
|
Calls,
sales, and other
|
|
|
756
|
|
|
(44
|
)
|
|
─
|
|
|
712
|
|
Re-designation
between credit reserve and discount
|
|
|
1,822
|
|
|
(4,429
|
)
|
|
─
|
|
|
(2,607
|
)
|
Upgrades
to investment-grade securities
|
|
|
(6,249
|
)
|
|
─
|
|
|
─
|
|
|
(6,249
|
)
|
Purchased
discount (premium)
|
|
|
2,609
|
|
|
(4,611
|
)
|
|
─
|
|
|
(2,002
|
)
|
Ending
balance of unamortized discount, net
|
|
$
|
108,371
|
|
$
|
20,473
|
|
$
|
8,048
|
|
$
|
136,892
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Beginning
balance of designated credit reserve
|
|
$
|
354,610
|
|
$
|
141,806
|
|
|
─
|
|
$
|
496,416
|
|
Realized
credit losses
|
|
|
(2,577
|
)
|
|
(2
|
)
|
|
─
|
|
|
(2,579
|
)
|
Calls,
sales, and other
|
|
|
(4,710
|
)
|
|
─
|
|
|
─
|
|
|
(4,710
|
)
|
Re-designation
between credit reserve and discount
|
|
|
(1,822
|
)
|
|
4,429
|
|
|
─
|
|
|
2,607
|
|
Purchased
discount designated as credit reserve
|
|
|
28,280
|
|
|
21,539
|
|
|
─
|
|
|
49,819
|
|
Ending
balance of designated credit reserve
|
|
$
|
373,781
|
|
$
|
167,772
|
|
|
─
|
|
$
|
541,553
|
|
Yields
recognized for GAAP for each security vary as a function of credit results,
prepayment rates, and, for our securities with variable rate coupons, interest
rates. If estimated future credit losses are less than our prior estimate,
credit losses occur later than expected, or prepayment rates are faster
than
expected (meaning the present value of projected cash flows is greater
than
previously expected), the yield over the remaining life of the security
may be
adjusted upwards. If estimated future credit losses exceed our prior
expectations, credit losses occur more quickly than expected, or prepayments
occur more slowly than expected (meaning the present value of projected
cash
flows is less than previously expected), the yield over the remaining life
of
the security may be adjusted downward or we may have an other-than-temporary
impairment. For the three months ended March 31, 2007 and 2006, we recognized
other-than-temporary impairments of $2.4 million and $3.2 million, respectively.
This includes AFS securities that were in unrealized loss positions of
$0.6
million at the end of the period (and were subsequently sold in April 2007)
that
we did not intend to hold for a period long enough to recover the unrealized
loss position. These impairments are included in valuation adjustments
in our
consolidated statements of income.
Gross
realized gains on sales of securities were $0.7 million and $1.1 million
for the
three months ended March 31, 2007 and 2006, respectively. Gross realized
losses
on sales of securities were $1.5 million and zero for the three months
ended
March 31, 2007 and 2006, respectively. Gains on calls of securities were
$0.8
million for the three months ended March 31, 2007. There were no gains
on calls
for the three months ended March 31, 2006.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Gross
unrealized gains and losses represent the difference between the net amortized
cost and the fair market value of individual securities. Gross unrealized
losses
represent a decline in fair market value for securities not deemed impaired
for
GAAP. The following tables show the gross unrealized losses, fair market
values,
and length of time that any real estate securities have been in a continuous
unrealized loss position as of March 31, 2007 and December 31, 2006. These
unrealized losses are not considered to be other-than-temporary impairments
because these losses are not due to adverse changes in cash flows and we
have
the intent and ability to hold these securities for a period sufficient
for
these securities to potentially recover their values.
Securities
with Unrealized Losses
March
31, 2007
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(In
thousands)
|
|
Less
Than 12 Months
|
|
12
Months or More
|
|
Total
|
|
|
|
Fair
Market Value
|
|
Unrealized
Losses
|
|
Fair
Market Value
|
|
Unrealized
Losses
|
|
Fair
Market
Value
|
|
Unrealized
Losses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
|
|
$
|
1,231,405
|
|
$
|
(56,179
|
)
|
$
|
497,662
|
|
$
|
(25,284
|
)
|
$
|
1,729,067
|
|
$
|
(81,463
|
)
|
Commercial
|
|
|
154,968
|
|
|
(7,588
|
)
|
|
155,555
|
|
|
(4,398
|
)
|
|
310,523
|
|
|
(11,986
|
)
|
CDO
|
|
|
102,607
|
|
|
(7,283
|
)
|
|
58,522
|
|
|
(3,244
|
)
|
|
161,129
|
|
|
(10,527
|
)
|
Total
securities
|
|
$
|
1,488,980
|
|
$
|
(71,050
|
)
|
$
|
711,739
|
|
$
|
(32,926
|
)
|
$
|
2,200,719
|
|
$
|
(103,976
|
)
|
December
31, 2006
(In
thousands)
|
|
Less
Than 12 Months
|
|
12
Months or More
|
|
Total
|
|
|
|
Fair
Market Value
|
|
Unrealized
Losses
|
|
Fair
Market Value
|
|
Unrealized
Losses
|
|
Fair
Market
Value
|
|
Unrealized
Losses
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
|
|
$
|
495,242
|
|
$
|
(9,938
|
)
|
$
|
385,170
|
|
$
|
(12,778
|
)
|
$
|
880,412
|
|
$
|
(22,716
|
)
|
Commercial
|
|
|
111,603
|
|
|
(1,055
|
)
|
|
85,010
|
|
|
(1,968
|
)
|
|
196,613
|
|
|
(3,023
|
)
|
CDO
|
|
|
29,378
|
|
|
(257
|
)
|
|
29,543
|
|
|
(601
|
)
|
|
58,921
|
|
|
(858
|
)
|
Total
real estate securities
|
|
$
|
636,223
|
|
$
|
(11,250
|
)
|
$
|
499,723
|
|
$
|
(15,347
|
)
|
$
|
1,135,946
|
|
$
|
(26,597
|
)
|
We
fund
some of the securities we acquire on a temporary basis with short-term
borrowings prior to the sale to the securitization entities we sponsor.
We also
acquire less credit-risk sensitive assets and finance these investments
with a
combination of Redwood debt and equity. The table below presents information
regarding our securities pledged under borrowing agreements and owned by
securitization entities as of March 31, 2007 and December 31, 2006.
Securities
Pledged and Unpledged
(In
thousands)
|
|
March
31, 2007
|
|
December
31, 2006
|
|
|
|
|
|
|
|
Unpledged
|
|
$
|
513,986
|
|
$
|
463,891
|
|
Pledged
for Redwood debt
|
|
|
708,721
|
|
|
593,070
|
|
Owned
by securitization entities, financed through issuance of
ABS
|
|
|
2,377,755
|
|
|
2,175,806
|
|
Carrying
value
|
|
$
|
3,600,462
|
|
$
|
3,232,767
|
|
Note
5. Other Real Estate Investments
Other
real estate investments shown on our balance sheets include IOs, NIMs and
residuals. We have elected to classify these investments as “trading
investments” as they contain derivatives under GAAP. These assets are carried at
fair market value on our consolidated balance sheet and changes in fair
market
value flow through market valuation adjustments, net on the consolidated
statements of income.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
The
table
below presents the carrying value (which equals fair market value as these
are
classified as trading instruments) of these investments as of March 31,
2007. We
did not have any assets classified as other real estate investments at
December
31, 2006. At the conclusion of the quarter we reclassified $18 million
of
investments from real estate securities available for sale to other real
estate
investments. We recorded a negative $4 million market valuation adjustment
as a
result of this transfer. We recorded a negative $5 million market valuation
adjustment in total for other real estate investments through the consolidated
statements of income during the first three months of 2007. The other $1
million
loss was the result of market valuation adjustments on other real estate
investments acquired during the first quarter of 2007.
Other
Real Estate Investments - Trading
|
|
|
|
|
|
|
|
|
|
|
|
March
31, 2007
|
|
|
|
|
|
(In
thousands)
|
|
Prime
|
|
Alt-a
|
|
Subprime
|
|
Total
|
|
Residential
|
|
|
|
|
|
|
|
|
|
|
|
|
|
IOs
|
|
$
|
1,625
|
|
$
|
410
|
|
$
|
─
|
|
$
|
2,035
|
|
NIMs
|
|
|
─
|
|
|
11,679
|
|
|
16,937
|
|
|
28,616
|
|
Residuals
|
|
|
─
|
|
|
16,219
|
|
|
3,187
|
|
|
19,406
|
|
Total
other real estate investments
|
|
$
|
1,625
|
|
$
|
28,308
|
|
$
|
20,124
|
|
$
|
50,057
|
|
As
of
March 31, 2007, $2.6 million of other real estate investments were owned
by
securitization entities, financed through the issuance of ABS. The remaining
$47.5 million were funded with equity.
Note
6. Derivative Financial Instruments
Interest
Rate Agreements
We
report
our interest rate agreements at fair market value as determined using
third-party models and confirmed by Wall Street dealers. As of March 31,
2007
and December 31, 2006, the net fair market value of interest rate agreements
was
$11.0 million and $20.6 million, respectively. Our total unrealized gain
on
interest rate agreements included in accumulated other comprehensive income
(loss) was $0.2 million and $7.0 million at March 31, 2007 and December
31,
2006, respectively.
The
following table shows the aggregate fair market value and notional amount
of our
interest rate agreements as of March 31, 2007 and December 31,
2006.
Interest
Rate Agreements
(In
thousands)
|
|
March
31, 2007
|
|
December
31, 2006
|
|
|
|
Fair
Market
Value
|
|
Notional
Amount
|
|
Fair
Market
Value
|
|
Notional
Amount
|
|
|
|
|
|
|
|
|
|
|
|
Accounted
for as Trading Instruments
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest
rate caps
purchased
|
|
$
|
1,389
|
|
$
|
66,900
|
|
$
|
1,114
|
|
$
|
71,900
|
|
Interest
rate caps sold
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Interest
rate corridors purchased
|
|
|
—
|
|
|
798,967
|
|
|
—
|
|
|
844,805
|
|
Interest
rate swaps
|
|
|
203
|
|
|
238,831
|
|
|
242
|
|
|
131,195
|
|
Credit
default swaps
|
|
|
(2,492
|
)
|
|
35,000
|
|
|
(6
|
)
|
|
1,000
|
|
Futures
|
|
|
—
|
|
|
—
|
|
|
90
|
|
|
204,000
|
|
Purchase
commitments
|
|
|
(192
|
)
|
|
81,676
|
|
|
(168
|
)
|
|
80,964
|
|
Accounted
for as Cash Flow Hedges
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Futures
|
|
|
—
|
|
|
—
|
|
|
(44
|
)
|
|
627,000
|
|
Interest
rate swaps
|
|
|
12,115
|
|
|
1,121,884
|
|
|
19,385
|
|
|
1,279,007
|
|
Total
Interest Rate Agreements
|
|
$
|
11,023
|
|
$
|
2,343,258
|
|
$
|
20,613
|
|
$
|
3,239,871
|
|
Our
interest rate agreements had net receipts of $2.4 million for the three
months
ended March 31, 2007 and net receipts of $2.2 million for the three months
ended
March 31, 2006.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Interest
rate agreements accounted for as cash flow hedges may be terminated prior
to the
completion of the forecasted transactions. In these cases, provided the
forecasted transaction is still likely to occur, the net gain or loss on
the
interest rate agreements remains in accumulated other comprehensive income
(loss) and will be reclassified from accumulated other comprehensive income
(loss) to our consolidated statements of income during the period the forecasted
transaction occurs. We reclassified $0.7 million and $0.3 million from
other
comprehensive income (loss) to interest expense for the three months ended
March
31, 2007 and 2006, respectively. At March 31, 2007, the maximum length
of time
over which we are hedging our exposure to the variability of future cash
flows
for forecasted transactions with cash flow hedges is ten years, and in
all
cases, the forecasted transactions are expected to occur within the next
year.
In
the
case when the hedge is terminated and the forecasted transaction is not
expected
to occur, we immediately recognize the gain or loss through gains on sales,
net
in our consolidated statements of income. For the three months ended March
31,
2007, there was one such instance which resulted in a gain of $1.1 million.
For
the three months ended March 31, 2006, there were no such instances. The
following table presents the interest income and expense for the three
months
ended March 31, 2007 and 2006.
Impact
on Interest Income (Expense) of Our Interest Rate
Agreements
|
|
Three
Months Ended March 31,
|
|
(In
thousands)
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Net
interest income on interest rate
agreements
|
|
$
|
2,399
|
|
$
|
2,231
|
|
Realized
net gains (losses) due to net ineffective portion of
hedges
|
|
|
(81
|
)
|
|
483
|
|
Realized
net (losses) gains reclassified from other comprehensive income
(loss)
|
|
|
(672
|
)
|
|
266
|
|
Total
|
|
$
|
1,646
|
|
$
|
2,980
|
|
When
the
interest rate agreement is accounted for as a trading instrument, changes
in the
fair market value of the interest rate agreement and all associated income
and
expenses are reported in earnings through market valuation adjustments
and were
negative $0.8 million and positive $0.3 million for three months ended
March 31,
2007 and 2006, respectively.
Purchase
Commitments
At
March
31, 2007, we had commitments to purchase $82 million residential real estate
loans and these commitments had an estimated fair market value of negative
$0.2
million. The change in fair market value is included in market valuation
adjustments on our consolidated statements of income.
We
have
committed to purchase commercial CES from a securitization entity to be
formed
in 2007 subject to adherence to representations and underwriting criteria
as set
forth in the agreement. At March 31, 2007, there were approximately $115
million
of commercial mortgage loans originated for this future securitization.
At March
31, 2007, we estimate the value of this commitment to be
negligible.
Credit
Default Swaps
A
credit
default swap is an agreement to provide (receive) credit event protection
based
on a financial index or specific security in exchange for receiving (paying)
a
fixed rate fee or premium over the term of the contract. In the first quarter
of
2007, we entered into several credit default swaps with an aggregate notional
amount of $35 million where we agreed to provide credit event protection
in
exchange for a premium. We intend to include these credit default swaps
in our
next Acacia CDO (scheduled to close in the second quarter of 2007) and
we plan
to acquire more credit default swaps in the future. These will likely increase
volatility of our GAAP income.
Credit
default swaps are accounted for as trading instruments, and are thus reported
at
fair market value with the changes in fair market values recognized through
our
income statements. Since the acquisition of these credit default swaps,
the
value has decreased $2.5 million, primarily as the result of widening spreads
in
these types of instruments. We currently do not believe that the probability
of
a credit event has substantially increased from our date of purchase through
March 31, 2007. As a trading instrument, the change in fair market value
is
included in valuation adjustments on our consolidated statements of
income.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Counterparty
Credit Risk
We
incur
credit risk to the extent that the counterparties to the derivative financial
instruments do not perform their obligations under the agreements. If one
of the
counterparties does not perform, we may not receive the cash to which we
would
otherwise be entitled under the agreement. In order to mitigate this risk,
we
only enter into agreements that are either a) transacted on a national
exchange
or b) transacted with counterparties that are either i) designated by the
U.S.
Department of Treasury as a primary government dealer, ii) affiliates of
primary
government dealers, or iii) rated BBB or higher. Furthermore, we generally
enter
into agreements with several different counterparties in order to diversify
our
credit risk exposure. At March 31, 2007, we had $2.6 million credit exposure
in
interest rate swaps. At December 31, 2006, we had $1.0 million credit exposure
on futures and $5.1 million credit exposure on interest rate agreements.
Note
7. Reserves for Credit Losses
We
establish reserves for credit losses on our real estate loans based on
our
estimate of losses inherent in our loan portfolio.
Delinquencies
in our consolidated residential real estate loan portfolio were $79 million
and
$74 million as of March 31, 2007 and December 31, 2006, respectively.
Delinquencies include loans delinquent more than 90 days, in bankruptcy,
and in
foreclosure. As a percentage of our current residential real estate loan
balances, delinquencies stood at 0.92% and 0.81% at March 31, 2007 and
December
31, 2006, respectively. As a percentage of the original balances, delinquencies
stood at 0.26% and 0.24% at March 31, 2007 and December 31, 2006,
respectively.
Our
residential loan servicers advance payment on delinquent loans to the extent
they deem them recoverable. We accrue interest on loans until they are
more than
90 days past due at which point they are placed on nonaccrual status. When
a
loan becomes REO, we estimate the specific loss, based on estimated net
proceeds
from the sale of the property (including accrued but unpaid interest) and
charge
this specific estimated loss against the reserve for credit losses.
The
following table summarizes the activity in reserves for credit losses for
our
consolidated residential real estate loans for the three months ended March
31,
2007 and 2006.
Residential
Real Estate Loan Reserves
for Credit Losses
(In
thousands)
|
|
Three
Months Ended March 31,
|
|
|
|
2007
|
|
2006
|
|
Balance
at beginning of period
|
|
$
|
20,119
|
|
$
|
22,656
|
|
Provision
for credit
losses
|
|
|
1,481
|
|
|
141
|
|
Charge-offs
|
|
|
(1,646
|
)
|
|
(425
|
)
|
Balance
at end of period
|
|
$
|
19,954
|
|
$
|
22,372
|
|
During
the first quarter of 2007, we fully reserved for an anticipated loss on
a junior
mezzanine commercial loan financing a condominium-conversion project. Principal
and accrued interest on this loan were scheduled to be paid upon the completion
of the project and sale of the units. Accordingly, the loan was not delinquent.
However, due to cost overruns and changing market conditions, we believe
it is
unlikely we will collect any outstanding principal upon completion of the
project. The provision for credit losses for the three months ended March
31,
2007 relates to that loan. The following table summarizes the activity
in
reserves for credit losses for our commercial real estate loans for the
three
months ended March 31, 2007 and 2006.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Commercial
Real Estate Loan Reserves for Credit Losses
(In
thousands)
|
|
Three
Months Ended March 31,
|
|
|
|
2007
|
|
2006
|
|
Balance
at beginning of period
|
|
$
|
—
|
|
$
|
—
|
|
Provision
for credit losses
|
|
|
2,348
|
|
|
35
|
|
Charge-offs
|
|
|
—
|
|
|
(35
|
)
|
Balance
at end of period
|
|
$
|
2,348
|
|
$
|
—
|
|
Note
8.
Other Assets
Other
assets as of March 31, 2007 and December 31, 2006 are summarized in the
following table.
(In
thousands)
|
|
March
31, 2007
|
|
December
31, 2006
|
|
Real
estate owned (REO)
|
|
$
|
8,925
|
|
$
|
7,963
|
|
Fixed
assets and leasehold improvements
|
|
|
6,128
|
|
|
4,439
|
|
Principal
receivable
|
|
|
7,184
|
|
|
4,417
|
|
Purchased
interest
|
|
|
4,272
|
|
|
1,045
|
|
Other
|
|
|
1,676
|
|
|
2,342
|
|
Total
other assets
|
|
$
|
28,185
|
|
$
|
20,206
|
|
Note
9. Redwood Debt
We
enter
into repurchase agreements, bank borrowings, and other forms of collateralized
(and generally uncommitted) borrowings with several banks and major investment
banking firms. We also issue commercial paper for financing residential
and
commercial real estate loans and securities. We refer to these borrowings
as
Redwood debt. We report Redwood debt at its unpaid principal balance. We
also
have other types of recourse debt such as junior subordinated notes (See
Note
11).
The
table below summarizes the outstanding balances of Redwood debt as of March
31,
2007 and December 31, 2006, by collateral type.
Redwood
Debt
(In
thousands)
|
|
March
31, 2007
|
|
|
|
Number
of
Facilities
|
|
Outstanding
|
|
Limit
|
|
Maturity
|
|
Facilities
by collateral
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Real
estate
loans
|
|
|
4
|
|
$
|
882,139
|
|
$
|
2,200,000
|
|
|
8/07-1/08
|
|
Real
estate securities
|
|
|
13
|
|
|
747,644
|
|
|
5,287,000
|
|
|
7/07-10/07
|
|
Unsecured
line of credit
|
|
|
1
|
|
|
—
|
|
|
10,000
|
|
|
10/07
|
|
Madrona
commercial paper facility
|
|
|
1
|
|
|
250,000
|
|
|
490,000
|
|
|
7/09
|
|
Total
facilities
|
|
|
19
|
|
$
|
1,879,783
|
|
$
|
7,987,000
|
|
|
|
|
(In
thousands)
|
|
December
31, 2006
|
|
|
|
Number
of
Facilities
|
|
Outstanding
|
|
Limit
|
|
Maturity
|
|
Facilities
by collateral
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Real
estate
loans
|
|
|
5
|
|
$
|
959,139
|
|
$
|
2,700,000
|
|
|
1/07-10/07
|
|
Real
estate securities
|
|
|
14
|
|
|
597,069
|
|
|
5,787,000
|
|
|
2/07-10/07
|
|
Unsecured
line of credit
|
|
|
1
|
|
|
—
|
|
|
10,000
|
|
|
10/07
|
|
Madrona
commercial paper facility
|
|
|
1
|
|
|
300,000
|
|
|
490,000
|
|
|
7/09
|
|
Total
facilities
|
|
|
21
|
|
$
|
1,856,208
|
|
$
|
8,987,000
|
|
|
|
|
At
March
31, 2007, Redwood debt was all short-term debt. Borrowings under these
facilities generally bear interest based on a specified margin over the
one-month LIBOR interest rate. For the three months ended March 31, 2007
and
2006, the average balance of Redwood debt was $2.2 billion and $0.1 billion,
respectively with a weighted-average interest cost of 5.68% and 6.04%,
respectively. At March 31, 2007 and December 31, 2006, accrued interest
payable
on Redwood debt was $8.0 million and $7.0 million, respectively.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
As
of
March 31, 2007 and December 31, 2006, we had $250 million and $300 million
of
commercial paper outstanding through our Madrona special purpose entity,
respectively.
The
table
below summarizes Redwood debt by weighted average interest rates and by
collateral type in Redwood debt at March 31, 2007 and December 31,
2006.
