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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, changes in fair values of assets and liabilities, and capital utilization. In addition, volatility may occur because of technical accounting issues, some of which are described below.
Loan Premium Amortization
Our unamortized loan premium on our consolidated residential real estate loans at March 31, 2008 was $79 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 $8 million in the first quarter of 2008 and $12 million in the first quarter of 2007. Declines in short-term interest rates and increases in prepayments 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 is currently in excess of their fair 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.
FVO Assets and Liabilities
As of January 1, 2008 we elected FVO for all assets, derivatives, and liabilities in Acacia and certain other assets at Redwood. We also plan to elect FVO for certain new acquisitions. These FVO elections under FAS 159 could lead to significant GAAP volatility as we will now MTM through the income statement each quarter all of the assets and liabilities of Acacia and certain other assets and liabilities. The market value of paired assets and liabilities may not move in tandem in any one quarter. Thus, even if the liabilities can only be paid from the cash flows of the collateral assets (as in the Acacia securitization entities), we may report significant income or loss in a period.
Changes in Fair Values on Real Estate Securities
All our securities are classified as AFS, trading instruments, or FVO, and in all cases, are carried on our consolidated balance sheets at their estimated fair values. For the trading instruments and FVO securities, changes in the fair value flow through the income statement. For AFS securities, cumulative unrealized gains and losses are reported as a component of accumulated other comprehensive (loss) income in our consolidated statements of stockholders’ equity. However, adverse changes to projected cash flows related to poor credit performance, our decision to sell assets, or the likelihood that fair values would return to previous levels within a reasonable time could create an other-than-temporary impairment for accounting purposes and could cause declines in fair values to be reported through our income statement as market valuation adjustments.
At March 31, 2008, we had $232 million of securities at Redwood. Of these, $98 million were backed by residential prime loans ($78 million CES and $20 million IGS), $17 million were backed by option alt-a residential loans ($9 million CES, $5 million IGS, and $3 million other real estate securities), $2 million were backed by residential subprime loans ($1 million CES and $1 million IGS), $100 million were CES backed by commercial loans, and $15 million were CDO IGS.
Most of these securities at Redwood (88%, or $205 million) are accounted for as AFS. In the event future credit performance on our CES securities is worse than our current projections, we would be required to report losses through our income statement. The remaining portion (12%, or $27 million, including prime and alt-a residential IGS, CDO IGS, and other real estate securities) are accounted for as FVO or trading instruments. All changes in their fair values are reported through our income statement.
At March 31, 2008, the Opportunity Fund had $36 million of securities accounted for as AFS. Of these, $9 million were subprime IGS and $27 million were CDO IGS.
Changes in Fair Values of Derivative Financial Instruments
To date, we have elected three classifications for derivative instruments: FVO, trading instruments, and cash flow hedges. All derivative instruments, regardless of classification, are reported on our consolidated
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balance sheets at fair value. Changes to the fair values of the derivatives classified as FVO or trading instruments are recognized through the consolidated statements of income (loss). For those derivatives accounted for as cash flow hedges, the changes in fair 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 changes in the fair values of the derivatives are reported through our income statement but changes in the fair values in the hedged assets or liabilities are not recognized in a similar manner. Earnings volatility 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.
Credit Losses
To determine taxable income we are not permitted to anticipate, or reserve for, credit losses. Taxable income can only be reduced when credit losses occur. 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 only accrete a portion of the purchase discount into income. Additionally, for GAAP we write-down these securities when they become impaired. 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, 2008, the cumulative difference between the GAAP and tax amortized costs basis of our residential, commercial, and CDO CES was $377 million. In addition, as of March 31, 2008, we had a credit reserve of $27 million for GAAP for our consolidated residential and commercial loans. As of March 31, 2008, we also had a $9 million reserve for accrued interest on securities backed by option ARMs for GAAP and no corresponding reserve on this income 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.
Income Recognition on Sequoia Interest-Only Securities (IOs)
As a result of rapid prepayments in prior years and in spite of the recent slowdown in prepayments on these loans, we continue to experience 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. That is, we are able to amortize our tax basis on these IOs by the amount of cash we received, effectively reporting zero income on these IOs until the tax basis is reduced. As a result, our current tax basis is $55 million and will continue to decrease as we earn cash on these IOs. Many of our Sequoia securitization entities are currently callable and others will become callable over the next two years. Depending on prevailing market conditions, we may call certain securitizations, at which time the remaining IO tax basis will be written off and an ordinary loss for tax will be realized. At this time, we do not anticipate calling any Sequoia deals in 2008. Our taxable earnings will vary from period to period based on the exact timing of these Sequoia calls.