Redwood
Debt
(In
thousands)
|
|
March
31, 2007
|
|
December
31, 2006
|
|
|
|
Amount
Borrowed
|
|
Weighted
Average
Interest
Rate
|
|
Weighted
Average
Days
Until
Maturity
|
|
Amount
Borrowed
|
|
Weighted
Average
Interest
Rate
|
|
Weighted
Average
Days
Until
Maturity
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Real
estate loan collateral
|
|
$
|
1,132,139
|
|
|
5.53
|
%
|
|
12
|
|
$
|
1,259,139
|
|
|
5.54
|
%
|
|
21
|
|
Securities
collateral
|
|
|
747,644
|
|
|
5.96
|
%
|
|
148
|
|
|
597,069
|
|
|
6.06
|
%
|
|
110
|
|
Total
Redwood debt
|
|
$
|
1,879,783
|
|
|
5.70
|
%
|
|
66
|
|
$
|
1,856,208
|
|
|
5.71
|
%
|
|
49
|
|
The
following table presents the remaining maturities of Redwood debt as of
March
31, 2007 and December 31, 2006.
Redwood
Debt
(In
thousands)
|
|
March
31,
2007
|
|
December
31,
2006
|
|
|
|
|
|
|
|
Within
30 days
|
|
$
|
1,132,139
|
|
$
|
1,259,138
|
|
31
to 90 days
|
|
|
—
|
|
|
392,566
|
|
Over
90 days
|
|
|
747,644
|
|
|
204,504
|
|
Total
Redwood debt
|
|
$
|
1,879,783
|
|
$
|
1,856,208
|
|
We
continue to be in compliance with all of our debt covenants for all of
our
borrowing arrangements and credit facilities. Additional collateral in
the form
of additional qualifying assets or cash may be required to meet changes
in fair
market values from time to time under these agreements. Covenants associated
with our debt generally relate to our tangible net worth, liquidity reserves,
and leverage requirements. We have not had, nor do we currently anticipate
having, any problems in meeting these covenants. It is our intention to
renew
committed and uncommitted facilities as needed, as well as pursue additional
facilities and other types of financing.
Note
10.
Asset-Backed Securities Issued
The
Sequoia and Acacia securitization entities sponsored by us issue ABS to
raise
the funds to acquire assets from us and others. Each series of ABS consists
of
various classes that pay interest at variable and fixed rates. Substantially
all
of the variable-rate ABS are indexed to one-, three- or six-month LIBOR,
with
interest paid monthly or quarterly. A lesser amount of the ABS is fixed
for a
term and then will adjust to a LIBOR rate (hybrid ABS) or is fixed for
its
entire term. Some of the ABS securities issued are interest-only securities
(IOs) and have coupons set at a fixed rate or a fixed spread, while others
earn
a coupon based on the spread between collateral owned by and the ABS issued
by a
securitized entity.
The
maturity of each class of ABS is directly affected by the rate of principal
prepayments on the assets of the issuing entity. Each series is also subject
to
redemption (call) according to the specific terms of the respective governing
documents. As a result, the actual maturity of an ABS is likely to occur
earlier
than its stated maturity. In March 2007 we called an Acacia securitization
and
sold off many of the assets in the securitization entity at the time of
the
call. The proceeds are retained in restricted cash and we will pay off
the
associated ABS issued in the second quarter of 2007.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
The
carrying value components of the collateral for ABS issued and outstanding
as of
March 31, 2007 and December 31, 2006 are summarized in the table
below.
Collateral
for Asset-Backed Securities Issued
(In
thousands)
|
|
March
31,
2007
|
|
December
31,
2006
|
|
|
|
|
|
|
|
Real
estate loans
|
|
$
|
7,449,591
|
|
$
|
7,955,632
|
|
Real
estate securities
|
|
|
2,377,755
|
|
|
2,175,806
|
|
Other
real estate investments
|
|
|
2,583
|
|
|
─
|
|
Real
estate owned (REO)
|
|
|
5,290
|
|
|
7,963
|
|
Restricted
cash owned by consolidated securitization entities
|
|
|
340,114
|
|
|
111,124
|
|
Accrued
interest receivable
|
|
|
55,103
|
|
|
61,617
|
|
Total
collateral for ABS issued
|
|
$
|
10,230,436
|
|
$
|
10,312,142
|
|
The
components of ABS issued by consolidated securitization entities as of
March 31,
2007 and December 31, 2006, along with other selected information, are
summarized in the table below.
Asset-Backed
Securities Issued
(In
thousands)
|
|
March
31,
2007
|
|
December
31,
2006
|
|
|
|
|
|
|
|
Sequoia
ABS issued — certificates with principal
value
|
|
$
|
7,124,729
|
|
$
|
7,575,062
|
|
Sequoia
ABS issued — interest-only certificates
|
|
|
61,751
|
|
|
74,548
|
|
Acacia
ABS issued
|
|
|
2,760,091
|
|
|
2,327,504
|
|
Madrona
ABS issued
|
|
|
5,400
|
|
|
5,400
|
|
Unamortized
discount on ABS
|
|
|
(5,463
|
)
|
|
(3,290
|
)
|
Total
consolidated ABS issued
|
|
$
|
9,946,508
|
|
$
|
9,979,224
|
|
|
|
|
|
|
|
|
|
Sequoia
ABS:
|
|
|
|
|
|
|
|
Range
of weighted average interest rates, by series
|
|
|
4.59%
to 6.35
|
%
|
|
4.64%
to 6.37
|
%
|
Stated
maturities
|
|
|
2007
- 2047
|
|
|
2007
- 2046
|
|
Number
of series
|
|
|
38
|
|
|
40
|
|
|
|
|
|
|
|
|
|
Acacia
ABS:
|
|
|
|
|
|
|
|
Range
of weighted average interest rates, by series
|
|
|
5.55%
- 6.01
|
%
|
|
5.84%
- 6.03
|
%
|
Stated
maturities
|
|
|
2039
- 2047
|
|
|
2038
- 2046
|
|
Number
of series
|
|
|
9
|
|
|
8
|
|
Amortization
of deferred asset-backed securities issuance costs were $7.1 million and
$5.9
million for the three months ended March 31, 2007 and 2006,
respectively.
The
following table summarizes the accrued interest payable on ABS issued as
of
March 31, 2007 and December 31, 2006. Interest due on Sequoia ABS is settled
monthly and on Acacia ABS is settled quarterly.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Accrued
Interest Payable on Asset-Backed Securities Issued
(In
thousands)
|
|
March
31,
2007
|
|
December
31,
2006
|
|
|
|
|
|
|
|
Sequoia
|
|
$
|
16,863
|
|
$
|
20,060
|
|
Acacia
|
|
|
25,577
|
|
|
23,137
|
|
Total
accrued interest payable on ABS issued
|
|
$
|
42,440
|
|
$
|
43,197
|
|
Note
11. Junior Subordinated Notes
In
December 2006, we issued $100 million of junior subordinated notes through
Redwood Capital Trust I, a newly formed wholly-owned Delaware statutory
trust,
in a private placement transaction. These trust preferred securities require
quarterly distributions at a floating rate equal to three-month LIBOR plus
2.25%
until the notes are redeemed in whole, which will be no later than January
30,
2037. The earliest optional redemption date without a penalty is January
30,
2012. We did not issue any junior subordinated notes during the three months
ended March 31, 2007. At March 31, 2007, and December 31, 2006, the accrued
interest payable balance related to these trust preferred securities was
$1.3
million and $0.4 million, respectively.
Note
12. Taxes
We
have
elected to be taxed as a REIT under the Internal Revenue Code and the
corresponding provisions of state law. In order to qualify as a REIT, we
must
distribute at least 90% of our annual REIT taxable income (this does not
include
taxable income retained in our taxable subsidiaries) to stockholders within
the
time frame set forth in the tax rules and we must meet certain other
requirements. We may retain up to 10% of our REIT ordinary taxable income
(and
currently intend to do so in 2007 as we did in 2006) and pay corporate
income
taxes on this retained income while continuing to maintain our REIT status.
We
distribute all capital gains we can pass along to our shareholders. We are
also subject to income taxes on taxable income earned at our taxable
subsidiaries.
We
recognized a total tax provision of $1.8 million and $2.8 million for the
three
months ended March 31, 2007 and 2006, respectively. Our taxable provision
is
based on estimates of taxable and reported annual income. The following
is a
reconciliation of the statutory federal and state rates to the effective
rates
for 2007 and 2006. Our quarterly estimates may be revised over the year
as our
projections are adjusted to reflect actual results.
Reconciliation
of Statutory Tax Rate to Effective Tax Rate
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Federal
statutory rate
|
|
|
35.0
|
%
|
|
35.0
|
%
|
State
statutory rate, net of Federal tax effect
|
|
|
7.0
|
%
|
|
7.0
|
%
|
Differences
in taxable income from GAAP income
|
|
|
11.7
|
%
|
|
11.6
|
%
|
Dividend
paid deduction
|
|
|
(44.8
|
%)
|
|
(46.3
|
%)
|
Effective
tax rate
|
|
|
8.9
|
%
|
|
7.3
|
%
|
Differences
in taxable income from GAAP income reflect various accounting treatments
for tax
and GAAP, such as the accounting for discount and premium amortization,
credit
losses, stock options, and compensation. As a REIT, we are able to deduct
for
tax purposes the dividends paid to shareholders, thereby reducing our effective
tax rate.
Our
policy for interest and penalties on material uncertain tax positions recognized
in the consolidated financial statements is to classify these as interest
expense and operating expense, respectively. However, in accordance with
Financial Accounting Standard Board Interpretation Number 48, Accounting
for Uncertainty in Income Taxes,
(FIN 48)
we assessed our tax positions for all open tax years (Federal, years 2003
to
2006 and State, years 2002 to 2006) as of March 31, 2007 and concluded
that we
have no material FIN 48 liabilities to be recognized at this time
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Note
13.
Fair Market Value of Financial Instruments
We
estimate the fair market value of our financial instruments using available
market information and other appropriate valuation methodologies. These
fair
market value estimates generally incorporate discounted future cash flows
at
current market discount rates for comparable investments. We validate our
fair
market value estimates on a quarterly basis by obtaining fair market value
estimates from dealers for securities who make a market in these financial
instruments and look at recent post period end acquisitions and sales.
We
believe the estimates we use reasonably reflect the values we may be able
to
receive should we choose to sell them. Many factors must be considered
in order
to estimate fair market values, including, but not limited to interest
rates,
prepayment rates, amount and timing of credit losses, supply and demand,
liquidity, and other market factors. Accordingly, our estimates are inherently
subjective in nature and involve uncertainty and judgment to interpret
relevant
market and other data. Amounts realized in actual sales may differ from
the fair
market values presented.
The
following table presents the carrying values and estimated fair market
values of
our financial instruments as of March 31, 2007 and December 31,
2006.
Fair
Market Value of Financial Instruments
(In
thousands)
|
|
March
31, 2007
|
|
December
31, 2006
|
|
|
|
Carrying
Value
|
|
Fair
Market
Value
|
|
Carrying
Value
|
|
Fair
Market
Value
|
|
Assets
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Real
estate loans (held-for-investment)
|
|
$
|
8,706,370
|
|
$
|
8,641,581
|
|
$
|
9,352,107
|
|
$
|
9,268,914
|
|
Real
estate securities (available-for-sale)
|
|
|
3,600,462
|
|
|
3,600,462
|
|
|
3,232,767
|
|
|
3,232,767
|
|
Other
real estate investments (trading)
|
|
|
50,057
|
|
|
50,057
|
|
|
—
|
|
|
—
|
|
Cash
and cash equivalents
|
|
|
91,656
|
|
|
91,656
|
|
|
168,016
|
|
|
168,016
|
|
Derivative
assets
|
|
|
18,424
|
|
|
18,424
|
|
|
26,827
|
|
|
26,827
|
|
Restricted
cash
|
|
|
340,114
|
|
|
340,114
|
|
|
112,167
|
|
|
112,167
|
|
Accrued
interest receivable
|
|
|
64,814
|
|
|
64,814
|
|
|
70,769
|
|
|
70,769
|
|
Liabilities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Redwood
debt
|
|
|
1,879,783
|
|
|
1,879,783
|
|
|
1,856,208
|
|
|
1,856,208
|
|
ABS
issued
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Sequoia
|
|
|
7,203,181
|
|
|
7,158,118
|
|
|
7,664,066
|
|
|
7,627,644
|
|
Acacia
|
|
|
2,737,855
|
|
|
2,696,902
|
|
|
2,309,673
|
|
|
2,302,427
|
|
Madrona
|
|
|
5,472
|
|
|
5,510
|
|
|
5,485
|
|
|
5,510
|
|
Total
ABS issued
|
|
|
9,946,508
|
|
|
9,860,530
|
|
|
9,979,224
|
|
|
9,935,581
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Derivative
liabilities
|
|
|
7,209
|
|
|
7,209
|
|
|
6,046
|
|
|
6,046
|
|
Commitments
to purchase
|
|
|
192
|
|
|
192
|
|
|
168
|
|
|
168
|
|
Accrued
interest payable
|
|
|
51,709
|
|
|
51,709
|
|
|
50,590
|
|
|
50,590
|
|
Junior
subordinated notes
|
|
|
100,000
|
|
|
100,000
|
|
|
100,000
|
|
|
100,000
|
|
Methodologies
we use to estimate fair market values for various asset types are described
below.
|
· |
Residential
real estate loan fair market values are determined by available
market
quotes and discounted cash flow
analyses.
|
|
· |
Commercial
real estate loan fair market values are determined by appraisals
on
underlying collateral and discounted cash flow
analyses.
|
|
· |
Real
estate securities fair market values are determined by discounted
cash
flow analyses and other valuation techniques using market pricing
assumptions confirmed by third party dealer/pricing
indications.
|
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
|
· |
Other
real estate investments
|
|
· |
Other
real estate investments fair market values are determined by
discounted
cash flow analyses and other valuation techniques using market
pricing
assumptions confirmed by third party dealer/pricing
indications.
|
|
·
|
Derivative
assets and liabilities
|
|
· |
Fair
market values on interest rate agreements are determined by third
party
vendor modeling software and from valuations provided by dealers
active in
derivative markets.
|
|
·
|
Cash
and cash equivalents
|
|
· |
Includes
cash on hand and highly liquid investments with original maturities
of
three months or less. Fair market values equal carrying
values.
|
|
· |
Includes
interest-earning cash balances in ABS entities for the purpose
of
distribution to bondholders and reinvestment. Due to the short-term
nature
of the restrictions, fair market values approximate carrying
values.
|
|
·
|
Accrued
interest receivable and payable
|
|
· |
Includes
interest due and receivable on assets and due and payable on
our
liabilities. Due to the short-term nature of when these interest
payments
will be received or paid, fair market values approximate carrying
values.
|
|
· |
All
Redwood debt is adjustable and matures within one year; fair
market values
approximate carrying values.
|
|
· |
Fair
market values are determined by discounted cash flow analyses
and other
valuation techniques confirmed by third party/dealer pricing
indications.
|
|
·
|
Commitments
to purchase
|
|
· |
Fair
market values are determined by discounted cash flow analyses
and other
valuation techniques confirmed by third party/dealer pricing
indications.
|
|
·
|
Junior
subordinated notes
|
|
· |
Junior
subordinated notes are adjustable; fair market values approximate
carrying
values.
|
Note
14.
Stockholders’ Equity
Accumulated
Other Comprehensive Income
(Loss)
Accumulated
other comprehensive income (loss) includes the difference between fair
market
value and our amortized cost of interest rate agreements accounted for
as cash
flow hedges and our real estate securities accounted for as AFS. Also included
in this account are any net gains or losses from interest rate agreements
accounted for as cash flow hedges that have been terminated and where the
hedge
transactions are still likely to occur. At March 31, 2007, there was $1.5
million of net gains from terminated hedges, of which a minimal amount
will be
amortized into income over the next twelve months. At December 31, 2006,
there
was $0.6 million of net losses from terminated hedges. At March 31, 2007
the
unrealized loss on AFS was $6.4 million, a decline of $92.8 million from
the
unrealized gain of $86.4 million at December 31, 2006.
The
following table provides a summary of the components of accumulated other
comprehensive income (loss) as of March 31, 2007 and December 31,
2006.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Accumulated
Other Comprehensive Income
(Loss)
(In
thousands)
|
|
March
31,
2007
|
|
December
31,
2006
|
|
|
|
|
|
|
|
Net
unrealized gains (losses) on real estate securities
|
|
$
|
(6,364
|
)
|
$
|
86,434
|
|
Net
unrealized gains on interest rate agreements accounted for as
cash flow
hedges
|
|
|
181
|
|
|
6,724
|
|
Total
accumulated other comprehensive (loss) income
|
|
$
|
(6,183
|
)
|
$
|
93,158
|
|
Note
15. Equity Compensation Plans
Incentive
Plan
In
March
2006, we amended the previously amended 2002 Redwood Trust, Inc. Incentive
Stock
Plan (Incentive Plan) for executive officers, employees, and non-employee
directors. This amendment was approved by our stockholders in May 2006.
The
Incentive Plan authorizes our board of directors (or a committee appointed
by
our board of directors) to grant incentive stock options as defined under
Section 422 of the Code (ISOs), options not so qualified (NQSOs), deferred
stock
units, restricted stock, performance shares, stock appreciation rights,
limited
stock appreciation
rights (awards), and DERs to eligible recipients other than non-employee
directors. ISOs and NQSOs awarded to employees and directors have a maximum
term
of ten years. Stock options, deferred stock units, and restricted stock
granted
to employees generally vest over a four-year period. Non-employee directors
are
automatically provided annual awards under the Incentive Plan that generally
vest immediately. The Incentive Plan has been designed to permit the
compensation committee of our board of directors to grant and certify awards
that qualify as performance-based and otherwise satisfy the requirements
of
Section 162(m) of the Code. As of March 31, 2007 and December 31, 2006,
492,647
and 514,217 shares of common stock, respectively, were available for
grant.
A
summary
of stock option activity during the three months ended March 31, 2007 and
2006
are presented in the table below. See Note
2
for a
discussion on the assumptions used to value stock options at grant
date.
Stock
Options Activity
|
|
Three
Months Ended March 31,
|
|
|
|
2007
|
|
2006
|
|
|
|
Shares
|
|
Weighted
Average
Exercise
Price
|
|
Shares
|
|
Weighted
Average
Exercise
Price
|
|
Stock
Options Outstanding
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Outstanding
options at beginning of period
|
|
|
1,072,622
|
|
$
|
34.70
|
|
|
1,548,412
|
|
$
|
32.60
|
|
Options
granted
|
|
|
15,715
|
|
|
55.76
|
|
|
33,871
|
|
|
41.09
|
|
Options
exercised
|
|
|
(54,176
|
)
|
|
32.24
|
|
|
(39,420
|
)
|
|
23.81
|
|
Options
forfeited
|
|
|
(1,699
|
)
|
|
56.11
|
|
|
(34,906
|
)
|
|
41.07
|
|
Outstanding
options at end of period
|
|
|
1,032,462
|
|
$
|
35.11
|
|
|
1,507,957
|
|
$
|
33.19
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options
exercisable at period-end
|
|
|
925,679
|
|
$
|
32.76
|
|
|
1,244,756
|
|
$
|
29.85
|
|
Weighted
average fair market value of options granted during the
period
|
|
|
|
|
$
|
4.29
|
|
|
|
|
$
|
3.41
|
|
With
the
adoption of FAS 123R on January 1, 2006, the grant date fair market value
of all
remaining unvested stock options (which includes the value of any future
dividend equivalent rights) is expensed to the consolidated statements
of income
over the remaining vesting period of each option.
For
both
the three months ended March 31, 2007 and 2006, expenses related to stock
options were $0.6 million. As of March 31, 2007, there was $1.4 million
of
unrecognized compensation cost related to unvested stock options. These
costs
will be expensed over a weighted-average period of 1.2 years.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
The
total
intrinsic value or gain (fair market value less exercise price) for options
exercised was $1.3 million for both the three months ended March 31, 2007
and
2006. The net cash proceeds received from the exercise of stock options
was $1.0
million and $0.4 million for the three months ended March 31, 2007 and
2006,
respectively.
The
aggregate intrinsic value of the options outstanding and options currently
exercisable was $18 million and $25 million at March 31, 2007 and December
31,
2006, respectively.
In
the
first quarter of 2007, officers exercised 23,487 in the money options and
surrendered 15,715 shares to pay exercise costs and taxes of $1 million
on the
gains on the options exercised.
The
following table summarizes information about stock options outstanding
at March
31, 2007.
Stock
Options Exercise Prices as of March
31, 2007
|
|
Options
Outstanding
|
|
Options
Exercisable
|
|
Range
of
Exercise
Prices
|
|
Number
Outstanding
|
|
Weighted-Average
Remaining
Contractual
Life
|
|
Weighted-Average
Exercise
Price
|
|
Number
Exercisable
|
|
Weighted-Average
Exercise
Price
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$10
to $20
|
|
|
314,783
|
|
|
2.40
|
|
$
|
12.90
|
|
|
314,783
|
|
$
|
12.90
|
|
$20
to $30
|
|
|
203,561
|
|
|
1.59
|
|
|
21.66
|
|
|
203,511
|
|
|
21.66
|
|
$30
to $40
|
|
|
10,000
|
|
|
6.11
|
|
|
36.19
|
|
|
10,000
|
|
|
36.19
|
|
$40
to $50
|
|
|
49,271
|
|
|
5.46
|
|
|
43.35
|
|
|
49,171
|
|
|
43.35
|
|
$50
to $60
|
|
|
454,046
|
|
|
6.59
|
|
|
55.58
|
|
|
347,413
|
|
|
55.58
|
|
$60
to $63
|
|
|
801
|
|
|
5.37
|
|
|
62.54
|
|
|
801
|
|
|
62.54
|
|
$
0
to $63
|
|
|
1,032,462
|
|
|
4.27
|
|
|
|
|
|
925,679
|
|
|
|
|
Restricted
Stock
As
of
March 31, 2007 and December 31, 2006, 23,124 and 27,524 shares, respectively,
of
restricted stock were outstanding. Restrictions on these shares lapse through
January 2011. Restricted stock activity for the three months ended March
31,
2007 and 2006 is presented in the table below. There were no restricted
stock
awards granted during either the first three months of 2007 or 2006.
Restricted
Stock Outstanding
|
|
Three
Months Ended March 31, 2007
|
|
Weighted
Average Grant Date Fair Market Value
|
|
Three
Months Ended March 31, 2006
|
|
Weighted
Average Grant Date Fair Market Value
|
|
|
|
Shares
|
|
|
|
Shares
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Restricted
stock outstanding at the beginning of period
|
|
|
27,524
|
|
$
|
49.57
|
|
|
21,038
|
|
$
|
45.96
|
|
Stock
for which restrictions lapsed
|
|
|
(4,308
|
)
|
|
46.88
|
|
|
(972
|
)
|
|
53.74
|
|
Restricted
stock forfeited
|
|
|
(92
|
)
|
|
56.18
|
|
|
(1,996
|
)
|
|
45.03
|
|
Restricted
stock outstanding at end of period
|
|
|
23,124
|
|
$
|
50.05
|
|
|
18,070
|
|
$
|
45.65
|
|
The
cost
of these grants is amortized over the vesting term using an accelerated
method
in accordance with FASB Interpretation No. 28 Accounting
for Stock Appreciation Rights and Other Variable Stock Options or Award
Plans
(FIN
28), and FAS 123R. For both the three months ended March 31, 2007 and 2006,
the
expenses related to restricted stock were $0.1 million. As of March 31,
2007,
there was $0.7 million of unrecognized compensation cost related to unvested
restricted stock. This cost will be recognized over a weighted average
period of
1.1 years.
Deferred
Stock Units
Deferred
stock units (DSUs) are granted or purchased by participants in the Executive
Deferred Compensation Plan. Some of the DSUs awarded may have a vesting
period
associated with them. Restrictions on some of the outstanding DSUs lapse
through
2013.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
For
the
three months ended March 31, 2007 and 2006, expenses related to DSUs were
$4.0
million and $2.0 million, respectively. As of March 31, 2007, there was
$15.6
million of unrecognized compensation cost related to nonvested DSUs. This
cost
will be recognized over a weighted-average period of 1.1 years. As of December
31, 2006, there was $19.4 million of unrecognized compensation cost related
to
nonvested DSUs. As of March 31, 2007 and December 31, 2006, the number
of
outstanding DSUs that had vested was 223,285 and 153,073,
respectively.
The
tables below provide summaries of the balances and activities relating
to the
DSUs for the three months ended March 31, 2007 and for the year ended December
31, 2006.
Deferred
Stock Units
(In
thousands)
|
|
March
31,
2007
|
|
December
31,
2006
|
|
|
|
|
|
|
|
Value
of DSUs at grant
|
|
$
|
37,366
|
|
$
|
36,542
|
|
Participant
forfeitures
|
|
|
(322
|
)
|
|
(110
|
)
|
Distribution
of DSUs
|
|
|
(2,447
|
)
|
|
(347
|
)
|
Change
in value at period end since grant
|
|
|
2,100
|
|
|
6,763
|
|
Value
of DSUs at end of period
|
|
$
|
36,697
|
|
$
|
42,848
|
|
Deferred
Stock Units Activity
(In
thousands, except unit amounts)
|
|
Three
Months Ended March 31,
|
|
|
|
2007
|
|
2006
|
|
|
|
Units
|
|
Fair
Market Value
|
|
Weighted
Average Grant Date Fair Market Value
|
|
Units
|
|
Fair
Market Value
|
|
Weighted
Average Grant Date Fair Market Value
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance
at beginning of period
|
|
|
737,740
|
|
$
|
42,848
|
|
$
|
48.91
|
|
|
418,126
|
|
$
|
17,252
|
|
$
|
45.65
|
|
Grants
of DSUs
|
|
|
13,431
|
|
|
784
|
|
|
58.35
|
|
|
72,995
|
|
|
3,012
|
|
|
41.26
|
|
Distribution
of DSUs
|
|
|
(43,751
|
)
|
|
(2,100
|
)
|
|
47.99
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Change
in valuation during period
|
|
|
—
|
|
|
(4,623
|
)
|
|
—
|
|
|
—
|
|
|
1,011
|
|
|
—
|
|
Participant
forfeitures
|
|
|
(4,150
|
)
|
|
(212
|
)
|
|
51.20
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Net
change in number/value of DSUs
|
|
|
(34,470
|
)
|
|
(6,151
|
)
|
|
—
|
|
|
72,995
|
|
|
4,023
|
|
|
—
|
|
Balance
at end of period
|
|
|
703,270
|
|
$
|
36,697
|
|
$
|
49.60
|
|
|
491,121
|
|
$
|
21,275
|
|
$
|
45.00
|
|
Executive
Deferred Compensation Plan
In
May
2002, our board of directors approved the 2002 Executive Deferred Compensation
Plan (EDCP). The EDCP allows eligible employees and directors to defer
portions
of current salary and certain other forms of compensation. Redwood matches
some
deferrals. Compensation deferred under the EDCP are assets of Redwood and
subject to the claims of the general creditors of Redwood. The EDCP allows
for
the investment of deferrals in either an interest crediting account or
additional DSUs. The rate of accrual in the interest crediting account
is set
forth in the EDCP. For deferrals prior to July 1, 2004, the accrual rate
is
based on a calculation of the marginal rate of return on our portfolio
of
earning assets. For deferrals after July 1, 2004 and through December 31,
2006,
the accrual rate is based on 120% of the long-term applicable federal rate
(AFR)
or the equivalent rate of employee pre-selected publicly traded mutual
funds.
For deferrals subsequent to December 31, 2006 - and beginning July 1, 2007,
for
all prior deferrals - the accrual rate is based on 120% of AFR. Participants
may
also use their deferrals to acquire additional DSUs.
For
the
three months ended March 31, 2007 and 2006, deferrals of $1.1 million and
$1.4
million, respectively, were made under the EDCP. The following table provides
detail on changes in participants’ EDCP accounts for the three months ended
March 31, 2007 and 2006.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
EDCP
Activity
(In
thousands)
|
|
Three
Months Ended March 31,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Transfer
into participants’ EDCP accounts
|
|
$
|
1,088
|
|
$
|
1,366
|
|
Accrued
interest earned in
EDCP
|
|
|
391
|
|
|
296
|
|
Participants’
withdrawals
|
|
|
(793
|
)
|
|
(241
|
)
|
Net
change in participants’ EDCP accounts
|
|
$
|
686
|
|
$
|
1,421
|
|
Balance
at beginning of period
|
|
$
|
9,693
|
|
$
|
7,005
|
|
Balance
at end of period
|
|
$
|
10,379
|
|
$
|
8,426
|
|
The
following table provides detail on the financial position of the EDCP at
March
31, 2007 and December 31, 2006.
Balance
of Participants’ EDCP Accounts
(In
thousands)
|
|
|
|
|
|
March
31, 2007
|
|
December
31, 2006
|
|
|
|
|
|
|
|
|
|
Participants’
deferrals
|
|
$
|
6,938
|
|
$
|
6,643
|
|
Accrued
interest credited
|
|
|
3,441
|
|
|
3,050
|
|
Balance
of participants’ EDCP accounts
|
|
$
|
10,379
|
|
$
|
9,693
|
|
Employee
Stock Purchase Plan
In
May
2002, our stockholders approved the 2002 Redwood Trust, Inc. Employee Stock
Purchase Plan (ESPP), effective July 1, 2002. The purpose of the ESPP is
to give
our employees an opportunity to acquire an equity interest in Redwood through
the purchase of shares of common stock at a discount. The ESPP allows eligible
employees to purchase common stock at 85% of its fair market value, subject
to
limits. Fair market value as defined under the ESPP is the lesser of the
closing
market price of the common stock on the first day of the calendar year
or the
first day of the calendar quarter of that year.
The
ESPP
allows a maximum of 100,000 shares of common stock to be purchased in aggregate
for all employees. As of March 31, 2007 and December 31, 2006, 38,228 and
35,570
shares have been purchased. As of March 31, 2007 and December 31, 2006,
there
remained a negligible amount of uninvested employee contributions in the
ESPP.
The
table
below presents the activity in the ESPP for the three months ended March
31,
2007 and 2006.
Employee
Stock Purchase Plan
(In
thousands)
|
|
Three
Months Ended March 31,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Balance
at beginning of period
|
|
$
|
3
|
|
$
|
13
|
|
Transfer
in of participants’ payroll deductions from the ESPP
|
|
|
124
|
|
|
87
|
|
Cost
of common stock issued to participants under the terms of the
ESPP
|
|
|
(118
|
)
|
|
(95
|
)
|
Net
change in participants’ equity
|
|
$
|
6
|
|
$
|
(8
|
)
|
Balance
at end of period
|
|
$
|
9
|
|
$
|
5
|
|
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
Note
16.
Commitments and Contingencies
As
of
March 31, 2007, we were obligated under non-cancelable operating leases
with
expiration dates through 2018 for $16.4 million. The majority of the future
lease payments relate to a ten-year operating lease for our executive offices,
which expires in 2013, and a lease for additional office space at our executive
offices beginning January 1, 2008 and expiring May 31, 2018. Prior to the
beginning of the lease of the additional office space, we are subleasing
this
office space from another tenant through the end of 2007. The total lease
payments to be made under the lease expiring in 2013 and the sublease,
including
certain free-rent periods, are being recognized as office rent expense
on
straight-line basis over the lease term. Operating lease expense was $0.3
million and $0.2 million for the quarters ended March 31, 2007 and 2006,
respectively. Leasehold improvements for our executive offices are amortized
into expense over the ten-year lease term. The unamortized leasehold improvement
balance at March 31, 2007 and December 31, 2006 was $3.0 million and $2.0
million, respectively. We will record additional leasehold improvements
as we
prepare the additional office space.
Future
Lease Commitments by Year
(In
thousands)
|
|
March
31, 2007
|
|
|
|
|
|
2007
(nine months)
|
|
$
|
988
|
|
2008
|
|
|
1,636
|
|
2009
|
|
|
1,680
|
|
2010
|
|
|
1,709
|
|
2011
|
|
|
1,831
|
|
2012
and thereafter
|
|
|
8,574
|
|
Total
|
|
$
|
16,418
|
|
At
March
31, 2007, to our knowledge there were no legal proceedings to which we
were a
party or to which any of our properties was subject.
The
table
below shows our commitments to purchase loans and securities as of March
31,
2007. The loan purchase commitments represent derivative instruments with
an
estimated value of negative $0.2 million at March 31, 2007 under FAS No.
149,
Amendment
of Statement 133 on Derivative Instruments and Hedging
Activities
(FAS
149). This is included in net recognized gains and valuation adjustments
on our
Statements of Income.
Commitments
to Purchase - Principal Amount
(In
thousands)
|
|
March
31, 2007
|
|
|
|
|
|
Real
estate loans
|
|
$
|
81,676
|
|
Real
estate securities
|
|
|
—
|
|
Total
|
|
$
|
81,676
|
|
We
have
committed to purchase commercial CES from a securitization entity to be
formed
in 2007, pending adherence to representations and underwriting criteria
as set
forth in the agreement. At March 31, 2007, there were approximately $115
million
of commercial mortgage loans originated for this future securitization.
At March
31, 2007, we estimate the value of this commitment to be
negligible.
Stock
Repurchases
We
announced stock repurchase plans on various dates from September 1997 through
November 1999 for the total repurchase of a total of 7,455,000 shares.
None of
these plans have expiration dates. There were no repurchases during the
first
quarter of 2007 and 1,000,000 shares remained available for repurchase
under
those plans.
Note
17. Recent Developments
In
the
second quarter of 2007 (through May 4, 2007), we committed to purchase
$441
million
residential real estate loans,
$71
million
residential and commercial IGS, and $51 million
residential, commercial and CDO CES.
REDWOOD
TRUST, INC. AND SUBSIDIARIES
NOTES
TO FINANCIAL STATEMENTS
In
the
second quarter of 2007 (through May 4,
2007),
we committed to sell residential IGS with market values of $3.5
million
for an estimated GAAP loss of $0.4
million,
and residential CES with market values of $5.5 million for an estimated
GAAP
loss of $0.1 million.
In
the
second quarter of 2007, we intend to securitize $1 billion of residential
real
estate loans through our Sequoia program.
In
April of 2007, we priced a $500 million CDO backed
by option ARM residential securities.
In
April
of 2007, residential CES with a principal value of $1.4 million and residential
IGS with a principal value of $1.4 million were called, for total estimated
GAAP
gains of $0.7 million.
In
April
of 2007, we called one Sequoia securitization. The principal balance of
the
residential real estate loans at the time of call was $139 million. We
replaced
the associated ABS issued liabilities with Redwood debt.
In
April
of 2007, the call of Acacia CDO 4 Ltd. was settled, resulting in the
extinguishment of $242 million of Acacia ABS issued. The associated assets
were
sold during the first quarter of 2007 in anticipation of the call.
In
April
of 2007, we issued 226,726 shares of common stock through our DSPP for
net
proceeds of $11 million.
Item
2.
|
MANAGEMENT’S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
|
Cautionary
Statement
This
Form
10-Q contains forward-looking statements within the safe harbor provisions
of
the Private Securities Litigation Reform Act of 1995. Statements that are
not
historical in nature, including the words “anticipated,” “estimated,” “should,”
“expect,” “believe,” “intend,” and similar expressions, are intended to identify
forward-looking statements. These forward-looking statements are subject
to
risks and uncertainties, including, among other things, those described
in our
Annual Report on Form 10-K for the year ended December 31, 2006 under the
caption “Risk Factors.” Other risks, uncertainties, and factors that could cause
actual results to differ materially from those projected are detailed from
time
to time in reports filed by us with the Securities and Exchange Commission
(SEC), including Forms 10-K, 10-Q, and 8-K.
We
undertake no obligation to publicly update or revise any forward-looking
statements, whether as a result of new information, future events, or otherwise.
In light of these risks, uncertainties, and assumptions, the forward-looking
events mentioned or discussed in, or incorporated by reference into, this
Form
10-Q might not occur. Accordingly, our actual results may differ from our
current expectations, estimates, and projections.
Important
factors that may impact our actual results include changes in interest
rates and
fair market values; changes in prepayment rates; general economic conditions,
particularly as they affect the price of earning assets and the credit
status of
borrowers; the level of liquidity in the capital markets as it affects
our
ability to finance our real estate asset portfolio; and other factors not
presently identified. This Form 10-Q contains 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.
Summary
and
Outlook
Redwood
Trust, Inc., together with its subsidiaries (Redwood, we, or us), is a
financial
institution focused on investing in, financing, and managing residential
and
commercial real estate loans and securities. We seek to invest in assets
that
have the potential to provide high cash flow returns over a long period
of time
to help support our goal of distributing attractive levels of dividends
per
share. For tax purposes, we are structured as a real estate investment
trust
(REIT).
We
assume
a range of credit risks in our investments and the level of assumed risk
dictates the manner in which we finance our purchase of and derive income
from
these investments. Our primary source of income is net interest income,
which
equals the interest income we earn from our investments in loans and securities
less the interest expenses we incur from our borrowed funds and other
liabilities.
Our
investments in residential, commercial, and collateral debt obligation
(CDO)
credit enhancement securities (CES, or below investment-grade securities)
have
concentrated credit risk. We finance the acquisition of most of our first-loss
and equivalent CES that are directly exposed to credit losses with capital.
We
generally finance the acquisition of our second-loss, third-loss, and equivalent
securities through our Acacia securitization program. To date, our primary
credit enhancement investment focus has been in 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. Our CES investment
returns depend on the amount and timing of most of the interest and principal
collected on the loans in the pools supporting the securities. In an ideal
environment for most of our residential CES, we would experience fast loan
prepayments and low credit losses which would, in turn, lead to attractive
CES
returns. The return on most of our residential CES investments would be
adversely affected by slow loan prepayments and high credit losses.
Our
investments in real estate loans and investment-grade securities (IGS)
have less
concentrated credit risk. To produce an attractive investment return on
these
lower credit risk assets, we use financial leverage. We earn income based
upon
the spread between the yield on the acquired asset and the cost of funds
we
borrowed to acquire the asset. We have obtained most of the financing used
to
acquire these assets through the issuance of asset-backed securities (ABS)
under
our Sequoia and Acacia securitization programs. These financings are not
obligations of Redwood. To
further facilitate these investments, we have established and initiated
the
funding of a wholly-owned qualified REIT subsidiary – Cypress Trust, Inc. – to
hold some of our investments in high-quality investment-grade residential
securities and high-quality prime residential loans. These assets will
be funded
initially with debt, although Cypress will likely also utilize securitization
as
a form of financing in the future. We believe spread lending opportunities
with
these types of securities and loans are becoming increasingly attractive.
Our
reported GAAP net income was $18 million ($0.66 per share) in the first
quarter
of 2007, a decrease from $28 million ($1.09 per share) for the first quarter
of
2006. Our GAAP return on equity was 7% for the three months ended March
31, 2007
compared to 12% for the three months ended March 31, 2006. In the first
quarter
of 2007, we declared a regular dividend of $0.75 per share, an increase
from the
$0.70 per share regular dividend paid in each of the four quarters in
2006.
Table
1 Net Income
(In
thousands, except share
data)
|
|
Three
Months Ended March 31,
|
|
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Total
interest income
|
|
$
|
215,105
|
|
|
225,882
|
|
Total
interest expense
|
|
|
(168,096
|
)
|
|
(180,655
|
)
|
|
|
|
|
|
|
|
|
Net
interest income
|
|
|
47,009
|
|
|
45,227
|
|
|
|
|
|
|
|
|
|
Operating
expenses
|
|
|
(17,782
|
)
|
|
(12,582
|
)
|
Realized
gains on sales and calls, net
|
|
|
1,146
|
|
|
1,062
|
|
Market
valuation adjustments, net
|
|
|
(10,264
|
)
|
|
(2,932
|
)
|
Provision
for income taxes
|
|
|
(1,800
|
)
|
|
(2,760
|
)
|
Net
income
|
|
$
|
18,309
|
|
|
28,015
|
|
|
|
|
|
|
|
|
|
Diluted
common shares
|
|
|
27,684,029
|
|
|
25,702,730
|
|
Net
income per share
|
|
$
|
0.66
|
|
|
1.09
|
|
The
largest factor in the decline of net income was a $7 million increase in
negative mark-to-market valuation adjustments on securities and interest
rate
agreements classified as trading. This decrease in fair value for these
securities reflects the overall market decline in prices for real estate
securities, and in particular for securities backed by subprime and alt-a
loans,
that occurred during the first quarter. We had no securities classified
as
trading in the first quarter of 2006 and therefore were not exposed to
these
negative mark-to-market valuation adjustments in net income. Another factor
that
contributed to the decline in net income was a $5 million increase in operating
expenses, of which $2 million was related to severance charges, and $3
million
related to increases in personnel and systems costs associated with our
plan to
diversify and grow our business.
On
the
positive side, our net interest income increased to $47 million during
the
quarter from $45 million in the same period last year. Higher net interest
income from our IGS and CES portfolios more than offset the decline in
net
interest income from a reduced balance of adjustable-rate residential loans
financed under our Sequoia program and from a $3 million charge related to an
expected loss on a commercial real estate loan. In addition, net income
for the
period was positively affected by a $1 million decrease in the provision
for
taxes from the same period last year.
Accounting
standards are moving in the direction of increased use of mark-to-market
(MTM)
accounting. As a consequence, while MTM accounting may have the benefit
of
increasing transparency, it will increasingly create substantial volatility
in
GAAP results.
Over
the
past year and a half, capital market pricing for residential real estate
assets
continued to tighten (increase in price), while at the same time underwriting
standards and loan quality was deteriorating. We have been cautioning about
and
preparing for a correction to these market conditions. In the first quarter,
the
long-awaited correction process in the residential mortgage market began
as
prices for real estate securities generally widened in response to credit
concerns in the subprime sector and as mortgage originators began taking
steps
to tighten underwriting standards. We believe both of these factors will
have a
positive long-term impact on our residential business; we will able to
buy
higher quality assets at more attractive prices.
While
we
believe the widening of spreads will be advantageous to us in the long-term,
it
had a negative accounting impact in the first quarter as MTM adjustments
to our
existing real estate securities portfolio caused our GAAP book accounting
value
and our GAAP earnings to decline. The MTM adjustments had little impact
on the
economics of our business. The vast majority of our credit-sensitive investments
are backed by prime or near-prime alt-a borrowers whose credit performance
continues to exceed our modeling expectations. Our expected cash flows
were
largely unaffected. Additionally, we experienced no margin calls and had
no
other liquidity issues, as virtually all the underlying securities were
financed
either through Acacia, non-recourse warehouse facilities, or with capital.
We
note
that the disruption in the capital markets not only affected real estate
asset
spreads, but liability spreads as well. Under GAAP, we are required to
carry our
real estate securities on our balance sheet at their fair value but we
are not
permitted to adjust paired Acacia ABS issued liabilities to fair value.
Using
the assumptions described in Note
13
to our
financial statements, we estimate that if we had recorded our Acacia ABS
issued
at fair value, our book value at March 31, 2007 would have been higher
than
reported by $41 million ($1.51 per share).
For
us,
there is one general real economic effect related to reduced asset prices
- and
it’s positive. When asset prices go down, as they recently have, we can buy
new
assets more cheaply. Although we remain cautious as the outlook for housing
remains unclear, we are finding some interesting, and perhaps extraordinary
investment opportunities in this difficult environment of falling prices.
On
average, however, we expect we will benefit far more from better pricing
and
much better asset quality in our ongoing core business than we will from
buying
distressed assets. We expect our CES acquisitions to continue at a measured
pace
for the remainder of the year.
In
April,
the turbulence in the residential mortgage markets began to impact the
CDO
market. Many CDOs completed in the beginning in 2006 and those marketed
in the
first quarter of 2007 had a high concentration of securities backed BBB
and BBB-
rated subprime securities from the 2006 vintage. The volume of CDO activity
has
now slowed and CDO debt spreads, especially for securities rated below
AAA, have
widened significantly. The level of our CDO activity in the second half
of the
year will largely depend on market conditions and debt spreads. Although
we
believe the likelihood is low, there may be a period of time where the
CDO
market temporarily shuts down as a financing option or debt spreads make
financing through a CDO structure unattractive. If the CDO market becomes
unavailable or unattractive, we will have to look to other potential sources
of
financing, such as Redwood debt, to fund acquisitions, or else we may slow
our
pace of acquisitions.
In
April,
we priced a $500 million CDO backed by option ARM residential securities.