Compensation Expense
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. For the most part, for GAAP, the total expense associated with an award is determined at the award date and is recognized over the vesting period. For tax, the expense is recognized at the date of distribution or exercise. This leads to the possibility that the total expense related to equity awards could be significantly different for GAAP than for tax in addition to the differences in timing.
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FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES
Management’s Supplemental Analysis
The table set forth below shows the consolidating components of our consolidated balance sheet at March 31, 2008 after giving effect to the adoption of FAS 159 on January 1, 2008. We elected to apply FAS 159 to fair value the assets and liabilities of Acacia and certain other real estate securities held at Redwood. We did not elect to apply FAS 159 to Sequoia assets or liabilities, to most of the securities owned by Redwood, or to Redwood’s debt or subordinated notes.
Table 21 Consolidating Balance Sheet
 | | | | | | | | | | |
March 31, 2008
(In Thousands) | | Redwood | | Sequoia | | Acacia | | Intercompany Adjustments | | Redwood Consolidated |
| Real estate loans | | $ | 4,695 | | | $ | 6,751,491 | | | $ | 18,801 | | | $ | — | | | $ | 6,774,987 | |
| Real estate and other securities – FVO | | | 23,371 | | | | — | | | | 925,768 | | | | — | | | | 949,139 | |
| Real estate and other securities – AFS | | | 242,030 | | | | — | | | | 88,188 | | | | (88,188 | ) | | | 242,030 | |
| Other real estate investments | | | 3,437 | | | | — | | | | — | | | | — | | | | 3,437 | |
| Non-real estate investments | | | — | | | | — | | | | 78,770 | | | | — | | | | 78,770 | |
| Cash and cash equivalents | | | 256,895 | | | | — | | | | — | | | | — | | | | 256,895 | |
| Total earning assets | | | 530,428 | | | | 6,751,491 | | | | 1,111,527 | | | | (88,188 | ) | | | 8,305,258 | |
| Investment in Sequoia | | | 145,680 | | | | — | | | | — | | | | (145,680 | ) | | | — | |
| Investment in Acacia | | | 68,614 | | | | — | | | | — | | | | (68,614 | ) | | | — | |
| Restricted cash | | | 11,180 | | | | 315 | | | | 137,758 | | | | — | | | | 149,253 | |
| Accrued interest receivable | | | (1,983 | ) | | | 32,284 | | | | 7,232 | | | | — | | | | 37,533 | |
| Derivative assets | | | — | | | | — | | | | 3,964 | | | | — | | | | 3,964 | |
| Deferred tax asset | | | 8,481 | | | | — | | | | — | | | | — | | | | 8,481 | |
| Deferred asset-backed securities issuance costs | | | 3,678 | | | | 12,820 | | | | — | | | | — | | | | 16,498 | |
| Other assets | | | 13,135 | | | | 3,009 | | | | 8,850 | | | | — | | | | 24,994 | |
| Total Assets | | $ | 779,213 | | | $ | 6,799,919 | | | $ | 1,269,331 | | | $ | (302,482 | ) | | $ | 8,545,981 | |
| Redwood debt | | $ | 2,086 | | | $ | — | | | $ | — | | | $ | — | | | $ | 2,086 | |
| Asset-backed securities issued – Sequoia | | | — | | | | 6,544,491 | | | | — | | | | — | | | | 6,544,491 | |
| Asset-backed securities issued – Sequoia FVO (IC) | | | — | | | | 88,188 | | | | — | | | | (88,188 | ) | | | — | |
| Asset-backed securities issued – Acacia FVO | | | — | | | | — | | | | 1,046,160 | | | | — | | | | 1,046,160 | |
| Accrued interest payable | | | 1,423 | | | | 16,847 | | | | 25,612 | | | | — | | | | 43,882 | |
| Derivative liabilities | | | 5,993 | | | | — | | | | 128,217 | | | | — | | | | 134,210 | |
| Accrued expenses and other liabilities | | | 10,085 | | | | 4,713 | | | | 728 | | | | — | | | | 15,526 | |
| Dividends payable | | | 24,532 | | | | — | | | | — | | | | — | | | | 24,532 | |
| Subordinated notes | | | 150,000 | | | | — | | | | — | | | | — | | | | 150,000 | |
| Total liabilities | | | 194,119 | | | | 6,654,239 | | | | 1,200,717 | | | | (88,188 | ) | | | 7,960,887 | |
| Total stockholders’ equity | | | 585,094 | | | | 145,680 | | | | 68,614 | | | | (214,294 | ) | | | 585,094 | |
| Total Liabilities and Stockholders’ Equity | | $ | 779,213 | | | $ | 6,799,919 | | | $ | 1,269,331 | | | $ | (302,482 | ) | | $ | 8,545,981 | |
At March 31, 2008, our stockholders’ equity totaled $585 million, we had unrestricted cash of $257 million, and we had short-term debt of only $2 million.