The
transaction is scheduled to close in May. We have another Acacia CDO planned
for
the second quarter. We are likely to complete this transaction though it
is
possible that the transaction may be delayed or even cancelled due to
unfavorable market conditions. The securities acquired to-date for this
planned
CDO are held in a non-recourse (to Redwood) warehouse facility.
In
the
longer term, we believe our CDO business will likely benefit from recent
market
developments. We believe that our successful track record as a CDO manager
and
our willingness to invest in the equity of our CDO transactions will give
us a
competitive advantage. Additionally, we believe existing non-recourse warehouse
facilities provided by lenders during the two-to-six month ramp-up phase
will
likely change. Going forward, we believe these warehouse providers will
require
issuers, including Redwood, to assume more risk during the aggregation
period.
Consequently, the competitive advantage will go to CDO managers, like Redwood,
with strong balance sheets and the hedging expertise necessary to bear
this
risk. Over the long-term, we believe the likely result for us will be decreased
competition and increased margins in our CDO business.
Commercial
real estate in the U.S. is healthy. In a manner similar to residential
real
estate, however, both underwriting standards and respect for risk have
been
deteriorating. We thought that the downturn in residential, when it hit,
might
slow or halt aggressiveness in the financing markets for commercial real
estate.
At least in some respects, this seems to be happening. For instance, the
rating
agencies are increasing capital requirements for commercial securitizations,
spreads have widened, and some B-piece buyers have been unwilling to meet
their
purchase commitments. To the extent this occurs, we believe it is beneficial
for
Redwood’s future opportunities.
During
the first quarter we raised $19 million capital through our direct stock
purchase plan (DSPP). We raised an additional $11 million through this
plan in
April 2007. Our plans for raising additional capital this year are uncertain
and
will largely depend on the level of our investment opportunities. In the
near-term, we expect to continue to raise capital through our DSPP and
we may
issue additional trust preferred securities, junior subordinated notes,
or other
long-term debt.
We
note
that more recently (in the beginning of the second quarter), we have observed
a
tightening of spreads with respect to some assets. Accordingly, some market
observers might conclude that the worst of the housing recession has past.
We
would caution that such predictions may very well be premature. In the
event the
housing market weakens further, we could expect increased losses and
delinquencies in our portfolios, and asset prices could decline further.
Moreover, a general economic recession in the U.S. economy would likely
accelerate and deepen those trends. That being said, we believe we are
prepared
to withstand those trends, and in the long run, we expect that they may
generate
attractive opportunities for us.
In
summary, we structured Redwood Trust with the goal of being a reliable
generator
of earnings and dividends under a variety of market conditions, and we
feel that
our strategy is holding up well given the volatility in the marketplace.
While
our actual investment decisions will depend largely on market conditions
and
opportunities, we have no plans to change our general approach to acquiring
high-quality real estate assets and creating high-quality securitization
products.
Subprime
Exposure
Most
of
the current problems in the residential loan market involve subprime
loans.
Recently, mortgage originators have been inundated by loan repurchase
demands
from investors due to underwriting issues and the poor credit performance
of
subprime borrowers. We do not originate, acquire or securitize subprime
mortgages. Accordingly we are not subject to subprime loan repurchase
issues.
We
have
subprime loan exposure through our investment in real estate securities
backed
by subprime loans. At March 31, 2007, our subprime investments consisted
of $9
million of CES, $20 million of NIMS and residuals and $471 million of
IGS. At
March 31, 2007, $386 million of these subprime securities were financed
through
Acacia securitization entities, $78 million in non-recourse warehouse
facilities
and $36 million with capital. As a result of these financing structures,
market
value declines do not subject us to margin calls or other liquidity issues.
Our
principal subprime exposure results from potential financial statement
mark-to-market adjustments to the carrying value of subprime securities.
This
risk is more fully discussed in the Potential GAAP Earnings Volatility
section
later in this document. Additional information with respect to our subprime
securities portfolio is set forth in Table 23.
RESULTS
OF
OPERATIONS
Interest
Income
Total
interest income consists of interest earned on consolidated earning assets
adjusted for amortization of discounts and premiums and provisions for
loan
credit losses. The table below summarizes interest income earned on real
estate
loans, real estate securities, other real estate investments, and
cash.
Table
2 Interest Income and Yield
(Dollars
in thousands)
|
|
Three
Months Ended March 31,
|
|
|
|
2007
|
|
2006
|
|
|
|
Interest
Income
|
|
Percent
of Total
Interest
Income
|
|
Average
Balance
|
|
Yield
|
|
Interest
Income
|
|
Percent
of Total
Interest
Income
|
|
Average
Balance
|
|
Yield
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Real
estate loans, net of provision for credit losses
|
|
$
|
126,850
|
|
|
58.97
|
%
|
$
|
8,732,333
|
|
|
5.81
|
%
|
$
|
166,902
|
|
|
73.89
|
%
|
$
|
12,599,296
|
|
|
5.30
|
%
|
Real
estate securities
|
|
|
83,458
|
|
|
38.80
|
%
|
|
3,265,496
|
|
|
10.22
|
%
|
|
56,503
|
|
|
25.01
|
%
|
|
2,386,492
|
|
|
9.47
|
%
|
Other
real estate investments
|
|
|
2,465
|
|
|
1.15
|
%
|
|
37,169
|
|
|
26.53
|
%
|
|
—
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Cash
and cash equivalents
|
|
|
2,332
|
|
|
1.08
|
%
|
|
244,816
|
|
|
3.81
|
%
|
|
2,477
|
|
|
1.10
|
%
|
|
244,002
|
|
|
4.06
|
%
|
Total
interest income
|
|
$
|
215,105
|
|
|
100.00
|
%
|
$
|
12,279,814
|
|
|
7.01
|
%
|
$
|
225,882
|
|
|
100.00
|
%
|
$
|
15,229,790
|
|
|
5.93
|
%
|
The
table
below details how our interest income changed by portfolio as a result
of
changes in consolidated asset balances (“volume”) and yield (“rate”) for the
three months ended March 31, 2007 as compared to the three months ended
March
31, 2006.
Table
3 Volume and Rate Changes for Interest Income
(In
thousands)
|
|
Change
in Interest Income
Three
Months Ended
March
31, 2007 Versus March 31, 2006
|
|
|
|
Volume
|
|
Rate
|
|
Total
Change
|
|
|
|
|
|
|
|
|
|
Real
estate loans, net of provisions for credit
losses
|
|
$
|
(51,225
|
)
|
$
|
11,173
|
|
$
|
(40,052
|
)
|
Real
estate securities
|
|
|
20,575
|
|
|
6,380
|
|
|
26,955
|
|
Other
real estate investments
|
|
|
2,465
|
|
|
—
|
|
|
2,465
|
|
Cash
and cash equivalents
|
|
|
8
|
|
|
(153
|
)
|
|
(145
|
)
|
Total
interest income
|
|
$
|
(28,177
|
)
|
$
|
17,400
|
|
$
|
(10,777
|
)
|
Note:
Volume change is the change in average portfolio balance between periods
multiplied by the rate earned in the earlier period. Rate change is the
change
in rate between periods multiplied by the average portfolio balance in
the prior
period. Interest income changes that result from changes in both rate and
volume
were allocated to the rate change amounts shown in the table.
Below
is
a further breakdown and discussion of the year-over-year changes for real
estate
loans, real estate securities, other real estate investments, and
cash.
Interest
Income -
Loans
The
following table provides detail on interest income earned on our residential
and
commercial real estate loan portfolios for the three months ended March
31, 2007
and 2006.
Table
4 Consolidated Real Estate Loans
(Dollars
in
thousands) |
|
|
|
|
|
|
|
|
|
|
|
Three
months ended March 31, 2007
Yield
as a Result of
|
|
|
|
Interest
Income
|
|
Net
(Premium)
Discount
Amortization
|
|
Provision
for Credit
Losses
|
|
Total
Interest Income
|
|
Average
Balance
|
|
Interest
Income
|
|
(Premium)
Discount
Amortization/
Credit
Provision
|
|
Total
Interest
Income
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
loans
|
|
$
|
142,350
|
|
$
|
(11,726
|
)
|
$
|
(1,481
|
)
|
$
|
129,143
|
|
$
|
8,704,147
|
|
|
6.54
|
%
|
|
(0.61
|
)%
|
|
5.93
|
%
|
Commercial
loans
|
|
|
34
|
|
|
21
|
|
|
(2,348
|
)
|
|
(2,293
|
)
|
|
28,186
|
|
|
0.48
|
%
|
|
(33.02
|
)%
|
|
(32.54
|
)%
|
Total
loans
|
|
$
|
142,384
|
|
$
|
(11,705
|
)
|
$
|
(3,829
|
)
|
$
|
126,850
|
|
$
|
8,732,333
|
|
|
6.53
|
%
|
|
(0.72
|
)%
|
|
5.81
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
Three
months ended March 31, 2006
Yield
as a Result of
|
|
|
|
Interest
Income
|
|
Net
(Premium)
Discount
Amortization
|
|
Provision
for
Credit
Losses
|
|
Total
Interest Income
|
|
Average
Balance
|
|
Interest
Income
|
|
(Premium)
Discount
Amortization/
Credit
Provision
|
|
Total
Interest
Income
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
loans
|
|
$
|
177,880
|
|
$
|
(12,075
|
)
|
$
|
(141
|
)
|
$
|
165,664
|
|
$
|
12,542,519
|
|
|
5.67
|
%
|
|
(0.39
|
)%
|
|
5.28
|
%
|
Commercial
loans
|
|
|
1,180
|
|
|
93
|
|
|
(35
|
)
|
|
1,238
|
|
|
56,777
|
|
|
8.31
|
%
|
|
0.41
|
%
|
|
8.72
|
%
|
Total
loans
|
|
$
|
179,060
|
|
$
|
(11,982
|
)
|
$
|
(176
|
)
|
$
|
166,902
|
|
$
|
12,599,296
|
|
|
5.69
|
%
|
|
(0.39
|
)%
|
|
5.30
|
%
|
Residential
Interest
income on residential real estate loans decreased to $129 million in the
three
months ended March 31, 2007 from $166 million in the three months ended
March
31, 2006 primarily as a result of lower average balances of residential
real
estate loans. This was due to high prepayments within our existing portfolio
of
LIBOR-indexed ARMs and a relatively low level of new loan acquisitions.
This
decline was partially offset by increased yields due to increases in the
short-term interest rates to which most of the residential real estate
loans are
indexed.
Our
residential real estate loan balance was $8.7 billion at March 31, 2007
and $9.4
billion at December 31, 2006. Of the $8.7 billion residential loan balance
at
March 31, 2007, 78% were one- and six-month LIBOR adjustable-rate residential
loans (LIBOR ARMs) that were financed through our Sequoia securitization
program. The flattening of the yield curve that began in 2005 and continued
through March 2007 has led to fast prepayments on existing LIBOR ARMs and
caused
origination levels of new LIBOR ARMs to significantly decline. The average
constant prepayment rate (CPR) for our LIBOR ARMs was 38% in the three
months
ended March 31, 2007 and was 46% for all of 2006.
Loan
premium amortization expense was $12 million for both the three months
ended
March 31, 2007 and 2006. On a percentage basis, loan premium amortization
expense for our LIBOR ARMs continues to lag the decrease in our LIBOR ARM
residential loan balance. The reason for this anomaly relates to the loan
premium amortization method we use for loans acquired prior to July 2004,
which
represented 52% of the loan balance at March 31, 2007. For these loans,
the
premium amortization rate is somewhat influenced by prepayments, but is
more
significantly influenced by short-term interest rates. As short-term rates
increase, premium amortization slows; as short-term rates decrease, premium
amortization potentially accelerates in a material way. See the Potential
for
GAAP Earnings Volatility discussion later in this document. For the remainder
of
the loans (those acquired after July 2004), we use a different accounting
method
for premium amortization, and as a result, the percentage of amortization
is
more closely correlated to prepayment rates regardless of changes in short-term
interest rates.
During
the first quarter of 2007, our provision for credit losses for residential
loans
was $1 million. On a percentage basis, our credit reserve increased to
0.23% of
the residential loan balance at March 31, 2007 from 0.22% at December 31,
2006.
The primary reason for the increase in our reserve was a percent of loans
was a
rise in residential loan serious delinquencies, which increased from 0.81%
of
the current loan balance at December 31, 2006 to 0.92% at March 31, 2007.
Delinquencies as a percent of original balances increased from 0.24% at
December
31, 2006 to 0.26% at March 31, 2007. Overall, residential loan credit
performance remains significantly better than our original
expectations.
Commercial
Interest
income on commercial real estate loans decreased by $3 million in the first
quarter of 2007 from the same period last year. During the first quarter
of
2007, we fully reserved for an anticipated loss on a mezzanine commercial
loan
financing a condominium-conversion project. Cost over-runs and changing
market
conditions make it probable that we will not collect any outstanding principal
or accrued interest upon completion of the project. The total charge for
this
loan was $3 million, of which $2 million related to principal and $1 million
to
accrued interest.
Interest
Income - Securities
The
table
below presents the income and yields of the components of our real estate
securities for the three months ended March 31, 2007 and 2006.
Table
5 Real Estate Securities — Interest Income and Yield
(Dollars
in thousands)
|
|
|
|
|
|
|
|
|
|
|
|
Three
months ended March 31, 2007
|
|
|
|
|
|
|
|
|
|
Yield
as a Result of
|
|
|
|
Interest
Income
|
|
Discount
(Premium)
Amortization
|
|
Total
Interest Income
|
|
Average
Balance
|
|
Interest
Income
|
|
Discount
(Premium)
Amortization
|
|
Total
Interest Income
|
|
Investment-grade securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
|
|
$
|
28,099
|
|
$
|
1,321
|
|
$
|
29,420
|
|
$
|
1,795,130
|
|
|
6.27
|
%
|
|
0.29
|
%
|
|
6.56
|
%
|
Commercial
|
|
|
1,808
|
|
|
67
|
|
|
1,875
|
|
|
122,099
|
|
|
5.92
|
%
|
|
0.22
|
%
|
|
6.14
|
%
|
CDO
|
|
|
3,865
|
|
|
(3
|
)
|
|
3,862
|
|
|
230,684
|
|
|
6.71
|
%
|
|
(0.01
|
)%
|
|
6.70
|
%
|
Total
investment-grade securities
|
|
$
|
33,772
|
|
$
|
1,385
|
|
$
|
35,157
|
|
$
|
2,147,913
|
|
|
6.29
|
%
|
|
0.26
|
%
|
|
6.55
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Credit
enhancement securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
|
|
$
|
18,772
|
|
$
|
18,892
|
|
$
|
37,664
|
|
$
|
673,114
|
|
|
11.15
|
%
|
|
11.23
|
%
|
|
22.38
|
%
|
Commercial
|
|
|
10,149
|
|
|
(9
|
)
|
|
10,140
|
|
|
426,121
|
|
|
9.53
|
%
|
|
(0.01
|
)%
|
|
9.52
|
%
|
CDO
|
|
|
497
|
|
|
─
|
|
|
497
|
|
|
18,348
|
|
|
10.84
|
%
|
|
0.00
|
%
|
|
10.84
|
%
|
Total
credit enhancement securities
|
|
$
|
29,418
|
|
$
|
18,883
|
|
$
|
48,301
|
|
$
|
1,117,583
|
|
|
10.53
|
%
|
|
6.76
|
%
|
|
17.29
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
real estate securities
|
|
$
|
63,190
|
|
$
|
20,268
|
|
$
|
83,458
|
|
$
|
3,265,496
|
|
|
7.74
|
%
|
|
2.48
|
%
|
|
10.22
|
%
|
Three
months ended March 31, 2006
|
|
|
|
|
|
|
|
|
|
Yield
as a Result of
|
|
|
|
Interest
Income
|
|
Discount
(Premium) Amortization
|
|
Total
Interest Income
|
|
Average
Balance
|
|
Interest
Income
|
|
Discount
(Premium) Amortization
|
|
Total
Interest Income
|
|
Investment-grade
securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
|
|
$
|
18,774
|
|
$
|
1,406
|
|
$
|
20,180
|
|
$
|
1,299,933
|
|
|
5.78
|
%
|
|
0.43
|
%
|
|
6.21
|
%
|
Commercial
|
|
|
2,875
|
|
|
5
|
|
|
2,880
|
|
|
181,549
|
|
|
6.34
|
%
|
|
0.01
|
%
|
|
6.35
|
%
|
CDO
|
|
|
2,483
|
|
|
8
|
|
|
2,491
|
|
|
157,570
|
|
|
6.30
|
%
|
|
0.02
|
%
|
|
6.32
|
%
|
Total
investment-grade securities
|
|
$
|
24,132
|
|
$
|
1,419
|
|
$
|
25,551
|
|
$
|
1,639,052
|
|
|
5.89
|
%
|
|
0.35
|
%
|
|
6.24
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Credit
enhancement securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
|
|
$
|
13,853
|
|
$
|
12,392
|
|
$
|
26,245
|
|
$
|
516,962
|
|
|
10.72
|
%
|
|
9.59
|
%
|
|
20.31
|
%
|
Commercial
|
|
|
4,832
|
|
|
(564
|
)
|
|
4,268
|
|
|
215,769
|
|
|
8.95
|
%
|
|
(1.04
|
)%
|
|
7.91
|
%
|
CDO
|
|
|
439
|
|
|
─
|
|
|
439
|
|
|
14,709
|
|
|
11.94
|
%
|
|
0.00
|
%
|
|
11.94
|
%
|
Total
credit enhancement securities
|
|
$
|
19,124
|
|
$
|
11,828
|
|
$
|
30,952
|
|
$
|
747,440
|
|
|
10.23
|
%
|
|
6.33
|
%
|
|
16.56
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
real estate securities
|
|
$
|
43,256
|
|
$
|
13,247
|
|
$
|
56,503
|
|
$
|
2,386,492
|
|
|
7.25
|
%
|
|
2.22
|
%
|
|
9.47
|
%
|
Investment-Grade
Securities
Interest
income from IGS increased to $35 million in the three months ended March
31,
2007 as compared $26 million for the three months ended March 31, 2006
due to
portfolio growth and increased yields. The majority of the IGS acquired
over the
past year were residential, in part because comparably rated commercial
securities traded at relatively higher prices and lower yields. The increase
in
yield is generally reflective of the rise in short-term interest rates
over the
past year as new securities were purchased in a higher interest rate environment
and many existing securities have a variable interest rate that reset to
higher
levels.
Residential
CES
We
acquire many first-loss securities at 25% to 35% of their principal value
and
other, more senior, credit-enhancement securities at 50% to 100% of their
principal value. Many of these securities are priced at a substantial discount
to their principal value as future credit losses could reduce or eliminate
the
principal value of these securities. Our yields on these investments depend
on
how much principal and interest we eventually collect and how
quickly we receive those payments. The faster we collect principal and
the
longer it takes to realize credit losses, the better it is for our investment
returns.
Interest
income from our residential CES was $38 million for the first three months
of
2007, an $11 million increase over the same period in 2006. This increase
is the
result of higher yields (22% in the first three months of 2007 vs. 20%
in the
first three months of 2006) and higher balances. Higher yields resulted
from the
strong credit performance and faster than anticipated prepayments rates
adjustable rate mortgages (ARMs). ARMs represented 59% of our residential
CES
portfolio at March 31, 2007, and average actual prepayment rates were in
excess
of 40% in the first quarter of 2007 compared to our initial expectations
(at the
time of acquisition) of 20% to 25%. Portfolio growth reflected our ability
to
find new assets at a pace in excess of our sales, calls, and principal
payments.
IGS
and CES Backed by Option ARMs
We
own
IGS and CES that are backed by option ARMs, which give the borrower the
option
of making a minimum payment that is less than the amount of interest owed
for
that loan period. The unpaid interest is added to the loan balance creating
negative amortization (neg am). The amount of neg am interest we currently
recognize or defer for GAAP purposes on option ARMs securities depends
on our
expectation of collectibility. We currently expect that accumulated neg
am
interest for securities rated BB and higher will be paid in full. In both
the
first quarter of 2007 and 2006, we recognized $1 million of neg am interest
on
securities rated BB and higher. During these time periods, we deferred
recognition of neg am interest of $1.1 million and $0.8 million, respectively,
on our unrated and B-rated securities. For these securities we do not currently
expect to collect the neg am interest and will recognize this deferred
interest
if cash is received. Our cumulative deferred neg am interest is $5.9 million
at
March 31, 2007. We will continue to monitor and assess these
assumptions.
Commercial
CES
Interest
income from our commercial CES was $10 million for first three months of
2007, a
$6 million increase over the same period in 2006. This increase is primarily
the
result of higher average balances. We have been active buyers of commercial
CES
as we have become more established in this marketplace.
The
average yield earned on our commercial CES portfolio in the first quarter
of
2007 was 9.52%. The yield was low relative to our other CES due to our
credit
loss assumptions. Similar to residential, commercial CES are acquired at
a net
discount. Commercial CES generally have a ten year maturity and are not
expected
to receive principal prepayments prior to maturity. As a result, it will
take
several years to further observe credit performance and re-assess our loss
assumptions. A decrease in loss assumptions would result in higher yields
(an
increase in discount amortization) while increased loss assumptions would
lead
to lower yields or impairments.
Interest
Income
- Other Real Estate Investments
The
table
below presents the interest income, average balances, and yield on our
other
real estate investments for the three months ended March 31, 2007. We had
no
other real estate investments for the three months ended March 31, 2006.
Table
6 Other Real Estate Investments - Interest Income and
Yield
(In
thousands)
|
|
Three
Months Ended March 31, 2007
|
|
|
|
Interest
Income
|
|
Average
Balance
|
|
Yield
as a Result
of
Interest Income
|
|
Other
real estate investments
|
|
$
|
2,465
|
|
$
|
37,169
|
|
|
26.53
|
%
|
Total
interest income from our other real estate investments was $2 million for
the
first three months of 2007. Other real estate assets consist of residential
IOs,
NIMs, and residuals. In prior periods, these assets were included in real
estate
securities. The majority of the interest income was from residuals we purchased
in the first quarter of 2007. Since we account for these assets as trading
assets, the yield on other real estate investments should be considered
in
conjunction with the market valuation adjustments recognized through the
income
statement on these assets during the first quarter of 2007, as discussed
further
later in this document.