The following supplemental non-GAAP balance sheet presents our assets and liabilities as reported under GAAP and as estimated by us using economic values for our investments. We show our investments in the Sequoia and Acacia securitization entities in separate line items similar to the equity method of accounting,
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reflecting the reality that the underlying assets and liabilities owned by these entities are legally not ours. We own only the securities we have acquired from these entities. This table, except for our estimates of economic value, is derived from the table above.
Table 22 Components of Book Value
| | | | | | |
| | March 31, 2008 |
| (In Millions, Except per Share Data) | | As Reported | | Adjustments | | Management's
Estimate of
Economic Value |
Real estate securities (excluding Sequoia and Acacia)
| | | | | | | | | | | | |
| Residential | | $ | 126 | | | | — | | | $ | 126 | |
| Commercial | | | 100 | | | | — | | | | 100 | |
| CDO | | | 42 | | | | — | | | | 42 | |
| Subtotal real estate securities | | | 268 | | | | — | | | | 268 | |
| Cash and cash equivalents | | | 257 | | | | — | | | | 257 | |
| Investments in Sequoia | | | 146 | | | | (54)(a) | | | | 92 | |
| Investments in Acacia | | | 68 | | | | (19)(b) | | | | 49 | |
| Other assets/liabilities, net(d) | | | (4 | ) | | | | | | | (4 | ) |
| Subordinated notes | | | (150 | ) | | | 78 | (c) | | | (72 | ) |
| Stockholders' Equity | | | $585 | | | | | | | | $590 | |
| Book Value Per Share | | | $17.89 | | | | | | | | $18.04 | |
| (a) | Our actual Sequoia investments consist of CES, IGS, and IOs acquired by Redwood from the Sequoia entities. We calculated the $92 million estimate of economic value for these securities using the same valuation process that we followed to fair value all other real estate securities. In contrast, the $146 million of GAAP carrying value of these investments represents the difference between residential real estate loans owned by the Sequoia entities and the asset-backed securities (ABS) issued by those entities to third party investors. We account for these loans and ABS issued at cost, not at fair value. This is the primary reason for the $54 million disparity between GAAP carrying value and our estimate of economic value. |
| (b) | Our actual Acacia investments consist of equity interests, and to a lesser extent ABS issued, that we acquired from the Acacia entities. The $49 million estimate of economic value of our investment interests in the Acacia entities at March 31, 2008 represents the net present value of projected cash flows from our Acacia investments and management fees discounted at 45%, except for the CDO ABS that we have recently repurchased at substantial discounts from face which are valued at cost. The reason for the difference between economic and GAAP carrying values is complex and relates to a significant difference in valuation methodology. |
| (c) | We issued $150 million of 30-year subordinated notes at an interest rate of LIBOR plus 225 basis points. Under GAAP, these notes are carried at cost. Economic value is difficult to estimate with precision as the market for these notes is currently inactive. We calculated the $72 million estimate of economic value using the same valuation process used to fair value our other financial assets and liabilities. Estimated economic value is $78 million lower than our GAAP carrying value because given the significant overall contraction in credit availability and re-pricing of credit risk, if we had issued these subordinated notes at March 31, 2008, investors would have required a substantially higher interest rate. |
| (d) | Other assets/liabilities, net are comprised of real estate loans of $5 million, restricted cash of $11 million, and other assets of $24 million, less Redwood debt of $2 million, dividend payable of $25 million, and other liabilities of $17 million. |
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Summary
The following is a discussion of our business of investing in, financing, and managing real estate loans and securities by type of earning asset consolidated on our balance sheet.
Real Estate Securities at Redwood
The following table provides detail of the activity for the first quarter of 2008 with respect to the securities at Redwood, excluding our investments in Acacia and Sequoia and securities owned by those securitization entities and excluding the securities held at the Opportunity Fund.