Interest
Income - Cash and Cash Equivalents
Interest
income from cash and cash equivalents was $2 million in both the first
quarter
of 2007 and 2006. Average cash balances and yields were similar for these
periods.
Interest
Expense
Interest
expense consists of interest payments on consolidated ABS issued from sponsored
securitization entities, Redwood debt, and junior subordinated notes. The
table
below presents our interest expense and balances for these components for
the
three months ended March 31, 2007 and 2006.
Table
7 Total Interest Expense
|
|
Three
Months Ended March 31,
|
|
(Dollars
in thousands)
|
|
2007
|
|
2006
|
|
Interest
expense on consolidated ABS
|
|
$
|
134,945
|
|
$
|
178,583
|
|
Interest
expense on Redwood debt
|
|
|
31,094
|
|
|
2,072
|
|
Interest
expense on junior subordinated
notes
|
|
|
2,057
|
|
|
—
|
|
Total
interest expense
|
|
$
|
168,096
|
|
$
|
180,655
|
|
|
|
|
|
|
|
|
|
Average
ABS issued balance
|
|
$
|
9,338,053
|
|
$
|
14,663,134
|
|
Average
Redwood debt balance
|
|
|
2,188,561
|
|
|
137,181
|
|
Average
junior subordinated notes balance
|
|
|
97,013
|
|
|
—
|
|
Average
total obligations
|
|
$
|
11,623,627
|
|
$
|
14,800,315
|
|
|
|
|
|
|
|
|
|
Cost
of funds of ABS issued
|
|
|
5.78
|
%
|
|
4.87
|
%
|
Cost
of funds of Redwood debt
|
|
|
5.68
|
%
|
|
6.04
|
%
|
Cost
of funds of junior subordinated notes
|
|
|
8.48
|
%
|
|
—
|
|
Cost
of funds of total obligations
|
|
|
5.78
|
%
|
|
4.88
|
%
|
Total
consolidated interest expense decreased to $168 million in the first three
months of 2007 from $181 million in the first three months of 2006. Interest
expense on consolidated ABS decreased by $44 million in the first three
months
of 2007, as compared to the first three months of 2006. This decline was
partially offset by a $29 million increase in interest expense on Redwood
debt
and a $2 million increase for interest expense on junior subordinated notes.
The
reduction in consolidated ABS interest expense was caused by a significant
decline in the average balance of outstanding consolidated ABS issued (36%)
as a
result of rapid prepayments of the loans within these securitization entities.
Offsetting some of the decline in balances was the higher cost of funds
due to
an increase in short-term interest rates as most of our debt and consolidated
ABS issued is indexed to one-, three-, or six-month LIBOR. These factors
are
illustrated in the volume and rate change table below.
Table
8 Volume and Rate Changes for Interest Expense
(In
thousands)
|
|
Change
in Interest Expense
Three
Months Ended
March
31, 2007 vs. March 31, 2006
|
|
|
|
Volume
|
|
Rate
|
|
Total
Change
|
|
Interest
expense on ABS
|
|
$
|
(64,854
|
)
|
$
|
21,216
|
|
$
|
(43,638
|
)
|
Interest
expense on Redwood debt
|
|
|
30,984
|
|
|
(1,962
|
)
|
|
29,022
|
|
Interest
expense on junior subordinated
notes
|
|
|
2,057
|
|
|
—
|
|
|
2,057
|
|
Total
interest expense
|
|
$
|
(31,813
|
)
|
$
|
19,254
|
|
$
|
(12,559
|
)
|
Volume
change is the change in average balance of obligations between periods
multiplied by the rate paid in the earlier period. Rate change is the change
in
rate between periods multiplied by the average outstanding obligations
in the
current period. Interest expense changes that resulted from changes in
both rate
and volume were allocated to the rate change amounts shown in the
table.
The
table
below presents the different components of our interest costs on ABS issued
for
the three months ended March 31, 2007 and 2006. ABS issuance premiums are
created when ABS are issued at prices greater than principal value, such
as
interest-only (IO) securities.
Table
9 Cost of Funds of Asset-Backed Securities
Issued
|
|
Three
Months Ended March 31,
|
|
(Dollars
in thousands)
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
ABS
interest expense
|
|
$
|
131,392
|
|
$
|
178,183
|
|
ABS
issuance expense amortization
|
|
|
7,068
|
|
|
5,907
|
|
Net
ABS interest rate agreement income
|
|
|
(1,646
|
)
|
|
(2,980
|
)
|
Net
ABS issuance premium income amortization on ABS issue
|
|
|
(1,869
|
)
|
|
(2,527
|
)
|
Total
ABS interest expense
|
|
$
|
134,945
|
|
$
|
178,583
|
|
|
|
|
|
|
|
|
|
Average
balance of ABS
|
|
$
|
9,338,053
|
|
$
|
14,663,134
|
|
|
|
|
|
|
|
|
|
ABS
interest expense
|
|
|
5.63
|
%
|
|
4.86
|
%
|
ABS
issuance expense amortization
|
|
|
0.30
|
%
|
|
0.16
|
%
|
Net
ABS interest rate agreement income
|
|
|
(0.07
|
)%
|
|
(0.08
|
)%
|
Net
ABS issuance premium income amortization on ABS issued
|
|
|
(0.08
|
)%
|
|
(0.07
|
)%
|
Cost
of funds of ABS
|
|
|
5.78
|
%
|
|
4.87
|
%
|
The
increase in Redwood debt interest expense was the result of increased use
of
Redwood debt to fund loans and securities. The average balance of our
outstanding Redwood debt during the first quarter of 2007 increased by
$2.1
billion over the same period last year. Of this increase, $1.6 billion
represented financing for the acquisition of residential real estate loans
(in
part, from calling our older Sequoia loan securitizations) and $0.5 billion
related to the financing for the acquisition of real estate securities.
Our
junior subordinated notes (issued December 2006) accrue interest expense
at
three month LIBOR plus basis points (2.25%). The overall cost of funds
includes
the amortization of deal costs.
Operating
Expenses
Total
operating expenses increased by 41% in the first three months of 2007 as
compared to the same period of 2006. Operating expenses excluding severance
expenses increased by 22% in the first three months of 2007 as compared
to the
same period of 2006. This is in line with the increase in number of employees
(from 75 employees at March 31, 2006 to 99 employees at March 31, 2007)
and
associated costs. We continue to lay the foundation for future growth and
diversification with the increase in personnel and related
infrastructure.
Components
of our operating expenses for the three months ended March 31, 2007 and
2006 are
presented in the table below.
Table
10 Operating Expenses
|
|
Three
Months Ended March 31,
|
|
(In
thousands)
|
|
2007
|
|
2006
|
|
|
|
|
|
|
|
Fixed
compensation expense
|
|
$
|
4,616
|
|
$
|
3,436
|
|
Variable
compensation expense
|
|
|
2,251
|
|
|
1,514
|
|
Equity
compensation expense
|
|
|
3,349
|
|
|
2,694
|
|
Severance
expense
|
|
|
2,380
|
|
|
—
|
|
Systems
|
|
|
1,656
|
|
|
1,425
|
|
Due
diligence
|
|
|
707
|
|
|
432
|
|
Office
costs
|
|
|
1,180
|
|
|
1,034
|
|
Accounting
and legal
|
|
|
855
|
|
|
1,334
|
|
Other
operating expenses
|
|
|
788
|
|
|
713
|
|
Total
operating expenses
|
|
$
|
17,782
|
|
$
|
12,582
|
|
Fixed
compensation expense includes employee salaries and related employee benefits.
Fixed compensation expense has increased in the first quarter of 2007 as
compared to the first quarter of 2006 due to increased staffing levels.
Variable
compensation expense includes employee bonuses which are based on the adjusted
return on equity earned by Redwood and individual performance. Equity
compensation expense primarily includes the expense of equity awards granted
to
employees and directors.
In
February 2007, we entered into severance agreements with two employees
as part
of a re-alignment of our commercial operations. In conjunction with these
severance agreements, we recorded additional compensation expense of $2.4
million which mainly represented acceleration of unvested equity
awards.
Due
diligence expenses are costs for services related to re-underwriting and
analyzing the loans we acquire or the loans we credit-enhance through the
purchase of securities. Due diligence expenses increased in the first quarter
of
2007 compared to the first quarter of 2006 due to increased commercial
CES
activity. These costs fluctuate from period to period as a function of
the level
and type of asset acquisitions.
Realized
Gains on Sales and Calls
Total
realized gains on sales and calls were comparable for the three months
ended
March 31, 2007 and 2006. The table below provides detail of the net realized
gains on sales and calls for the three months ended March 31, 2007 and
2006.
Table
11 Realized Gains on Sales and Calls, Net
(In
thousands)
|
|
Three
Months Ended
March
31,
|
|
|
|
2007
|
|
2006
|
|
Realized
gains (losses) on sales of:
|
|
|
|
|
|
|
|
Real
estate securities
|
|
$
|
(784
|
)
|
$
|
1,062
|
|
Interest
rate agreements
|
|
|
1,087
|
|
|
—
|
|
Gains
on sales
|
|
|
303
|
|
|
1,062
|
|
|
|
|
|
|
|
|
|
Gains
on calls of residential CES
|
|
|
843
|
|
|
—
|
|
|
|
|
|
|
|
|
|
Total
realized gains on sales and calls
|
|
$
|
1,146
|
|
$
|
1,062
|
|
Market
Valuation
Adjustments
Valuation
adjustments reflect those changes in fair market values of assets that
we
recognize through our income statement. These include changes in the fair
market
value of our trading instruments (other real estate investments, credit
default
swaps, and certain interest rate agreements), the write-downs of assets
that are
impaired under the provisions of EITF 99-20, and the change in the value
of our
commitments.
The
table
below provides the components of valuation adjustments for the three months
ended March 31, 2007 and 2006. Other than interest rate agreements, we
did not
have any assets accounted for as trading securities in 2006.
Table
12 Market Valuation Adjustments, Net
(In
thousands)
|
|
Three
Months Ended March 31,
|
|
|
|
2007
|
|
2006
|
|
Changes
in fair market value of trading instruments
|
|
|
|
|
|
|
|
Other
real estate investments
|
|
|
|
|
|
|
|
Residuals
|
|
$
|
(5,564
|
)
|
$
|
—
|
|
NIMs
|
|
|
(155
|
)
|
|
—
|
|
IOs
|
|
|
379
|
|
|
—
|
|
Subtotal
- other real estate investments
|
|
|
(5,340
|
)
|
|
—
|
|
|
|
|
|
|
|
|
|
Derivative
financial instruments
|
|
|
|
|
|
|
|
Credit
default swaps
|
|
|
(2,526
|
)
|
|
—
|
|
Interest
rate agreements
|
|
|
(847
|
)
|
|
297
|
|
Subtotal
- derivative financial instruments
|
|
|
(3,373
|
)
|
|
297
|
|
Total
change in fair market value of trading instruments
|
|
|
(8,713
|
)
|
|
297
|
|
|
|
|
|
|
|
|
|
Write-downs
to fair market value under EITF 99-20
|
|
|
(2,387
|
)
|
|
(3,229
|
)
|
Change
in value of purchase commitments
|
|
|
836
|
|
|
—
|
|
Total
market value adjustments
|
|
$
|
(10,264
|
)
|
$
|
(2,932
|
)
|
Our
portfolio of other real estate investments accounted for as trading securities
was $50 million at March 31, 2007. We had no other real estate investments
accounted for as trading securities at March 31, 2006. Due to the implementation
of a new accounting standard (FAS 155) in the first quarter of 2007, we
elected
at the end of the first quarter to classify certain securities (IOs, NIMs
and
residuals) that contain embedded derivatives as trading instruments. Under
previous GAAP guidance, we would have classified these securities as available
for sale (AFS). The fair market value of these securities declined during
the
quarter as spreads widened considerably from February to the end of March
2007.
Additionally, at March 31, 2007, we owned credit default swaps that are
also
accounted for as trading securities and that decreased in value during
the
quarter due to spread widening. We did not own any credit default swaps
at March
31, 2006.
Impairments
for accounting purposes on our real estate securities are generally caused
by an
adverse change in projected cash flows in conjunction with a decrease in
the
fair market value. We recorded $2.4 million of impairment on AFS securities
in
the first quarter of 2007 as we believed that, in addition to the fair
market
value decrease due to the spread widening described above, the actual future
cash flows on those securities were impaired or we did not have the intent
to
hold the securities for a long enough future time period to recover the
unrealized loss generated by widening spreads. We recorded $3.2 million
of
impairments for the first quarter of 2006.
The
fair
market value changes of those interest rate agreements accounted for as
trading
decreased by $1 million. All changes, whether positive or negative, of
these
particular interest rate agreements are recognized through the income statement.
We use interest rate agreements to manage our interest rate risks, and
the
changes in the value of the hedged asset or liability are not included
in the
valuation adjustment. Consequently, our use of interest rate agreements
accounted for as trading instruments, could lead to volatile reported earnings
even when they are accomplishing the goal of hedging some of our interest
rate
risks.
Changes
in fair market values of our loan purchase commitments are also reflected
through our income statement (positive $0.8 million). We commit to purchase
certain loans and generally do not take possession of the loans for up
to a
month. During that time, the value of the loan may change from our commitment
purchase price and the resulting change in value is recognized through
our
income statement.
Other
ComprehensiveIncome
(Loss)
Most
of
our real estate securities are accounted for as AFS and are reported on
our
consolidated balance sheets at fair market value. Many of our derivative
instruments are accounted for as cash flow hedges and are
also
reported on our consolidated balance sheets at fair market value. The
differences between the value of these assets and our amortized cost are
shown
as a component of stockholders’ equity as accumulated other comprehensive income
(loss). Periodic changes in the fair market value of these assets relative
to
amortized cost are included in other comprehensive income (loss).
As
a
result of the spread widening on real estate securities that occurred during
the
first quarter of 2007, the fair market value adjustments on AFS assets
decreased
by $93 million and the fair market value adjustments on cash flow hedges
decreased by $7 million. These adjustments reduced our reported book value.
The
table
below provides the change during the current quarter and cumulative balances
of
unrealized gains and losses by type of real estate securities and by IGS
and
CES.
Table
13 Other Comprehensive Income (Loss) - Real Estate
Securities
|
|
|
|
|
|
|
|
Cumulative
Unrealized Gain (Loss)
|
|
Carrying
Value
|
|
(In
thousands)
|
|
March
31,
2007
|
|
December
31, 2006
|
|
Change
|
|
March
31,
2007
|
|
December
31, 2006
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Investment-Grade
Securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
|
|
|
(49,027
|
)
|
$
|
5,025
|
|
$
|
(54,052
|
)
|
$
|
2,025,850
|
|
$
|
1,697,250
|
|
Commercial
|
|
|
(2,071
|
)
|
|
111
|
|
|
(2,182
|
)
|
|
116,494
|
|
|
119,613
|
|
CDO
|
|
|
(7,985
|
)
|
|
2,174
|
|
|
(10,159
|
)
|
|
254,307
|
|
|
224,349
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
IGS
|
|
|
(59,083
|
)
|
|
7,310
|
|
|
(66,393
|
)
|
|
2,396,651
|
|
|
2,041,212
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Credit-Enhancement
Securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Residential
|
|
|
44,263
|
|
|
58,015
|
|
|
(13,752
|
)
|
|
752,277
|
|
|
721,531
|
|
Commercial
|
|
|
9,063
|
|
|
21,081
|
|
|
(12,018
|
)
|
|
435,382
|
|
|
448,060
|
|
CDO
|
|
|
(575
|
)
|
|
122
|
|
|
(697
|
)
|
|
16,152
|
|
|
21,964
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
CES
|
|
|
52,751
|
|
|
79,218
|
|
|
(26,467
|
)
|
$
|
1,203,811
|
|
|
1,191,555
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total
real estate securities
|
|
|
(6,332
|
)
|
$
|
86,528
|
|
$
|
(92,860
|
)
|
$
|
3,600,462
|
|
$
|
3,232,767
|
|
Taxes
Provisions
for Income Taxes
As
a
REIT, we are able to pass through substantially all of our earnings generated
at
our REIT to stockholders without paying income tax at the corporate level.
We
pay income tax on the REIT taxable income we choose to retain and on the
income
we earn at our taxable subsidiaries.
Our
income tax provision in the first quarter of 2007 was $2 million, a decrease
from the $3 million income tax provision recorded for the same period in
2006,
primarily due to a decline in net income.
Taxable
Income and Dividends
In
the
first quarter of 2007, we earned an estimated $40 million of total taxable
income, or $1.48 share outstanding. Of this amount, $36 million was earned
at
the REIT and $4 million was earned at our taxable subsidiaries. Total taxable
income is not a measure calculated in accordance with GAAP; it is the pre-tax
income calculated for tax purposes. REIT taxable income is that portion
of our
taxable income that we earn at Redwood Trust and its qualifying REIT
subsidiaries and does not include taxable income earned in taxable subsidiaries.
Estimated REIT taxable income is an important measure as it is the basis
of our
required dividend distributions to shareholders.
Taxable
income calculations differ from GAAP income calculations in a variety of
ways.
The most significant differences include the timing of amortization of
premium
and discounts and the timing of the recognition of gains or losses on assets.
The rules for both GAAP and tax accounting for loans and securities are
technical and complicated, and the impact of changing interest rates, actual
and
projected prepayment rates, and actual and projected credit losses can
have a
very different impact on the amount of GAAP and tax income recognized in
any one
period. See the discussions under Potential GAAP Earnings Volatility and
Potential Tax Earnings Volatility below.
The
table
below reconciles GAAP income to total taxable income for the three months
ended
March 31, 2007 and 2006.
Table
14 Differences Between GAAP Net Income and Total Taxable
Income
(In
thousands, except per share data)
|
|
Three
Months Ended
March
31, 2007
|
|
Three
Months Ended
March
31, 2006
|
|
GAAP
net income
|
|
$
|
18,309
|
|
$
|
28,015
|
|
Difference
in taxable income calculations
|
|
|
|
|
|
|
|
Amortization
and credit losses (net interest income)
|
|
|
10,417
|
|
|
4,939
|
|
Operating
expense differences
|
|
|
(1,713
|
)
|
|
1,604
|
|
Realized
gains on calls and sales
|
|
|
2,100
|
|
|
(613
|
)
|
Unrealized
market valuation adjustments
|
|
|
9,118
|
|
|
3,226
|
|
Income
tax provisions
|
|
|
1,800
|
|
|
(703
|
)
|
Total
differences in GAAP/tax income
|
|
|
21,722
|
|
|
8,453
|
|
Taxable
income
|
|
$
|
40,031
|
|
$
|
36,468
|
|
|
|
|
|
|
|
|
|
Shares
used for taxable EPS calculations
|
|
|
27,129
|
|
|
25,382
|
|
Total
taxable income per share
|
|
$
|
1.48
|
|
$
|
1.44
|
|
Our
taxable income estimates are based on a number of assumptions regarding
future
events. To the extent such events do not occur, or others occur which we
have
not anticipated, our quarterly estimates could change and could be significantly
different quarter over quarter. See the discussion in Potential Tax Income
Volatility below.
Our
board
of directors declared a regular dividend of $0.75 per share for the first
quarter of 2007. In 2007, as in the past few years, we intend to permanently
retain 10% of our taxable REIT income and defer the distribution of a portion
of
our taxable REIT income to shareholders in the subsequent year. At March
31,
2007, there was $60 million ($2.20 per share) of estimated 2006 and 2007
undistributed REIT taxable income that we plan to distribute to our shareholders
during 2007.
We
continue to be in compliance with all REIT tests. We generally attempt
to avoid
acquiring assets or structuring financings or sales at the REIT that could
generate unrelated business taxable income or excess inclusion income that
would
be distributed to our shareholders or that would cause prohibited transaction
taxes on the REIT. There can be no assurance that we will be successful
in doing
so.
Potential
GAAP Earnings Volatility
We
expect
quarter-to-quarter GAAP earnings volatility for a variety of reasons, including
the timing of sales and calls of assets, changes in interest rates, prepayments,
credit losses, fair market values of assets, and capital utilization. In
addition, volatility may occur because of technical accounting issues,
some of
which are described below.
Loan
Premium
Our
unamortized loan premium on our consolidated residential real estate loans
at
March 31, 2007 was $117 million. This will be expensed over the remaining
life
of these loans. Amortization for a significant portion of this premium
balance
is driven by effective yield calculations that depend on interest rates
and
prepayments (see Critical Accounting Policies for further details). Loan
premium
amortization was $12 million in both of the first quarters of 2007 and
2006.
Declines in short-term interest rates could cause a significant increase
in
required amortization in subsequent periods.
In
addition, premium amortization expense acceleration could occur if we reclassify
a portion of the underlying loans from held-for-investment to held-for-sale,
as
the GAAP carrying value of these loans are currently in excess of their
fair
market value. This reclassification could occur as the various underlying
pools
of loans become callable and we decide to sell these loans, or it could
occur if
there is a change in accounting principles (for example, if we adopt SFAS
159
and elect to account for our loans as fair value instruments.)
Real
Estate Securities
Currently,
all of our IGS and CES real estate securities are classified as AFS and
are
carried on our balance sheets at their estimated fair market value. Cumulative
unrealized fair market value gains and losses are reported as a component
of
accumulated other comprehensive income (loss) in our consolidated statements
of
stockholders’ equity. However, adverse changes to projected cash flows related
to poor credit performance, adverse changes to prepayment speeds, or our
or our
decision to sell assets could create an other-than-temporary impairment
for
accounting purposes and could cause fair market value losses to be reported
through our income statement.
In
particular, we own $480 million of securities backed by subprime loans
($9
million of CES and $471 million of IGS). Additionally, we own $1.3 billion
of
securities backed by option ARMs ($237 million of prime CES, $359 million
of
prime IGS, $156 million of alt-a CES, and $534 million alt-a IGS). The
future
credit performance of these securities could potentially be worse than
our
current projections requiring us to report losses through our income statement.
See the Financial Condition discussion later in this document for further
detail
on these securities.
Other
Real Estate Investments
Due
to
the implementation of a new accounting standard (FAS 155) in the first
quarter
of 2007, we elected at the end of the first quarter to classify certain
securities (IOs, NIMs and residuals) that contain embedded derivatives
as
trading instruments within the portfolio other real estate investments.