Table 23 Real Estate Securities Activity at Redwood
| | | | | | | | | | | | |
March 31, 2008
(In Thousands) | | Residential
CES | | Residential
IGS | | Commercial
CES | | CDO
CES | | CDO
IGS | | Total |
| Balance at beginning of period | | $ | 151,009 | | | $ | 12,226 | | | $ | 148,508 | | | $ | 2,372 | | | $ | 18,450 | | | $ | 332,565 | |
| Acquisitions | | | 10,159 | | | | 28,048 | | | | — | | | | — | | | | — | | | | 38,207 | |
| Principal repayments (including calls) | | | (16,787 | ) | | | (1,702 | ) | | | — | | | | 30 | | | | — | | | | (18,459 | ) |
| Recognized gains on calls, net | | | 42 | | | | — | | | | — | | | | — | | | | — | | | | 42 | |
| Discount amortization | | | 11,570 | | | | 63 | | | | (1,523 | ) | | | — | | | | — | | | | 10,110 | |
| Transfer from (to) other portfolios | | | 953 | | | | 3,105 | | | | — | | | | — | | | | — | | | | 4,058 | |
| Change in fair value adjustments, net | | | (68,749 | ) | | | (15,890 | ) | | | (47,462 | ) | | | (1,716 | ) | | | (2,946 | ) | | | (136,763 | ) |
| Balance at End of Period | | $ | 88,197 | | | $ | 25,850 | | | $ | 99,523 | | | $ | 686 | | | $ | 15,504 | | | $ | 229,760 | |
During the quarter, we acquired $38 million securities, had MTM adjustments of negative $139 million, principal payments of $19 million and discount amortization of $10 million, resulting in a net $112 million reduction in our securities portfolio from $344 to $229 million at March 31, 2008.
At March 31, 2008, in addition to the $229 million of securities described above there were $3 million of OREI at Redwood.
The table below provides product type and vintage information regarding the $232 million of securities owned by Redwood.
Table 24 Real Estate Securities at Redwood
| | | | | | | | | | | | |
March 31, 2008
(In Millions) | | 2004 & Earlier | | 2005 | | 2006 | | 2007 | | 2008 | | Grand
Total |
Prime
| | | | | | | | | | | | | | | | | | | | | | | | |
| IGS | | $ | 4 | | | $ | 1 | | | $ | 9 | | | $ | — | | | $ | 6 | | | $ | 20 | |
| CES | | | 48 | | | | 15 | | | | 5 | | | | 8 | | | | 2 | | | | 78 | |
Alt-a
| | | | | | | | | | | | | | | | | | | | | | | | |
| IGS | | | — | | | | — | | | | 1 | | | | 4 | | | | — | | | | 5 | |
| CES | | | 1 | | | | 4 | | | | 1 | | | | 3 | | | | — | | | | 9 | |
| OREI | | | — | | | | — | | | | 2 | | | | 1 | | | | — | | | | 3 | |
Subprime
| | | | | | | | | | | | | | | | | | | | | | | | |
| IGS | | | 1 | | | | — | | | | — | | | | — | | | | — | | | | 1 | |
| CES | | | — | | | | — | | | | — | | | | 1 | | | | — | | | | 1 | |
| Residential Subtotal | | | 54 | | | | 20 | | | | 18 | | | | 17 | | | | 8 | | | | 117 | |
| Commercial IGS | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | |
| Commercial CES | | | 16 | | | | 21 | | | | 48 | | | | 15 | | | | — | | | | 100 | |
| CDO IGS | | | 7 | | | | 7 | | | | — | | | | 1 | | | | — | | | | 15 | |
| Totals | | $ | 77 | | | $ | 48 | | | $ | 66 | | | $ | 33 | | | $ | 8 | | | $ | 232 | |
The following table presents the carrying value (which equals fair value) as a percent of face value at March 31, 2008 for the securities at Redwood.
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Over 80% of our investments in real estate securities at March 31, 2008 were residential and commercial CES. We acquire CES at a significant discount to their principal value as credit losses could reduce or totally eliminate the principal value of these bonds. Our return on these investments is based on how much principal and interest we receive, and how quickly we receive it. In an ideal environment we would experience fast prepayments and low credit losses allowing us to recover a substantial part of the discount as income. Conversely, the least beneficial environment would be slow prepayments and high credit losses.
The following table presents the components of carrying value (which equals fair value) at March 31, 2008 for residential and commercial CES.
Table 26 Credit-Enhancement Securities at Redwood
| | | | | | |
March 31, 2008
(In Millions) | | Residential | | |
| | | Prime | | Alt-a | | Commercial |
| Current face | | $ | 538 | | | $ | 217 | | | $ | 523 | |
| Unamortized discount, net | | | (61 | ) | | | (1 | ) | | | (37 | ) |
| Discount designated as credit reserve | | | (358 | ) | | | (205 | ) | | | (378 | ) |
| Amortized cost | | | 119 | | | | 11 | | | | 108 | |
| Gross unrealized market value gains | | | 3 | | | | — | | | | 2 | |
| Gross unrealized market value losses | | | (44 | ) | | | (2 | ) | | | (10 | ) |
| Carrying Value | | $ | 78 | | | $ | 9 | | | $ | 100 | |
| Carrying value as a percentage of face | | | 14 % | | | | 4 % | | | | 19 | % |
We also own $1 million subprime CES with a face value of $36 million.
Residential Credit-Enhancement Securities at Redwood
A significant 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 come from taking on concentrated credit risks.
We acquired $10 million residential CES the first quarter of 2008 which were all prime securities.
Our residential CES portfolio had a fair value of $88 million at March 31, 2008, a decrease of $63 million from the fair value of $151 million at December 31, 2007. The primary reason was a decline in fair values in these securities during this period.
As a result of the concentrated credit risk associated with residential CES, we are generally able to acquire these securities at a discount to their face (principal) value. At March 31, 2008, the difference between the principal value ($778 million) and carrying value ($88 million) — which equals the fair value of these residential loan CES — was $690. Of this difference, $584 million was designated as internal credit reserve (reflecting our estimate of credit losses on the underlying loans over the life of these securities), $64 million represented unamortized discount we are accreting into income over time, and $42 million represented net unrealized mark-to-market losses. Amortized cost (principal value less internal credit reserve less amortized discount) decreased $72 million from $202 million at December 31, 2007 to $130 million at March 31, 2008 primarily as a result of declines in fair values and the effect of the impairment charges. Net unrealized mark-to-market gains fell by $9 million from net losses of $51 million at December 31, 2007 to net losses of $42 million at March 31, 2008.
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The following table details our residential CES portfolios by the product type and collateral vintage at March 31, 2008.
Table 27 Residential Credit-Enhancement Securities at Redwood — Product and Vintage
| | | | | | | | | | | | |
| | Vintage |
March 31, 2008
(In Millions) | | 2004 &
Earlier | | 2005 | | 2006 | | 2007 | | 2008 | | Total |
Prime
| | | | | | | | | | | | | | | | | | | | | | | | |
| Option ARM | | $ | 3 | | | $ | 3 | | | $ | 1 | | | $ | 1 | | | $ | — | | | $ | 8 | |
| ARM | | | 4 | | | | — | | | | — | | | | — | | | | — | | | | 4 | |
| Hybrid | | | 28 | | | | 12 | | | | 3 | | | | 3 | | | | 1 | | | | 47 | |
| Fixed | | | 13 | | | | — | | | | 1 | | | | 4 | | | | 1 | | | | 19 | |
| Total prime | | | 48 | | | | 15 | | | | 5 | | | | 8 | | | | 2 | | | | 78 | |
Alt-a
| | | | | | | | | | | | | | | | | | | | | | | | |
| Option ARM | | | — | | | | 4 | | | | 1 | | | | 3 | | | | — | | | | 8 | |
| Hybrid | | | 1 | | | | — | | | | — | | | | — | | | | — | | | | 1 | |
| Total alt-a | | | 1 | | | | 4 | | | | 1 | | | | 3 | | | | — | | | | 9 | |
Subprime
| | | | | | | | | | | | | | | | | | | | | | | | |
| Hybrid | | | — | | | | — | | | | — | | | | 1 | | | | — | | | | 1 | |
| Total subprime | | | — | | | | — | | | | — | | | | 1 | | | | — | | | | 1 | |
| Total Residential CES | | $ | 49 | | | $ | 19 | | | $ | 6 | | | $ | 12 | | | $ | 2 | | | $ | 88 | |
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 existing 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. Borrower’s 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 loans underlying all of our residential CES totaled $151 billion at March 31, 2008, and consist of $127 billion prime, $18 billion alt-a, and $6 billion subprime. These loans are located nationwide with a large concentration in California (49%). During the first quarter of 2008, realized residential credit losses were $31 million of principal value, a rate that equals eight basis points (0.08%) on an annualized basis of the balance of the loans. Serious delinquencies (90+ days, in foreclosure or REO) at March 31, 2008 were 3.06% of current balance and 1.46% of original balance. For loans in prime pools, delinquencies were 1.27% of current balance and 0.60% of original balance. Alt-a pools had delinquencies of 9.51% of current balance and 4.49% of original balance. Subprime pools had delinquencies of 22.13% of current balance and 17.21% of original balance.
Residential Investment-Grade Securities at Redwood
We invest in investment-grade residential securities (IGS) backed by prime, alt-a, and subprime residential loans. Our residential IGS portfolio totaled $26 million at March 31, 2008, an increase from the
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$12 million at December 31, 2007. The increase in this portfolio was the result of net acquisitions of $28 million, partially offset by decreases in the fair values of these securities during the period. The $28 million of net IGS acquired in the first quarter of 2008 were all prime securities.
The following table details our residential IGS portfolio by the product type and collateral vintage at March 31, 2008.