IOs,
NIMs, and residuals typically contain embedded derivatives that require
bifurcation and separate valuation through the income statement under FAS
155.
We have elected to treat these investments as trading securities (FAS 115)
rather than bifurcate the embedded derivative component. Trading securities
are
required to be reported on our consolidated balance sheet at their estimated
fair market values with changes in fair market values reported through
our
consolidated statements of income (through market valuation adjustments).
We
expect to increase our investments in NIMs and residuals in the future.
Using
FAS 155 in this manner will increase GAAP earnings volatility going forward.
Under previous GAAP guidance, we would have classified these securities
as
available for sale (AFS).
Derivative
Financial Investments
To
date,
we have elected two classifications for derivative instruments: trading
instruments and cash flow hedges. All derivative instruments, regardless
of
classification, are reported on our consolidated balance sheets at fair
market
value. Changes to the fair market value of the derivatives classified as
trading
instruments are recognized through the consolidated statements of income.
For
those derivatives accounted for as cash flow hedges, the changes in fair
market
values are reported through our consolidated balance sheets with only the
ineffective portions (as determined according to the accounting provisions)
reported through our income statement.
We
could
experience significant earnings volatility from our use of derivatives.
This
could occur, for example, when the recognition in changes in the fair market
value of the derivatives are reported through our income statement but
changes
in the fair market value in the hedged asset or liability are not recognized
in
a similar manner. It could also occur as we expand our use of derivatives
(including acquiring derivatives as investments and not just as hedging
instruments).
Potential
Tax Income Volatility
Taxable
income may vary from quarter to quarter based on many reasons, three of
which
are discussed below.
CES
and Loans
To
determine taxable income we are not permitted to anticipate, or reserve
for,
credit losses. Taxable income can only be reduced by actual losses. As
a
consequence, we are required to accrete the entire purchase discount on
CES into
taxable income over their expected life. For GAAP purposes, we do anticipate
credit losses and thus only accrete a portion of the CES discount into
income.
As a result, our income recognition on CES is faster for tax as compared
to
GAAP, especially in the early years of owning the assets (when there are
generally few credit losses). At March 31, 2007, the cumulative difference
between the GAAP and tax amortized costs basis of our residential, commercial,
and CDO CES was $99 million. In addition, as of March 31, 2007, we had
a credit
reserve of $30 million for GAAP on our residential and commercial loans,
and
none for tax. As we have no credit reserves for tax and a higher CES basis,
any
future credit losses on our CES or loans would have a more significant
impact on
tax earnings as compared to GAAP and may create significant taxable income
volatility to the extent the level of credit losses varies during
periods.
Sequoia
Interest-Only Certificates (IOs)
As
a
result of rapid prepayments, we are experiencing negative economic returns
on
some IOs we acquired from prior Sequoia securitizations. For tax purposes,
however, we are not permitted to recognize a negative yield, so premium
amortization expenses for tax have not been as high as they otherwise would
have
been based on the economic returns. As a result, our current tax bases
on these
IOs are higher than the fair market values by approximately $52 million.
We
expect to call most Sequoia securitization entities over the next two years,
at
which time the remaining IO tax basis will be written off and a capital
loss for
tax created. Capital losses do not reduce ordinary income (or our requirement
to
distribute ordinary income as dividends). Capital losses do offset capital
gains
realized from sales or calls of assets, and thus will reduce future
distributions of these capital gains. Our taxable earnings will vary from
period
to period based on the exact timing of these Sequoia calls.
Compensation
Compensation
expense for tax varies depending on the timing of dividend equivalent rights
payments, the exercise of stock options, the distribution of deferred stock
units, and deferrals to and withdrawals from our executive deferred compensation
plan.
FINANCIAL
CONDITION, LIQUIDITY, AND CAPITAL RESOURCES
Summary
In
the
first quarter of 2007, concerns over subprime credit issues caused prices
of
securities backed by subprime loans to decline significantly. The turbulence
in
subprime then led to a broad market decline for prices of real estate
securities. The total mark-to-market valuation impact to Redwood’s investments
in real estate securities and other investments was a write-down of $101
million. Of this amount $8 million flowed through our income statement
and $93
million was recorded as a reduction of stockholders’ equity. The vast majority
of the accounting fair market value write-downs taken in the first quarter
were
related to a general decline in the market prices of securities and not
due to
changes in expected cash flows - impairments under EITF-99-20 were $2
million.
A
summary
of the changes in fair market value during the first quarter of 2007 by
type and
security is shown in the table below.
Table
15 Mark-To-Market Adjustments
|
|
Three
Months Ended March 31, 2007
|
|
(In
millions)
|
|
Residential
|
|
Commercial
|
|
CDO
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
IGS
|
|
$
|
(55
|
)
|
$
|
(2
|
)
|
$
|
(10
|
)
|
$
|
(67
|
)
|
CES
|
|
|
(16
|
)
|
|
(12
|
)
|
|
(1
|
)
|
|
(29
|
)
|
NIMs,
residential and IOs
|
|
|
(5
|
)
|
|
—
|
|
|
—
|
|
|
(5
|
)
|
Total
mark-to-market adjustments
|
|
$
|
(76
|
)
|
$
|
(14
|
)
|
$
|
(11
|
)
|
$
|
(101
|
)
|
All
the
securities that were affected by write-downs were either held by Acacia
securitization entities, CDO warehouse facilities, or with capital. These
reductions in fair market values did not cause any margin calls or cause
any
other liquidity issues.
In
March
2007, we segregated assets with embedded derivatives under FAS 155 (residential
IOs, NIMs, and residuals) into a new balance sheet line item - other real
estate
investments and classified them as trading.
We
discuss our business of investing in, financing, and managing real estate
loans
and securities in each of our earnings asset portfolios below.
Residential
Real Estate Loans
We
acquire high-quality residential real estate loans on a bulk or flow basis
from
major originators. Prior to 2006, these loan purchases were predominately
comprised of short reset LIBOR indexed ARMs (LIBOR ARMs). Since then, we
have
expanded our residential conduit’s product offerings to include high-quality
hybrid loans (loans with a fixed rate coupon for a period of two to ten
years
before becoming adjustable).
The
following table provides details of the activity with respect to our residential
real estate loans for the three months ended March 31, 2007.
Table
16
Residential Real Estate Loans - Activity
(In
thousands)
|
|
Three
Months Ended March 31, 2007
|
|
Balance
at beginning of
period
|
|
$
|
9,323,935
|
|
Acquisitions
|
|
|
415,283
|
|
Principal
repayments
|
|
|
(1,042,061
|
)
|
Transfers
to REO
|
|
|
(3,463
|
)
|
Premium
amortization
|
|
|
(11,726
|
)
|
Provision
for credit losses
|
|
|
(1,481
|
)
|
Balance
at end of period
|
|
$
|
8,680,487
|
|
Our
residential real estate loan balance declined to $8.7 billion at March
31, 2007
from $9.3 billion at December 31, 2006. Of the balance at March 31, 2007,
78% of
the loans were one- and six-month LIBOR ARMs. The flattening of the yield
curve
since 2005 has continued to result in fast prepayments on existing LIBOR
ARMs
and has caused origination levels of new LIBOR ARMs to decline significantly.
The average constant prepayment rate (CPR) for our LIBOR ARMs continues
to be
high at 38% in the three months ended March 31, 2007.
In
a flat
yield curve environment, hybrid or fixed-rate loans are a more attractive
loan
alternative to a borrower. Of the $415 million of acquisitions during the
first
quarter of 2007, $360 million were hybrid loans and $55 million were short
reset
LIBOR ARMs.
Our
March
31, 2007 residential loan balance of $8.7 billion included $7.4 billion
loans
funded via securitization and $1.3 billion loans financed with equity and
Redwood debt. We will either securitize loans through our Sequoia program,
sell
loans to third parties, or continue to hold loans funded with Redwood debt
to
earn an interest spread. Our funding decision depends on a number of factors,
including our level of excess cash and the availability of attractive
alternative investment opportunities.
Residential
CES
The
largest part of our business in terms of capital employed is investing
in
residential CES. These credit-enhancement securities have credit ratings
that
are below investment-grade and have both the upside opportunities and downside
risks that could come from taking on concentrated credit risks.
Our
residential CES portfolio had a fair market value of $752 million at March
31,
2007 and $722 million at December 31, 2006, reflecting an annualized growth
rate
of 17% during the first quarter of 2007. The following table provides detail
of
the activity with respect to our residential CES for the three months ended
March 31, 2007.
Table
17 Residential CES - Activity
(In
thousands)
|
|
Three
Months Ended March 31, 2007
|
|
Balance
at beginning of period
|
|
$
|
721,531
|
|
Acquisitions
|
|
|
73,725
|
|
Sale
proceeds
|
|
|
(5,214
|
)
|
Gains
(losses) recognized on sales, net
|
|
|
387
|
|
Principal
repayments (including calls)
|
|
|
(35,672
|
)
|
Gains
recognized on calls, net
|
|
|
733
|
|
Discount
amortization
|
|
|
18,892
|
|
Transfer
to other portfolios
|
|
|
(4,480
|
)
|
Change
in fair market value adjustments, net
|
|
|
(17,625
|
)
|
Balance
at end of period
|
|
$
|
752,277
|
|
The
$74
million residential CES acquired in the first quarter of 2007 were comprised
of
$33 million prime securities, $37 million alt-a securities, and $4 million
subprime securities.
Prime
securities are residential mortgage-backed securities backed primarily
by high
credit quality loans. Many of the loans are jumbos, with loan balances
greater
than conforming loan limits. Prime securities typically have relatively
high
weighted average FICO scores (700 or higher), low (75% or less), weighted
average loan-to-value ratios (LTV), and limited concentrations of investor
properties.
Alt-a
securities are residential mortgage-backed securities that have higher
credit
quality than subprime and lower credit quality than prime. Alt-a originally
represented loans with alternative documentation, but has shifted over
time to
include loans with additional risk characteristics and a higher percentage
of
investor loans. For example, borrowers’ income may not be verified, and in some
cases, may not be disclosed on the loan application. Expanded criteria
also
allows for higher debt-to-income ratios with higher accompanying LTV than
otherwise would be permissible for prime loans.
Subprime
securities are residential mortgage-backed securities backed by loans to
borrowers who have impaired credit histories, but who appear to exhibit
the
ability to repay the current loan. Typically, these borrowers have lower
credit
scores or other credit deficiencies that prevent them from qualifying for
prime
or alt-a mortgages. To compensate for the greater risks and higher costs
to
service these loans, subprime borrowers pay higher interest rates, points,
and
origination fees. When evaluating the acquisition of CES backed by subprime
loans, we use loss assumptions that are significantly higher than those
we use
for prime loans.
The
following table details our residential CES portfolios by the underlying
loan
type (prime, alt-a, subprime) and by current credit rating at March 31,
2007 and
December 31, 2006.
Table
18 Residential CES - Credit Rating and Collateral Type
March
31, 2007
|
|
|
|
Rating
|
|
(In
millions)
|
|
BB
|
|
B
|
|
Unrated
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
Prime
|
|
$
|
316
|
|
$
|
132
|
|
$
|
124
|
|
$
|
572
|
|
Alt-a
|
|
|
101
|
|
|
30
|
|
|
40
|
|
|
171
|
|
Subprime
|
|
|
9
|
|
|
—
|
|
|
—
|
|
|
9
|
|
Total
residential CES
|
|
$
|
426
|
|
$
|
162
|
|
$
|
164
|
|
$
|
752
|
|
December
31, 2006
|
|
|
|
Rating
|
|
|
|
BB
|
|
B
|
|
Unrated
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
Prime
|
|
$
|
307
|
|
$
|
119
|
|
$
|
129
|
|
$
|
555
|
|
Alt-a
|
|
|
94
|
|
|
23
|
|
|
40
|
|
|
157
|
|
Subprime
|
|
|
7
|
|
|
—
|
|
|
3
|
|
|
10
|
|
Total
residential CES
|
|
$
|
408
|
|
$
|
142
|
|
$
|
172
|
|
$
|
722
|
|
The
following table details our residential CES portfolios by the product type
and
collateral vintage at March 31, 2007.
Table
19 Residential CES - Product and Vintage
March
31, 2007 |
|
(In
millions)
|
|
Product
and Vintage
|
|
|
|
2004
& Earlier
|
|
2005
|
|
2006
|
|
2007
|
|
Total
|
|
Prime
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Option
ARM
|
|
$
|
74
|
|
$
|
110
|
|
$
|
48
|
|
$
|
5
|
|
$
|
237
|
|
ARM
|
|
|
43
|
|
|
6
|
|
|
─
|
|
|
─
|
|
|
49
|
|
Hybrid
|
|
|
98
|
|
|
36
|
|
|
75
|
|
|
17
|
|
|
226
|
|
Fixed
|
|
|
36
|
|
|
17
|
|
|
7
|
|
|
─
|
|
|
60
|
|
Total
prime
|
|
|
251
|
|
|
169
|
|
|
130
|
|
|
22
|
|
|
572
|
|
Alt-a
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Option
ARM
|
|
|
35
|
|
|
25
|
|
|
64
|
|
|
32
|
|
|
156
|
|
ARM
|
|
|
1
|
|
|
─
|
|
|
─
|
|
|
─
|
|
|
1
|
|
Hybrid
|
|
|
8
|
|
|
2
|
|
|
1
|
|
|
─
|
|
|
11
|
|
Fixed
|
|
|
1
|
|
|
─
|
|
|
─
|
|
|
2
|
|
|
3
|
|
Total
Alt-a
|
|
|
45
|
|
|
27
|
|
|
65
|
|
|
34
|
|
|
171
|
|
Subprime
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Hybrid
|
|
|
─
|
|
|
─
|
|
|
1
|
|
|
─
|
|
|
1
|
|
Fixed
|
|
|
─
|
|
|
─
|
|
|
4
|
|
|
4
|
|
|
8
|
|
Total
subprime
|
|
|
─
|
|
|
─
|
|
|
5
|
|
|
4
|
|
|
9
|
|
Total
residential CES
|
|
$
|
296
|
|
$
|
196
|
|
$
|
200
|
|
$
|
60
|
|
$
|
752
|
|
The
loans
underlying all of our residential CES totaled $237 billion at March 31,
2007,
and consist of $213 billion prime, $20 billion alt-a, and $4 billion subprime.
These loans are located nationwide with a large concentration in California
(46%). These loans continue to perform well from a credit perspective --
during
the first quarter of 2007, realized residential credit losses were $3.8
million
of principal value, a rate that is less than one basis point (0.01%) on
an
annualized basis of the balance of loans. Serious delinquencies (90+ days,
in
foreclosure, in bankruptcy or REO) at March 31, 2007 were 0.43% of current
balance and 0.26% of original balance. For loans in prime pools, delinquencies
were 0.23% of current balance and 0.14% of original balance. Alt-a pools
had
delinquencies of 1.51% of current balance and 0.82% of original balance.
Subprime loans had delinquencies of 6.23% of current balance and 5.60%
of
original balance.
As
a
result of the concentrated credit risk associated with residential loan
CES, we
are generally able to acquire these securities at a discount to their face
(principal) value. At March 31, 2007, the difference between the principal
value
($1.3 billion) and carrying value ($752 million) -- which equals fair market
value of these residential loan CES -- was $507 million. Of this difference,
$393 million was designated as internal credit reserve (reflecting our
estimate
of credit losses on the underlying loans over the life of these securities),
$158 million represented a purchase discount we are accreting into income
over
time, and $44 million represented net unrealized mark-to-market
gains.
Residential
Investment-Grade
Securities
We
invest
in investment-grade residential securities (IGS) backed by prime, alt-a,
and
subprime residential loans. These IGS are not directly exposed to first-loss
credit risk as they benefit from credit-enhancement provided by others’
securities. The credit performance of these assets continued to be strong
during
the first quarter of 2007. The majority of these securities are funded
through
securitizations under our Acacia program.
Our
residential investment-grade securities totaled $2.0 billion at March 31,
2007
and $1.7 billion at December 31, 2006. The following table provides detail
of
the activity for the three months ended March 31, 2007.
Table
20 Residential IGS - Activity
(In
thousands)
|
|
Three
Months Ended
March
31, 2007
|
|
Balance
at beginning of period
|
|
$
|
1,697,250
|
|
Acquisitions
|
|
|
535,346
|
|
Sale
proceeds
|
|
|
(108,372
|
)
|
Gains
(losses) recognized on sales, net
|
|
|
(1,216
|
)
|
Principal
repayments (including calls)
|
|
|
(32,248
|
)
|
Gains
recognized on calls, net
|
|
|
76
|
|
Discount
amortization
|
|
|
1,321
|
|
Transfer
to other portfolios
|
|
|
(13,816
|
)
|
Change
in fair market value adjustments, net
|
|
|
(52,491
|
)
|
Balance
at end of period
|
|
$
|
2,025,850
|
|
The
$535
million IGS acquired in the first quarter of 2007 included $132 million
prime,
$337 million alt-a, and $66 million subprime. In the first quarter of 2007
we
called a prior Acacia CDO and sold most of the assets underlying this
securitization.
The
following table details the type of underlying loans (prime, alt-a, subprime)
and the current credit rating of our residential IGS as of March 31, 2007
and
December 31, 2006.
Table
21 Residential IGS - Credit Rating and Collateral
Type
March
31, 2007 |
(In
millions)
|
|
Rating
|
|
|
|
AAA
|
|
AA
|
|
A
|
|
BBB
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Prime
|
|
$
|
67
|
|
$
|
180
|
|
$
|
247
|
|
$
|
295
|
|
$
|
789
|
|
Alt-a
|
|
|
206
|
|
|
92
|
|
|
225
|
|
|
243
|
|
|
766
|
|
Subprime
|
|
|
8
|
|
|
152
|
|
|
173
|
|
|
138
|
|
|
471
|
|
Total
residential IGS
|
|
$
|
281
|
|
$
|
424
|
|
$
|
645
|
|
$
|
676
|
|
$
|
2,026
|
|
December
31, 2006 |
|
|
|
Rating
|
|
|
|
AAA
|
|
AA
|
|
A
|
|
BBB
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Prime
|
|
$
|
14
|
|
$
|
181
|
|
$
|
243
|
|
$
|
285
|
|
$
|
723
|
|
Alt-a
|
|
|
136
|
|
|
84
|
|
|
106
|
|
|
130
|
|
|
456
|
|
Subprime
|
|
|
8
|
|
|
127
|
|
|
209
|
|
|
174
|
|
|
518
|
|
Total
residential IGS
|
|
$
|
158
|
|
$
|
392
|
|
$
|
558
|
|
$
|
589
|
|
$
|
1,697
|
|
The
following table details our residential CES portfolios by the product type
and
collateral vintage at March 31, 2007.
Table
22 Residential IGS - Product and Vintage
March
31, 2007 |
|
(In
millions)
|
|
Product
and Vintage
|
|
|
|
2004
& Earlier
|
|
2005
|
|
2006
|
|
2007
|
|
Total
|
|
Prime
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Option
ARM
|
|
$
|
46
|
|
$
|
213
|
|
$
|
69
|
|
$
|
31
|
|
$
|
359
|
|
ARM
|
|
|
31
|
|
|
─
|
|
|
─
|
|
|
─
|
|
|
31
|
|
Hybrid
|
|
|
79
|
|
|
120
|
|
|
45
|
|
|
68
|
|
|
312
|
|
Fixed
|
|
|
29
|
|
|
23
|
|
|
12
|
|
|
23
|
|
|
87
|
|
Total
prime
|
|
|
185
|
|
|
356
|
|
|
126
|
|
|
122
|
|
|
789
|
|
Alt-a
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Option
ARM
|
|
|
31
|
|
|
51
|
|
|
237
|
|
|
215
|
|
|
534
|
|
ARM
|
|
|
5
|
|
|
─
|
|
|
─
|
|
|
─
|
|
|
5
|
|
Hybrid
|
|
|
13
|
|
|
8
|
|
|
32
|
|
|
12
|
|
|
65
|
|
Fixed
|
|
|
5
|
|
|
─
|
|
|
111
|
|
|
46
|
|
|
162
|
|
Total
Alt-a
|
|
|
54
|
|
|
59
|
|
|
380
|
|
|
273
|
|
|
766
|
|
Subprime
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Hybrid
|
|
|
166
|
|
|
71
|
|
|
75
|
|
|
24
|
|
|
336
|
|
Fixed
|
|
|
48
|
|
|
23
|
|
|
37
|
|
|
27
|
|
|
135
|
|
Total
subprime
|
|
|
214
|
|
|
94
|
|
|
112
|
|
|
51
|
|
|
471
|
|
Total
residential IGS
|
|
$
|
453
|
|
$
|
509
|
|
$
|
618
|
|
$
|
446
|
|
$
|
2,026
|
|
The
following table details the vintage of the underlying loan collateral behind
our
sub prime IGS at March 31, 2007.
Table
23 Subprime IGS - Credit Rating and Collateral
Vintage
March
31, 2007 |
|
(In
millions)
|
|
Credit
Rating and Vintage
|
|
|
|
2004
& Earlier
|
|
2005
|
|
2006
|
|
2007
|
|
Total
|
|
IGS
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
AAA
|
|
$
|
─
|
|
$
|
5
|
|
$
|
3
|
|
$
|
─
|
|
$
|
8
|
|
AA
|
|
|
44
|
|
|
58
|
|
|
22
|
|
|
28
|
|
|
152
|
|
A
|
|
|
118
|
|
|
31
|
|
|
14
|
|
|
10
|
|
|
173
|
|
BBB+
|
|
|
52
|
|
|
─
|
|
|
46
|
|
|
10
|
|
|
108
|
|
BBB
|
|
|
─
|
|
|
─
|
|
|
15
|
|
|
─
|
|
|
15
|
|
BBB-
|
|
|
─
|
|
|
─
|
|
|
12
|
|
|
3
|
|
|
15
|
|
Total
IGS
|
|
$
|
214
|
|
$
|
94
|
|
$
|
112
|
|
$
|
51
|
|
$
|
471
|
|
Commercial
Real Estate Loans
We
have
invested in commercial real estate loans since 1998. At March 31, 2007
and
December 31, 2006, commercial real estate loans totaled $26 million and
$28
million, respectively. These include mezzanine loans, subordinated (junior
or
senior lien) loans, and b-notes (b-notes represent a structured commercial
real
estate loan that retains a higher portion of the credit risk and generates
a
higher yield than the initial loan). Except for one loan (where we fully
reserved for an anticipated loss on a junior mezzanine loan financing a
condominium-conversion project), credit performance of our commercial loan
portfolio remains strong and in line with our expectations.