Table 28 Residential Investment Grade Securities at Redwood — Product and Vintage
| | | | | | | | | | | | |
| | Vintage |
March 31, 2008
(In Millions) | | 2004 &
Earlier | | 2005 | | 2006 | | 2007 | | 2008 | | Total |
Prime
| | | | | | | | | | | | | | | | | | | | | | | | |
| Hybrid | | $ | 3 | | | $ | 1 | | | $ | 1 | | | $ | — | | | $ | 3 | | | $ | 8 | |
| Fixed | | | 1 | | | | — | | | | 8 | | | | — | | | | 3 | | | | 12 | |
| Total prime | | | 4 | | | | 1 | | | | 9 | | | | — | | | | 6 | | | | 20 | |
Alt-a
| | | | | | | | | | | | | | | | | | | | | | | | |
| Option ARM | | | — | | | | — | | | | 1 | | | | — | | | | — | | | | 1 | |
| Hybrid | | | — | | | | — | | | | — | | | | 4 | | | | — | | | | 4 | |
| Fixed | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | |
| Total alt-a | | | — | | | | — | | | | 1 | | | | 4 | | | | — | | | | 5 | |
Subprime
| | | | | | | | | | | | | | | | | | | | | | | | |
| Hybrid | | | 1 | | | | — | | | | — | | | | — | | | | — | | | | 1 | |
| Total subprime | | | 1 | | | | — | | | | — | | | | — | | | | — | | | | 1 | |
| Total Residential IGS | | $ | 5 | | | $ | 1 | | | $ | 10 | | | $ | 4 | | | $ | 6 | | | $ | 26 | |
Commercial Credit-Enhancement Securities at Redwood
Our total commercial CES was $100 million at March 31, 2008, a decrease from $149 million at December 31, 2007 due primarily to a decrease in the fair value of these securities. At March 31, 2008, these securities ($73 million were non-rated, $13 million were B-rated, and $14 million were BB-rated) provided credit-enhancement on $55 billion of underlying loans on office, retail, multifamily, industrial, and other income-producing properties nationwide.
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 ($523 million) and carrying value ($100 million) of our commercial CES at March 31, 2008 was $423 million. Of this difference, $378 million was designated as internal credit reserve (reflecting our estimate of likely credit losses on the underlying loans over the life of these securities), $37 million represented unamortized discount we are accreting into income over time, and $8 million represented net unrealized MTM losses.
Seriously delinquent loans underlying commercial CES at March 31, 2008 were $227 million, an increase of $44 million from the beginning of the year. To date, most of the delinquencies have been concentrated in a few deals for which we have increased our credit reserves and impaired the securities through our income statement. We consider our credit reserve of $378 million to be appropriate as of March 31, 2008.
There were no acquisitions of commercial CES during the quarter although we may renew our acquisition of these types of securities later this year to the extent we find the pricing adequately reflects the risks of future commercial loan performance.
CDO Credit-Enhancement Securities at Redwood
At March 31, 2008, our CDO CES totaled $1 million, a decrease from $2 million at December 31, 2007 as the value of these securities declined during the quarter. There were no acquisitions during this period.
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CDO Investment-Grade Securities at Redwood and Opportunity Fund
At March 31, 2008, our CDO IGS totaled $14 million, a decrease from the December 31, 2007 balance of $18 million as the fair values declined. For the most part, changes in the fair values reflect the bid/ask spread on these securities.
Other Real Estate Investments at Redwood
Our OREI totaled $3 million at March 31, 2008, a decrease from the $12 million at December 31, 2007 as a result of the decrease in the fair value of these securities. At March 31, 2008, we had an equal amount of other real estate investments rated BB, B, and unrated.
Residential Real Estate Loans at Sequoia and Redwood
We did not acquire any residential real estate loans during the first quarter of 2008. As we have in prior years, however, we plan to continue to acquire high-quality residential real estate loans on a bulk or flow basis from originators once the market for residential securitizations returns. Prior to 2006, our loan purchases were predominately comprised of short reset LIBOR indexed ARMs (LIBOR ARMs). In 2006 and 2007 we 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, 2008. The majority of these loans are owned by the Sequoia securitization entities and the reported activity is primarily associated with those loans. The residential loans held outside of any securitization entity and owned by Redwood totaled $4 million at March 31, 2008. This was a $1 million decrease during the quarter due to prepayments and lower market values.
Table 29 Residential Real Estate Loans at Sequoia and Redwood — Activity
| | |
| (In Thousands) | | Three Months Ended
March 31, 2008 |
| Balance at beginning of period | | $ | 7,178,473 | |
| Principal repayments | | | (399,728 | ) |
| Transfers to real estate owned | | | (7,170 | ) |
| Changes in fair value, net | | | (74 | ) |
| Premium amortization | | | (7,510 | ) |
| Provision for credit losses | | | (8,058 | ) |
| Balance at End of Period | | $ | 6,755,933 | |
Our residential real estate loan balance declined to $6.8 billion at March 31, 2008 from $7.2 billion at December 31, 2007. Of the balance at March 31, 2008, 68% (by unpaid principal balance) of the loans were one- and six-month LIBOR ARMs, and were financed almost entirely through securitization entities (only $4 million was funded with equity).
Securities at Acacia
The following table provides detail of the activity with respect to the securities held at Acacia for the three months ended March 31, 2008
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Table 30 Real Estate Securities at Acacia — Activity
| | | | | | | | | | | | | | |
March 31, 2008
(In Thousands) | | Residential
CES | | Residential
IGS | | Commercial
CES | | Commercial
IGS | | CDO
CES | | CDO
IGS | | Total |
| Balance at beginning of period | | $ | 250,936 | | | $ | 1,142,113 | | | $ | 188,327 | | | $ | 89,676 | | | $ | 8,169 | | | $ | 83,094 | | | $ | 1,762,315 | |
| Principal repayments | | | (16,312 | ) | | | (37,003 | ) | | | — | | | | (658 | ) | | | (271 | ) | | | (375 | ) | | | (54,619 | ) |
| Recognized gains on calls, net | | | — | | | | 3 | | | | — | | | | — | | | | — | | | | — | | | | 3 | |
| Transfer from (to) other portfolios | | | 17,357 | | | | (17,036 | ) | | | — | | | | (5,482 | ) | | | 1,596 | | | | 3,886 | | | | 321 | |
| Change in fair value adjustments, net | | | (149,057 | ) | | | (499,338 | ) | | | (75,773 | ) | | | (20,755 | ) | | | (3,467 | ) | | | (33,862 | ) | | | (782,252 | ) |
| Balance at End of Period | | $ | 102,924 | | | $ | 588,739 | | | $ | 112,554 | | | $ | 62,781 | | | $ | 6,027 | | | $ | 52,743 | | | $ | 925,768 | |
In addition to the $926 million of real estate securities included in the table above, Acacia owned $88 million of ABS issued by Sequoia, $79 million in non-real estate securities, and $19 million in commercial loans.
The table below presents the assets owned by each Acacia entity, by product type, and the corresponding liabilities as reported on March 31, 2008.
Table 31 Acacia Balance Sheets
| | | | | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | |
March 31, 2008
(In Millions) | | Acacia 5
Issued
Jul-04 | | Acacia 6
Issued
Nov-04 | | Acacia 7
Issued
Mar-05 | | Acacia 8
Issued
Jul-05 | | Acacia CRE1
Issued
Dec-05 | | Acacia 9
Issued
Mar-06 | | Acacia 10
Issued
Aug-06 | | Acacia 11
Issued
Feb-07 | | Acacia OA1
Issued
May-07 | | Acacia 12
Issued
Jun-07 | | Total |
Residential IGS
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Prime Sequoia | | $ | 12 | | | $ | 13 | | | $ | 9 | | | $ | 5 | | | $ | 1 | | | $ | 3 | | | $ | 3 | | | $ | 3 | | | $ | 7 | | | $ | 14 | | | $ | 70 | |
| Prime other | | | 22 | | | | 35 | | | | 28 | | | | 22 | | | | 13 | | | | 37 | | | | 40 | | | | 20 | | | | 2 | | | | 15 | | | | 234 | |
| Alt-a | | | 13 | | | | 9 | | | | 5 | | | | 7 | | | | 1 | | | | 6 | | | | 19 | | | | 50 | | | | 43 | | | | 52 | | | | 205 | |
| Subprime | | | 26 | | | | 53 | | | | 45 | | | | 4 | | | | — | | | | 6 | | | | 1 | | | | 6 | | | | 1 | | | | 8 | | | | 150 | |
Residential CES
| | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | | |
| Prime Sequoia | | | 2 | | | | 3 | | | | 3 | | | | 5 | | | | — | | | | 2 | | | | 3 | | | | — | | | | — | | | | — | | | | 18 | |
| Prime other | | | 11 | | | | 7 | | | | 4 | | | | 11 | | | | — | | | | 7 | | | | 24 | | | | 8 | | | | — | | | | 5 | | | | 77 | |
| Alt-a | | | — | | | | — | | | | — | | | | 1 | | | | — | | | | 1 | | | | 1 | | | | 5 | | | | 5 | | | | 2 | | | | 15 | |
| Subprime | | | 4 | | | | 1 | | | | — | | | | 1 | | | | — | | | | — | | | | 1 | | | | 2 | | | | — | | | | 2 | | | | 11 | |
| Commercial IGS | | | 6 | | | | 6 | | | | 5 | | | | 8 | | | | 32 | | | | 2 | | | | — | | | | — | | | | — | | | | 3 | | | | 62 | |
| Commercial CES | | | 1 | | | | 3 | | | | 9 | | | | 13 | | | | 46 | | | | 7 | | | | 14 | | | | 12 | | | | — | | | | 8 | | | | 113 | |
| Commercial loans | | | 3 | | | | — | | | | 6 | | | | 3 | | | | 7 | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 19 | |
| CDO: CMBS | | | 2 | | | | 3 | | | | 1 | | | | — | | | | 10 | | | | 5 | | | | 5 | | | | 12 | | | | 2 | | | | 4 | | | | 44 | |
| CDO: RMBS | | | 2 | | | | 3 | | | | 1 | | | | 2 | | | | — | | | | 1 | | | | 1 | | | | 2 | | | | — | | | | 3 | | | | 15 | |
| GIC | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | — | | | | 79 | | | | — | | | | 79 | |