The
following table provides activity on our commercial real estate loans for
the
three months ended March 31, 2007.
Table
24
Commercial Real Estate Loans -
Activity
(In
thousands)
|
|
Three
Months Ended
March
31, 2007
|
|
Commercial
real estate loans at beginning of period
|
|
$
|
28,172
|
|
Recognized
gains on sales, net
|
|
|
—
|
|
Principal
repayments
|
|
|
38
|
|
Discount
amortization
|
|
|
21
|
|
Provision
for credit losses
|
|
|
(2,348
|
)
|
Commercial
real estate loans at end of period
|
|
$
|
25,883
|
|
Commercial
CES
Our
total
commercial CES was $435 million at March 31, 2007, a decrease from $448
million
at December 31, 2006. At March 31, 2007, these securities provided credit
enhancement on $57 billion underlying loans on office, retail, multifamily,
industrial, and other income-producing properties nationwide. The following
table provides detail of the activity for the three months ended March
31,
2007.
Table
25 Commercial CES - Activity
(In
thousands)
|
|
Three
Months Ended
March
31, 2007
|
|
Balance
at beginning of period
|
|
$
|
448,060
|
|
Acquisitions
|
|
|
2,743
|
|
Principal
repayments (including calls)
|
|
|
—
|
|
Discount
amortization
|
|
|
(9
|
)
|
Upgrades
to investment-grade securities
|
|
|
(3,501
|
)
|
Change
in fair market value adjustments, net
|
|
|
(11,911
|
)
|
Balance
at end of period
|
|
$
|
435,382
|
|
The
following table presents the current credit ratings of our commercial CES
at
March 31, 2007 and December 31, 2006.
Table
26 Commercial CES - Credit Rating
|
|
Rating
|
|
(In
millions)
|
|
BB
|
|
B
|
|
Unrated
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
March
31, 2007
|
|
$
|
222
|
|
$
|
89
|
|
$
|
124
|
|
$
|
435
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December
31, 2006
|
|
$
|
224
|
|
$
|
90
|
|
$
|
134
|
|
$
|
448
|
|
As
a
result of the concentrated credit risk associated with commercial CES,
we are
generally able to acquire these securities at a discount to their face
(principal) value. The difference between the principal value ($792 million)
and
carrying value ($435 million) of our commercial CES at March 31, 2007 was
$357
million. Of this difference, $294 million was designated as internal credit
reserve (reflecting our estimate of likely credit losses on the underlying
loans
over the life of these securities), $72 million represented a purchase
discount
we are accreting into income over time, and $9 million represented net
unrealized mark-to-market gains.
Commercial
IGS
Our
commercial IGS totaled $116 million at March 31, 2007 and $120 million
at
December 31, 2006. The following table provides detail of the activity
for the
three months ended March 31, 2007.
Table
27
Commercial IGS - Activity
(In
thousands)
|
|
Three
Months Ended
March
31, 2007
|
|
Balance
at beginning of period
|
|
$
|
119,613
|
|
Acquisitions
|
|
|
2,964
|
|
Sale
proceeds
|
|
|
(6,464
|
)
|
Gains
recognized on calls, net
|
|
|
45
|
|
Principal
repayments (including calls)
|
|
|
(938
|
)
|
Discount
amortization
|
|
|
67
|
|
Upgrades
from commercial CES
|
|
|
3,501
|
|
Change
in fair market value adjustments,
net
|
|
|
(2,294
|
)
|
Balance
at end of period
|
|
$
|
116,494
|
|
In
the
first quarter of 2007, we sold securities in conjunction with the call
of a
prior Acacia securitization. Our balance of commercial IGS has generally
been
declining over the last several quarters, as we have slowed acquisitions
of
commercial IGS as pricing has become extremely competitive.
The
following table presents the current credit ratings of our commercial
investment-grade securities at March 31, 2007 and December 31,
2006.
Table
28
Commercial IGS - Credit Rating
(In
millions)
|
|
Rating
|
|
|
|
AAA
|
|
AA
|
|
A
|
|
BBB
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March
31, 2007
|
|
$
|
9
|
|
$
|
4
|
|
$
|
24
|
|
$
|
79
|
|
$
|
116
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December
31, 2006
|
|
$
|
9
|
|
$
|
2
|
|
$
|
16
|
|
$
|
93
|
|
$
|
120
|
|
CDO
CES
CDOs
are
a form of securitization in which a diverse portfolio of assets is acquired
by a
securitization entity that creates and sells securities (CDO securities)
in
order to fund its asset purchases. We acquire CDO securities created by
others
as an asset portfolio investment. These CDO securities are generally backed
by
residential and commercial real estate assets and are generally financed
through
our CDOs.
At
March
31, 2007, our CDO CES totaled $16 million, a decrease from $22 million
at
December 31, 2006. The change in balance consisted of $5 million in upgrades
to
CDO IGS and a negative $1 million change of fair market value recognized
through
other comprehensive income (loss). The following tables present the credit
ratings of our CDO CES at March 31, 2007 and December 31, 2006.
Table
29 CDO CES - Credit Rating
(In
millions)
|
|
Rating
|
|
|
|
BB
|
|
B
|
|
Unrated
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
March
31, 2007
|
|
$
|
13
|
|
$
|
─
|
|
$
|
3
|
|
$
|
16
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December
31, 2006
|
|
$
|
14
|
|
$
|
─
|
|
$
|
8
|
|
$
|
22
|
|
CDO
IGS
At
March
31, 2007, our CDO IGS totaled $254 million, an increase of $30 million
from the
December 31, 2006 balance of $224 million.
During
the first quarter of 2007, acquisitions of CDO investment-grade securities
were
$35 million, upgrades from CDO CES to CDO IGS were $5 million, and balance
sheet
mark-to-market adjustments were negative $10 million.
The
following tables present the credit ratings of our CDO IGS at March 31,
2007 and
December 31, 2006.
Table
30 CDO IGS - Credit Rating
(In
millions)
|
|
Rating
|
|
|
|
AAA
|
|
AA
|
|
A
|
|
BBB
|
|
Total
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March
31, 2007
|
|
$
|
86
|
|
$
|
27
|
|
$
|
57
|
|
$
|
84
|
|
$
|
254
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December
31, 2006
|
|
$
|
66
|
|
$
|
30
|
|
$
|
52
|
|
$
|
76
|
|
$
|
224
|
|
Other
Real Estate Investments
Our
other
real estate investments totaled $50 million at March 31, 2007. There were
no
assets classified as other real estate investments at December 31, 2006.
The
following table represents the activity within other real estate investments
during the first three months ended March 31, 2007.
Table
31
Other Real Estate Investment - Activity
(In
thousands)
|
|
Three
Months Ended
March
31, 2007
|
|
Balance
at beginning of period
|
|
|
─
|
|
Acquisitions
|
|
|
40,790
|
|
Principal
repayments (including calls)
|
|
|
(3,079
|
)
|
Discount
amortization
|
|
|
(532
|
)
|
Transfers
from other portfolios
|
|
|
18,296
|
|
Change
in fair market value adjustments,
net
|
|
|
(5,418
|
)
|
Balance
at end of period
|
|
$
|
50,057
|
|
Acquisitions
during the first quarter of 2007 were $41 million, which consisted of $21
million of alt-a securities and $20 million of subprime securities. Of
the $5
million of negative value change in other real estate investments for the
first
quarter of 2007, $4 million related to investments acquired prior to this
year,
which were reclassified into this portfolio this quarter.
The
following table presents the current credit ratings of our other real estate
investments at March 31, 2007.
Table
32 Other Real Estate Investments - Credit
Rating
|
|
Rating
|
|
|
|
AAA
|
|
AA
|
|
A
|
|
BBB
|
|
BB
|
|
B
|
|
Unrated
|
|
Total
|
|
(In
millions)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
March
31, 2007
|
|
$
|
2
|
|
$
|
─
|
|
$
|
19
|
|
$
|
6
|
|
$
|
4
|
|
$
|
─
|
|
$
|
19
|
|
$
|
50
|
|
Liabilities
and Stockholders’ Equity
Redwood
Debt
We
use
repurchase (repo) agreements and our Madrona commercial paper facility
to
finance certain of our residential real estate loans. We may securitize
those
loans in the future or continue to fund them with debt. We also use warehouses
and repo agreements to finance securities. To date, the warehouses have
limited
recourse to Redwood, whereas other Redwood debt facilities have full recourse
to
us. Redwood debt is secured by pledges of our loans and securities. The
table
below shows the amount of debt outstanding by facility at March 31, 2007
and
December 31, 2006.
Table
33 Redwood Debt by Facility
(In
thousands)
Loans
|
|
March
31, 2007
|
|
December
31, 2006
|
|
Repo
agreements
|
|
$
|
882,139
|
|
$
|
959,139
|
|
Madrona
commercial paper facility
|
|
|
250,000
|
|
|
300,000
|
|
Securities
|
|
|
|
|
|
|
|
Repo
agreements
|
|
|
79,874
|
|
|
─
|
|
Acacia
warehouses
|
|
|
667,770
|
|
|
597,069
|
|
Total
Redwood
debt
|
|
$
|
1,879,783
|
|
$
|
1,856,208
|
|
In
the
last few years, we generally used Redwood debt to fund the acquisition
of loans
and securities on a temporary basis prior to their sale to a securitization
entity. We are more frequently acquiring these assets as a longer-term
investment that
we
intend to fund on an ongoing basis with Redwood debt.
Asset-Backed
Securities Issued
Redwood
has securitized the majority of the assets shown on its consolidated balance
sheets. In a securitization, Redwood sells assets to a securitization entity
that creates and sells asset-backed securities (ABS) in order to fund its
asset
purchases. The residential whole loan securitization entities Redwood sponsors
are called Sequoia and the CDO securitization entities Redwood sponsors
are
called Acacia. These securitization entities are bankruptcy-remote from
Redwood,
so that Redwood’s liabilities cannot become liabilities of the securitization
entity and the ABS issued by the securitization entity cannot become obligations
of Redwood. Nevertheless, since, according to accounting definitions, we
control
these securitization entities, we show both the assets and liabilities
of these
entities on our consolidated balance sheets. At March 31, 2007, our consolidated
balance sheets included $10.2 billion of assets owned by the securitization
entities (79% of total consolidated assets) and included $9.9 billion of
liabilities of the securitization entities (83% of total consolidated
liabilities).
The
following table provides detail of the activity for asset-backed securities
(ABS) for the three months ended March 31, 2007.
Table
34
ABS -
Activity
(In
thousands)
|
|
December 31,
2006
|
|
New
Issuance
|
|
Paydowns
|
|
Amortization
|
|
March 31,
2007
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Sequoia ABS with principal value, net
|
|
$
|
7,595,003
|
|
$
|
888,363
|
|
$
|
(1,333,810
|
)
|
$
|
(2,655
|
)
|
$
|
7,146,901
|
|
Sequoia
interest only ABS
|
|
|
74,548
|
|
|
—
|
|
|
—
|
|
|
(12,797
|
)
|
|
61,751
|
|
Acacia
ABS with principal value, net
|
|
|
2,294,629
|
|
|
465,000
|
|
|
(44,073
|
)
|
|
104
|
|
|
2,715,660
|
|
Acacia
CES issued
|
|
|
15,044
|
|
|
6,470
|
|
|
—
|
|
|
682
|
|
|
22,196
|
|
Commercial
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Total
ABS issued
|
|
$
|
9,979,224
|
|
$
|
1,359,833
|
|
$
|
(1,377,883
|
)
|
$
|
(14,666
|
)
|
$
|
9,946,508
|
|
Generally,
when we securitize assets, as opposed to owning them directly and funding
them
with Redwood debt and equity, our reported cost of funds is higher (the
cost of
ABS securities issued is generally higher than that of our debt) but we
utilize
less equity capital. As a result, our return on equity may increase after
securitization. In addition, liquidity risks are generally reduced or
eliminated, as the Redwood debt associated with the accumulation of these
assets
during their accumulation is paid off following securitization.
Junior
Subordinated Notes
In
December 2006, we issued $100 million of junior subordinated notes (trust
preferred securities) through Redwood Capital Trust I, a newly formed
wholly-owned Delaware statutory trust, in a private placement transaction.
These
trust preferred securities require quarterly distributions at a floating
rate
equal to LIBOR plus 2.25% until they are redeemed in whole, or mature on
January
30, 2037. The earliest optional redemption date without a penalty is January
30,
2012. In our internal risk-adjusted capital calculations, we consider these
trust preferred securities as part of our capital base.
Derivative
Financial Investments
We
currently have three kinds of derivative instruments; interest rate agreements,
commitments to purchase, and credit default swaps. All derivatives are
reported
on our balance sheet at fair market value. Changes in the fair market values
of
derivatives are either recorded through our consolidated statements of
income or
through accumulated other comprehensive income (loss) on our consolidated
balance sheets.
We
enter
into interest rate agreements to help manage some of our interest rate
risks. We
enter into these agreements with highly rated counterparties and maintain
certain risk management policies limiting our exposure concentrations to
any
counterparty. At March 31, 2007, we were party to interest rate agreements
with
an aggregate notional value of $2 billion and a net positive fair market
value
of $11 million. At December 31, 2006, we were party to interest rate agreements
with an aggregate notional value of $3 billion and a net positive fair
market
value of $21 million.
At
March
31, 2007, we had outstanding commitments to purchase $82 million residential
real estate loans. We estimate the value of these commitments at negative
$0.2
million. At December 31, 2006, we had commitments to purchase $81 million
residential real estate loans with an estimated value of negative $0.2
million.
Purchase commitments have zero value at the date of the commitment so any
changes in value during the quarter are recognized through our income
statements. Once the loans are purchased, the value of the purchase commitment
adjusts our cost basis in the loans.
We
entered into our first credit default swaps in the first quarter of 2007.
At
March 31, 2007 we had a $35 million notional balance worth negative $2.5
million. The swaps have zero value at purchase, so the entire change in
value
was recognized through our income statement this quarter.
Stockholders’
Equity
Our
reported book value at March 31, 2007 was $34.06 per share, a decrease
from
$37.51 per share at the beginning of the year. Our book value per share
decreased this quarter primarily as a result of decreases in the net fair
market
value of our assets and interest rate agreements.
Cash
Requirements, Sources of Cash, and Liquidity
We
use
cash to fund our operations and securitization activities, invest in earning
assets, service and repay Redwood debt, fund working capital, and fund
our
dividend distributions. One primary source of cash is principal and interest
payments received on a monthly basis from real estate loans and securities.
Other sources of cash include proceeds from sales of assets to securitizations
entities, proceeds from sales of other assets, proceeds from calls of
securities, borrowings, and issuance of equity and debt.
Cash
flows generated and used within consolidated ABS securitization entities
are not
directly available to Redwood, although they are shown on our consolidated
statement of cash flows. We own the call rights for many of these securitization
entities, generally allowing us, when certain targets or dates have been
met, to
pay off the ABS liabilities of these entities and acquire their assets
at par.
This was the primary reason for the large change in other asset balances
as we
began selling assets from Acacia 4 in anticipation of calling the ABS in
April
and the proceeds from these sales remained in the securitization trust
as of
March 31, 2007.
We
generally use capital, rather than securitization proceeds or Redwood debt,
to
fund investments in assets that have highly concentrated credit risks,
including
residential CES, commercial CES, and CDO CES and similar illiquid assets.
For
the acquisition of assets with less credit sensitivity, we employ leverage
under
which the capital component is much lower, generally from 8% to 30%. This
consists of structured leverage through Sequoia and Acacia (which is
non-recourse to us) or Redwood debt.
At
March
31, 2007, we had $114 million of excess capital, a decrease from the $182
million excess capital we had at December 31, 2006. We derive our excess
capital
figures by calculating the amount of cash we have available for investment
if we
fully leveraged our loans and securities in accordance with our internal
risk-adjusted capital policies and deducted from the resulting cash balances
an
amount we believe is sufficient to fund operations, working capital, and
to
provide for certain potential liquidity risks. We include trust preferred
securities in our capital base calculations.
Excess
capital declined by $68 million during the quarter. In the first quarter,
uses
of
capital included new asset acquisitions ($182 million) and dividends
($21
million). Sources of capital included asset sales ($39 million), principal
payments ($64 million), and equity issuance ($24 million). Other elements,
including cash from earnings, the (relatively small) effect on excess
capital of
market value declines, and changes in financings netted to an increase
of $8
million of available capital for the quarter.
Some
of
the capital utilized during the quarter is currently used on a temporary
basis
in an inefficient manner to fund assets that would be more efficiently
financed
with debt or via securitization or to fund delinquent loans from called
Sequoia
securitizations. Over time, we will employ this capital more efficiently,
freeing capital to support future growth.
We
anticipated net capital absorption of $200 million to $400 million for
2007. At
this point, the outlook for capital absorption is uncertain due to market
turmoil. Given our current acquisition plans, it is possible that we will
finish the year at the lower end of that range.
Our
current plan is to continue to invest in new assets but also to hold
some excess
capital in reserve to fund several quarters of future acquisitions. To
accomplish both of these objectives to their full extent, we will need
to raise
additional capital (long-term debt or equity) in 2007 and we will also
need to
take advantage of opportunities to recycle capital currently employed
on our
balance sheet through re-securitizations and other secure
financings.
CONTRACTUAL
OBLIGATIONS AND COMMITMENTS
The
table
below presents our contractual obligations and commitments as of March
31, 2007,
as well as the obligations of the securitization entities that we sponsored
and
are consolidated on our balance sheets. The operating leases are commitments
that are expensed based on the terms of the related contracts.
Table
35 Contractual Obligations and Commitments as of March 31,
2007
(In
thousands)
|
|
Payments
Due or Commitment Expiration by Period
|
|
|
|
Total
|
|
Less
Than
1
Year
|
|
1
to 3
Years
|
|
3
to 5
Years
|
|
After
5
Years
|
|
Redwood
Obligations:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Redwood
debt
|
|
$
|
1,879,783
|
|
$
|
1,879,783
|
|
$
|
—
|
|
$
|
—
|
|
$
|
—
|
|
Junior
subordinated notes
|
|
|
100,000
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
100,000
|
|
Accrued
interest payable
|
|
|
9,269
|
|
|
9,269
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Operating
leases
|
|
|
16,418
|
|
|
1,406
|
|
|
3,342
|
|
|
3,568
|
|
|
8,102
|
|
Purchase
commitments
|
|
|
81,676
|
|
|
81,676
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Total
Redwood obligations and commitments
|
|
$
|
2,087,146
|
|
$
|
1,972,134
|
|
$
|
3,342
|
|
$
|
3,568
|
|
$
|
108,102
|
|
Obligations
of Securitization Entities:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Consolidated
asset-backed securities*
|
|
$
|
9,946,508
|
|
$
|
374,461
|
|
$
|
—
|
|
$
|
—
|
|
$
|
9,572,047
|
|
Accrued
interest payable
|
|
|
42,440
|
|
|
42,440
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Total
obligations of securitization entities
|
|
$
|
9,988,948
|
|
$
|
416,901
|
|
$
|
—
|
|
$
|
—
|
|
$
|
9,680,149
|
|
Total
consolidated obligations and commitments
|
|
$
|
12,076,094
|
|
$
|
2,389,035
|
|
$
|
3,342
|
|
$
|
3,568
|
|
$
|
9,680,150
|
|
*All
consolidated ABS issued are collateralized by associated assets and, although
the stated maturity is as shown (except for ABS called in April 2007),
the ABS
obligations will pay down as the principal of the associated real estate
loans
or securities pay down. In March 2007 we exercised our right to call one
Sequoia
and one Acacia securitization. These calls were completed in April 2007
and
therefore the table shows these amounts as becoming due in less than one
year.
MARKET
RISKS
We
seek
to manage the risks inherent in our business - including but not limited
to
credit risk, interest rate risk, prepayment risk, liquidity risk, and fair
market value risk - in a prudent manner designed to enhance our earnings
and
dividends and preserve our capital. In general, we seek to assume risks
that can
be quantified from historical experience, to actively manage such risks,
and to
maintain capital levels consistent with these risks.
Credit
Risk
Integral
to our core business is assuming the credit risk of real estate loans primarily
through the ownership of residential and commercial real estate loans and
securities. Much of our capital base is employed in owning credit-enhancement
securities that have below investment-grade credit ratings due to their
concentrated credit risks with respect to underlying real estate loans.
We
believe that many of the loans underlying these securities are above-average
in
credit quality as compared to U.S. real estate loans in general, but the
balance
and percentage of loans with special risk factors (higher risk commercial
loans,
interest-only and negative amortization residential loan types, and alt-a
and
subprime residential loans) has increased and will likely continue to increase.
We also own a wide variety of residential and commercial real estate loans
of
various quality grades that are not securitized.
Credit
losses from any of the loans in securitized loan pools reduce the principal
value of and economic returns on the lower-rated securities in these pools.
Credit losses on real estate loans can occur for many reasons, including:
poor
origination practices; fraud; faulty appraisals; documentation errors;
poor
underwriting; legal errors; poor servicing practices; weak economic conditions;
decline in the value of homes, businesses, or commercial properties; special
hazards; earthquakes and other natural events; over-leveraging of the borrower
or on the property; reduction in market rents and occupancies and poor
property
management practices; changes in legal protections for lenders; reduction
in
personal incomes; job loss; and personal events such as divorce or health
problems. In addition, if the U.S. economy or the housing market weakens,
our
credit losses could increase beyond levels that we have anticipated. Credit
losses on real estate loans can vary for reasons not related to the general
economy.
With
respect to most of the loans securitized by securitization entities sponsored
by
us and for a portion of the loans underlying residential loan CES we have
acquired from securitizations sponsored by others, the interest rate is
adjustable. Accordingly, when short-term interest rates rise, required
monthly
payments from homeowners will rise under the terms of these ARMs, and this
may
increase borrowers’ delinquencies and defaults.
We
also
acquire credit-enhancement securities backed by negative amortization
adjustable-rate loans made to residential borrowers, some of which are
prime-quality loans while many are alt-a quality loans. We invest in these
riskier loan types with the expectation of significantly higher delinquencies
and losses as compared to regular amortization loans, but believe these
securities offer us the opportunity to generate attractive risk-adjusted
returns
as a result of attractive pricing and the manner in which these securitizations
are structured. Nevertheless, there remains substantial uncertainty about
the
future performance of these assets.
The
large
majority of the commercial loans we credit-enhance are fixed-rate loans,
some of
which are interest-only loans. In general, these loans are not fully amortizing
and therefore require balloon payments at maturity. Consequently, we could
be
exposed to credit losses at the maturity of these loans if the borrower
is
unable to repay or refinance the borrowing with another third party
lender.
We
will
experience credit losses on residential and commercial loans and CES, and
to the
extent the losses are consistent with the amount and timing of our assumptions,
we expect to earn attractive returns on our investments. We manage our
credit
risks by understanding the extent of the risk we are taking and insuring
the
appropriate underwriting criteria are met, and we utilize systems and staff
to
continually monitor the ongoing credit performance of each loan and security.
To
the extent we find the credit risks on specific assets are changing adversely,
we will take actions (including selling the assets) to mitigate potential
losses. However, we may not always be successful in foreseeing adverse
changes
in credit performance or in effectively mitigating future credit
losses.
In
addition to residential and commercial CES, the Acacia entities we sponsor
own
investment-grade and other securities issued by securitization entities
that are
sponsored by others. These investment-grade securities are typically rated
AAA
through B, and are in a second-loss or better position or are otherwise
effectively more senior in the credit structure in comparison to first-loss
CES
or their equivalent. A risk we face with respect to these securities is
that we
do not generally control or influence the underwriting, servicing, management,
or loss mitigation with respect to these underlying loans.
The
Acacia entities also own securities backed by subprime and alt-a residential
loans that have substantially higher credit risk characteristics than
prime-quality loans. Consequently, we can expect these lower-quality loans
to
have higher rates of delinquency and loss, and if such losses differ from
our
assumptions, Acacia (and thus Redwood) could suffer losses.
In
addition to the foregoing, the Acacia entities own certain investment-grade
BB-rated, and B-rated residential loan securities purchased from the Sequoia
securitization entities we sponsor. These securities are less likely to
suffer
credit losses than other securities since credit losses ordinarily would
not
occur until cumulative credit losses within the pool of securitized loans
exceed
the principal value of the subordinated CES underneath and other credit
protections have been exhausted. However, if the pools of residential and
commercial loans underlying these securities were to experience poor credit
results, these Acacia securities could have their credit ratings down-graded,
could suffer losses in fair market value, or could experience principal
losses.
If any of these events occurs, it would likely reduce our returns from
the
Acacia CDO equity securities we have acquired and may reduce our ability
to
sponsor Acacia transactions in the future.
Interest
Rate Risk
Interest
rates and the shape of the yield curve can affect the cash flows and fair
market
values of our assets, liabilities, and interest rate agreements, and
consequently, affect our earnings and reported equity. Our general strategy
with
respect to interest rates is to maintain an asset/liability posture (including
hedges) on a consolidated basis that assumes some interest rate risks but
not to
such a degree that the achievement of our long-term goals would likely
be
affected by changes in interest rates. Accordingly, we are willing to accept
short-term volatility of earnings and changes in our reported equity in
order to
accomplish our goal of achieving attractive long-term returns.
To
implement our interest rate risk strategy, we may use interest rate agreements
in an effort to maintain a close match between pledged assets and Redwood
debt,
as well as between the interest rate characteristics of the assets in the
securitization entities and the corresponding ABS issued. However, we do
not
attempt to completely hedge changes in interest rates, and at times, we
may be
subject to more interest rate risk than we generally desire in the long
term.
Changes in interest rates will have an impact on the values and cash flows
of
our assets and corresponding liabilities.
Prepayment
Risk
We
seek
to maintain an asset/liability posture that benefits from investments in
prepayment-sensitive assets while limiting the risk of adverse prepayment
fluctuations to an amount that, in most circumstances, can be absorbed
by our
capital base while still allowing us to make regular dividend
payments.
Prepayments
affect GAAP earnings in the near-term primarily through the timing of the
amortization of purchase premium and discount and through triggering fair
market
value write-downs. For example, amortization income from discount assets
may not
necessarily offset amortization expense from premium assets, and vice-versa.
In
addition, variations in current and projected prepayment rates for individual
assets and changes in interest rates (as they affect projected coupons
on ARMs
and other assets and thus change effective yield calculations) may cause
net
premium amortization expense or net discount amortization income to vary
substantially from quarter to quarter. Moreover, the timing of premium
amortization on assets may not always match the timing of the premium
amortization on liabilities even when the underlying assets and liabilities
are
in the same securitization and pay down at the same rate.
With
respect to ABS (and in particular, IO securities), changes in prepayment
forecasts by market participants could affect the market prices of those
securities sold by securitization entities, and thus could affect the profits
we
earn from securitized assets.
Prepayment
risks also exist in the assets and associated liabilities consolidated
on our
balance sheets. In general, discount securities (such as CES) benefit from
faster prepayment rates on the underlying real estate loans while premium
securities (such as IO securities) benefit from slower prepayments on the
underlying loans. Our largest current potential exposure to changes in
prepayment rates is on short-term residential ARM loans. We are currently
biased
in favor of faster prepayment speeds with respect to the long-term economic
effect of ARM prepayments. However, for GAAP in the short-term, increases
in ARM
prepayment rates could result in negative GAAP earnings volatility.
Through
our ownership of discount residential loan CES backed by fixed rate and
hybrid
residential loans, we generally benefit from faster prepayments on those
underlying loans. Prepayment rates for those loans typically accelerate
as
medium-and-long-term interest rates decline.
Our
credit results and risks can also be affected by prepayments. For example,
credit risks for the CES we own are reduced each time a loan prepays. All
other
factors being equal, faster prepayment rates should reduce our credit risks
on
our existing portfolio.
We
caution that prepayment rates are difficult to predict or anticipate, and
variations in prepayment rates can materially affect our earnings and dividends.
ARM prepayment rates, for example, are driven by many factors, one of which
is
the steepness of the yield curve. As the yield curve flattens (short-term
interest rates rise relative to longer-term interest rates), ARM prepayments
typically increase.
We
do not
believe it is possible or desirable to control the effects of prepayments
in the
short-term. Consequently, our general approach is to seek to balance overall
characteristics of our balance sheet so that the net present values of
cash
flows generated over the life of the assets and liabilities in our consolidated
portfolios do not materially change as prepayment rates change.
Fair
Market
Value and Liquidity Risks
Our
consolidated real estate loans are accounted for as held-for-investment
and
reported at amortized cost. Most of these loans have been sold to Sequoia
entities and, thus, changes in the fair market value of the loans do not
have an
impact on our liquidity. However, changes in fair market values during
the
accumulation period (while these loans are funded with Redwood debt before
they
are sold to a Sequoia entity) may have a short-term effect on our
liquidity.
The
consolidated securities are accounted for as available-for-sale and are
generally marked-to-market through our balance sheets and not through our
income
statement. Some of these assets are credit-sensitive, and all are interest-rate
sensitive. Fair market value fluctuations of these assets can affect reported
stockholders’ equity. Most of these securities are owned by securitization
entities we sponsor and fair market value fluctuations on these securities
do
not have an impact on our liquidity. Fair market value fluctuations on
securities we own and fund with short-term debt (generally prior to
securitization) could have an impact on our liquidity. Our earnings could
be
affected by adverse changes in fair market values on all securities we
own or
consolidate to the extent there is an accompanying adverse change in projected
cash flows. In these cases, the negative changes in fair market values
are
reported through our income statement.
Beginning
in the first quarter of 2007, we classified other real estate investments
as
trading instruments. Changes in the fair market values of these investments
are
recognized through our income statement. Thus, changes in fair market values
may
add to the quarterly volatility of our earnings. This could occur whether
these
instruments are hedged or are financed with non-recourse debt.
Our
consolidated obligations consist primarily of ABS issued. These are reported
at
amortized cost. Generally, changes in fair market value of ABS issued have
no
impact on our liquidity. However, because many of our consolidated assets
funded
with ABS issued are reported at fair market value, the resulting reported
net
equity may not necessarily reflect the true net fair market value of assets
and
liabilities in these securitization entities. Specifically,
we
mark-to-market most of the assets and derivatives owned by the Acacia entities,
but none of Acacia’s liabilities. If fair market values for Acacia’s $2.7
billion assets declined sufficiently, we could be required to record balance
sheet charges in excess of the total maximum economic amount ($95 million)
that
Redwood actually has invested. Conversely, we would not be able to reflect
an
offsetting improvement in Acacia liability fair market value changes in
our
consolidated financial statements. None of these fair market value changes
would
affect the cash flows we expect to earn from our Acacia investments, however.
The net balance sheet fair market value markdown for assets and derivatives
in
closed Acacia transactions was $49 million for the first
quarter.
Increasingly,
we are holding debt-funded assets for longer terms as an ongoing investment.
That is, we are increasing the level of loans and securities funded with
debt
that is recourse to Redwood. This will increase our fair market value and
liquidity risks. We manage these risks by maintaining what we believe to
be
conservative capital levels under our internal risk-adjusted capital and
risk
management policies and by ensuring we have a variety of financing facilities
available to fund each of our assets.
Inflation
Risk
Virtually
all of our consolidated assets and liabilities are financial in nature.
As a
result, changes in interest rates and other factors drive our performance
far
more than does inflation. Changes in interest rates do not necessarily
correlate
with inflation rates or changes in inflation rates.
Our
financial statements are prepared in accordance with GAAP. Our activities
and
balance sheets are measured with reference to historical cost or fair market
value without considering inflation.
CRITICAL
ACCOUNTING POLICIES
The
preparation of financial statements in conformity with GAAP requires us
to make
estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the consolidated financial statements and the
reported amounts of revenues and expenses during the reported period. Actual
results could differ from those estimates. The critical accounting policies
and
the possible effect of changes in estimates on our financial results and
statements are discussed below. Management discusses the ongoing development
and
selection of these critical accounting policies with the audit committee
of the
board of directors.
Revenue
Recognition
When
recognizing revenue on consolidated earning assets, we employ the effective
yield method and use assumptions about the future to determine an effective
yield that drives amortization of premiums, discounts, and other net capitalized
fees and costs associated with purchasing and financing real estate loans
and
securities.
Loan
Premium Amortization
For
consolidated real estate loans, the effective yield method is applied as
prescribed under FAS 91. For loans acquired prior to July 2004, we apply
the
existing interest rate at the reporting date rate to determine the effective
yield for each pool of loans. During a period of rising short-term rates,
the
coupon is projected to increase, resulting in a higher effective yield.
Under
those circumstances, prior to the coupon rate resetting (generally one
to six
months for these loans), the amount of amortization is lower than it will
be
once the coupon rate resets. Consequently, for the past two years, as short-term
rates increased, the amount of purchase premium we amortized was less than
it
would have been in a flat interest rate environment. With lower premium
amortization expenses as a result of rising interest rates combined with
rapid
prepayments, our cost bases have increased on our remaining loans. The
cost
bases in these loans continues to exceed their estimated fair market
values.
For
loans
acquired after July 1, 2004, we use the initial coupon interest rate of
the
loans (without regard to future changes in the underlying indices) and
anticipated principal payments on a pool basis to calculate an effective
yield
and to amortize the premium or discount. Any volatility in amortization
expense
is dependent primarily on prepayments. The cost bases of these loans are
approximately equal to their fair market values.
Securities
Discount Amortization
For
discount amortization on our consolidated securities, an effective yield
is
applied by projecting cash flows that incorporate assumptions of credit
losses,
prepayment speeds, and interest rates over the remaining life of each asset.
If
our assumptions prove to be accurate, then the yield that we recognize
in the
current period will remain the same over the life of the security. We constantly
review - and update as necessary - our assumptions and resulting cash flow
projections based on historical performance, input and analyses received
from
external sources, internal models, and our own judgment and experience.
There
can be no assurance that our assumptions used to generate future cash flows
will
prove to be accurate or that these estimates will not change
materially.
The
majority of our discount amortization is generated from residential and
commercial CES purchased at a significant discount to par value. Discount
balances equal to the credit losses that we expect to incur are set aside
as a
form of credit reserve and are not amortized into income. The level of
this
reserve is based upon our assessment of various factors including economic
conditions, characteristics and delinquency status of the underlying loans,
past
performance of similar loans, and other factors. Thus, when credit losses
do
occur, they are recorded against this reserve and there is no income statement
impact at that time. The difference between the amount of our total discount
and
the credit reserve is the accretable discount. The accretable discount
represents the amount of discount amortization that we expect to recognize
into
income over the remaining life of the assets. As we update our estimate
of
future credit losses, increases in projected losses will increase the discount
set aside as reserve resulting in less accretable discount for amortization
into
income and lower portfolio yields. In contrast, lower credit loss projections
will decrease the reserve and increase the accretable discount balance,
increasing our CES discount amortization and resulting in higher portfolio
yields.
The
timing of projected receipt of cash flows from our CES is also an important
driver in the effective yield. Slower actual or projected prepayment speeds
will
cause projected receipt of cash flows to be delayed and will reduce the
rate of
CES discount accretion resulting in a lower yield for the portfolio. An
increase
in actual or projected
prepayment speeds will generally result in a higher portfolio yield as
a result
of increased CES discount amortization.
Amortization
of ABS Premium
We
apply
the effective yield method in determining amortization for the sales premium
and
deferred asset-backed securities issuance cost for ABS issued. ABS sales
premium
is eventually recognized through our income statement as a reduction in
interest
expense and the issuance cost amortized as additional interest expense.
Similar
to our securities discount amortization, the use of this method requires
us to
project cash flows over the remaining life of each liability. These projections
are primarily impacted by forecasted prepayment rates of the related assets.
If
prepayment speeds are faster than modeled, the average life of the liability
will shorten, and we will recognize the ABS sales premium as expense at
a faster
rate, and increasing net income. If prepayment speeds are slower than expected,
the average life of the liability will lengthen, and it will take us longer
to
recognize the ABS sales premium. For the deferred asset-backed securities
issuance costs, faster prepayments will result in faster amortization and
an
increase in interest expense while slower prepayments will result in slower
amortization and a decrease in interest expense.
Establishing
Valuations and Accounting for Changes in Valuations
We
report
our securities at fair market value on our consolidated balance sheets.
We
believe that the estimates of fair market value we use reflect fair market
values that we may be able to obtain should we choose to sell assets. Our
estimates, however, are inherently subjective in nature and involve matters
of
uncertainty and judgment in interpreting relevant market and other data.
Because
we are also active acquirers, an issuer of debt securities, and an occasional
seller of assets, we believe that we have the ability to understand and
determine changes in assumptions that are taking place in the marketplace
and
make appropriate changes in our assumptions for valuing assets. However,
changes
in perceptions regarding future events in spreads used to price assets
can have
a material impact on the fair market values of our assets. Should such
changes
occur, there could be significant decreases in the fair market values of
these
assets.
We
estimate the fair market values using available market information and
other
appropriate valuation methodologies. Many assumptions are necessary to
estimate
fair market values, including, but not limited to, interest rates, prepayment
rates, amount and timing of credit losses, supply and demand, liquidity,
and
other market factors. We apply these factors to each of our assets, as
appropriate, in order to determine fair market values. Our expectations
of
future performance are shaped by historical performance and input and analyses
received from external sources, internal models, and our own judgment and
experience. In addition to our valuation processes, we use third party
sources
to validate our valuation estimates. We mark our assets to fair value at
the
lower of our internal valuation process and external values received from
third
party sources on our specific assets. This gives us a fair market value
at the
conservative end of the possible range.
Changes
in the fair market value of real estate securities are reported through
equity.
However, it is possible that decreases in fair market values of real estate
securities could be reported through the income statement. See the discussion
on
other-than-temporary impairments below. Changes in the fair market value
of
other real estate investments are reported through current period earnings
as
these are treated as trading securities. Total income recognized in current
period earnings on these investments equals coupon interest earned plus
or minus
change in fair market value. Interest income is equal to the instruments’ yields
based on market expectations.
Other-than-Temporary
Impairments
Increases
in our credit loss assumptions or changes in projected prepayment rates
could
result in an adverse change in the net present value of expected cash flows.
If
we have an adverse change in projected cash flows and also the fair market
value
of that asset is less than our amortized cost, we have an other-than-temporary
impairment. The basis of the asset is written down to fair market value
through
our consolidated statements of income. Fair market value write-downs of
this
type could be substantial, reducing GAAP income and causing a loss. However,
for
securitized assets, reductions in fair market values may not affect our
cash
flows or investment returns at all, or may not affect them to the degree
implied
by the accounting write-down.
Credit
Reserves - Loans Held-for-Investment
For
consolidated real estate loans held-for-investment, we establish and maintain
credit reserves that we believe represent probable credit losses that will
result from intrinsic losses existing in our pool of consolidated real
estate
loans held-for-investment as of the date of the financial statements. The
reserves for credit losses are adjusted by taking provisions for credit
losses
recorded as a reduction in interest income on real estate loans on our
consolidated statements of income. The reserves consist of estimates of
specific
loan impairment and estimates of collective losses on pools of loans with
similar characteristics.
To
calculate the reserve for credit losses for real estate loans, we determine
intrinsic losses by applying loss factors (default, the timing of defaults,
and
the loss severity upon default) that can be specifically applied to each
pool of
loans and estimate expected losses of each pool over their expected lives.
Once
we determine the loss factors, we then estimate the timing of these losses
and
the losses probable to occur over an effective loss confirmation period.
This
period is defined as the range of time between the probable occurrence
of a
credit loss (such as the initial deterioration of the borrower’s financial
condition) and the confirmation of that loss (the actual charge-off of
the
loan). The losses expected to occur within the estimated loss confirmation
period are the basis of our credit reserves because we believe those losses
exist as of the reported date of the financial statements.
We
do not
maintain a loan repurchase reserve, as any risk of loss due to loan repurchases
(i.e., due to breach of representations) would normally be covered by recourse
to the companies from whom we acquired the loans.
Accounting
for Derivative Instruments
We
use
derivative instruments to manage certain risks such as interest rate risk
and
fair market value risks. We may also acquire derivative financial instruments
as
investments. Derivative instruments are reported on our consolidated balance
sheets at their fair market value. If a derivative instrument has a positive
fair market value, it is reported as an asset. If the fair market value
is
negative, the instrument is reported as a liability.
Changes
in fair market values of derivative instruments are reported either through
the
income statement or through our equity. For derivatives accounted for as
trading
instruments, all changes in the fair market values are recognized through
the
income statement. For interest rate agreements (a type of derivative) accounted
for as a cash flow hedge, most of the changes in fair market values are
recorded
in our balance sheet through equity. Only the ineffective portions (as
determined according to the accounting principle) of the derivatives accounted
for as cash flow hedges are included in our income.
Using
derivatives may increase our earnings volatility, as the accounting results
for
derivatives may not match the accounting results for the hedged asset or
liability due to our inability to, or decision not to, meet the requirements
for
certain accounting treatments, or if the derivatives do not perform as
intended.
ITEM
3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Discussions
about our quantitative and qualitive disclosures about market risk are
included
in our Management’s Discussion and Analysis included herein.
ITEM
4. CONTROLS AND PROCEDURES
We
have
carried out an evaluation, under the supervision and with the participation
of
our management including our principal executive officer and principal
financial
officer, of the effectiveness of the design and operation of our disclosure
controls and procedures, as that term is defined in Rules 13a-15(e) under
the
Securities Exchange Act of 1934, as amended. Based on that evaluation,
our
principal executive officer and principal financial officer concluded that
as of
March 31, 2007, which is the end of the period covered by this Report on
Form
10-Q, our disclosure controls and procedures are effective.
There
have been no changes in our internal controls over financial reporting
in the
fiscal quarter ended March 31, 2007 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
PART
II
Item
2. UNREGISTERED
SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
|
|
Issuer
Purchases of Equity Securities
|
|
Period
|
|
Total
Number
of
Shares
Purchased
|
|
Average
Price
Paid
per
Share
|
|
Total
Number of
Shares
Purchased
As
Part of Publicly
Announced
Programs
|
|
Maximum
Number
of
Shares Available
for
Purchase Under
Publicly
Announced
Programs
|
|
January
1- January 31, 2007
|
|
|
1,585
|
|
$
|
58.08
|
|
|
—
|
|
|
—
|
|
February
1 - February 28, 2007
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
—
|
|
March
1 - March 31, 2007
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Total
|
|
|
1,585
|
|
$
|
58.08
|
|
|
—
|
|
|
1,000,000
|
|
The
1,585
shares purchased for the three months ended March 31, 2007 represent shares
required to satisfy tax withholding requirements on the vesting of restricted
shares. We announced stock repurchase plans on various dates from September
1997
through November 1999 for the total repurchase of 7,455,000 shares. None
of
these plans have expiration dates on repurchases. Shares totaling 1,000,000
are
currently available for repurchase under those plans.
Item
6.
EXHIBITS
Exhibit
Number
|
|
Exhibit
|
|
|
|
31.1
|
|
Certification
of the Chief Executive Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
|
31.2
|
|
Certification
of the Chief Financial Officer pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002
|
32.1
|
|
Certification
of the Chief Executive Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002 (filed herewith)
|
32.2
|
|
Certification
of the Chief Financial Officer pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
|
SIGNATURES
Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant
has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
|
|
|
|
REDWOOD
TRUST, INC.
|
|
|
|
Dated:
May 8, 2007
|
By: |
/s/
Douglas B. Hansen |
|
Douglas
B. Hansen
|
|
President
(authorized
officer of registrant)
|
|
|
|
|
|
|
Dated:
May 8, 2007
|
By: |
/s/
Martin S. Hughes |
|
Martin
S. Hughes
|
|
Vice
President, Chief Financial Officer,
and
Secretary
(principal
financial officer)
|
|
|
|
|
|
|
Dated:
May 8, 2007
|
By: |
/s/
Raymond S. Jackson |
|
Raymond
S. Jackson
|
|
Vice
President and Controller
(principal
accounting officer)
|