| Totals | | | 104 | | | | 136 | | | | 116 | | | | 82 | | | | 110 | | | | 77 | | | | 112 | | | | 120 | | | | 139 | | | | 116 | | | | 1,112 | |
| Restricted cash and other assets | | | 11 | | | | 15 | | | | 39 | | | | 26 | | | | 8 | | | | 12 | | | | 15 | | | | 9 | | | | (11 | ) | | | 33 | | | | 157 | |
| Total Assets | | $ | 115 | | | $ | 151 | | | $ | 155 | | | $ | 108 | | | $ | 118 | | | $ | 89 | | | $ | 127 | | | $ | 129 | | | $ | 128 | | | $ | 149 | | | $ | 1,269 | |
| ABS issued and other liabilities | | $ | 107 | | | $ | 136 | | | $ | 147 | | | $ | 123 | | | $ | 111 | | | $ | 95 | | | $ | 108 | | | $ | 117 | | | $ | 107 | | | $ | 150 | | | $ | 1,201 | |
| Total equity | | | 8 | | | | 15 | | | | 8 | | | | (15 | ) | | | 7 | | | | (6 | ) | | | 19 | | | | 12 | | | | 21 | | | | (1 | ) | | | 68 | |
| Total Liabilities and Equity | | $ | 115 | | | $ | 151 | | | $ | 155 | | | $ | 108 | | | $ | 118 | | | $ | 89 | | | $ | 127 | | | $ | 129 | | | $ | 128 | | | $ | 149 | | | $ | 1,269 | |
The following table presents the carrying value (which equals fair value) as a percent of face value at March 31, 2008 for the securities at Acacia.
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Real Estate Securities at the Opportunity Fund
We began acquiring assets for the Opportunity Fund in the fourth quarter of 2007 and acquired $20 million of assets during the first quarter of 2008, bringing the total cost of securities acquired to date to $42 million. Due to the bid/ask spread on these illiquid securities and principal paydowns net of discount accretion, the fair value of securities held in the Opportunity Fund at March 31, 2008 was $36 million ($6 million less than our cost). The table below provides information on the activity in this Fund during the first quarter of 2008.
Table 33 Securities at Opportunity Fund — Activity
| | | | | | |
March 31, 2008
(In Thousands) | | Residential
IGS | | CDO
IGS | | Total |
| Balance at beginning of period | | $ | 3,126 | | | $ | 12,075 | | | $ | 15,201 | |
| Acquisitions | | | 7,672 | | | | 12,336 | | | | 20,008 | |
| Principal repayments (including calls) | | | (1,137 | ) | | | (9 | ) | | | (1,146 | ) |
| Discount amortization | | | 319 | | | | 435 | | | | 754 | |
| Change in fair value adjustments, net | | | (880 | ) | | | 1,704 | | | | 824 | |
| Balance at End of Period | | $ | 9,100 | | | $ | 26,541 | | | $ | 35,641 | |
At March 31, 2008, the $36 million of securities held in the Opportunity Fund consisted of $9 million of residential subprime IGS originated prior to 2005, $16 million of CDO IGS created in 2004, and $11 million of CDO IGS created in 2005. These securities are performing in line with our expectations and we did not recognize any other-than-temporary impairments on these securities on our consolidated financial statements.
We anticipate acquiring additional securities and fully investing the $96 million in capital commitments within the next two quarters.
Liabilities and Stockholders’ Equity
Redwood Debt
At the end of the first quarter of 2008, we had $2 million of recourse debt in the form of repurchase (repo) agreements incurred to finance the acquisition of certain residential investment grade real estate securities. This was a decrease from $8 million at December 31, 2007.
We may increase our use of recourse debt in the future, especially to finance temporarily the accumulation of loans and securities prior to a securitization. We will continue to take into account the mortgage market and economic conditions in determining prudent levels of recourse leverage that are consistent with our internal risk-adjusted capital guidelines.
Asset-Backed Securities Issued by Sequoia and Acacia
Through our sponsored securitization entities, we have securitized the majority of the assets shown on our consolidated balance sheet. These securitization entities acquire assets and create and sell asset-backed securities (ABS) in order to fund their asset purchases. The residential whole loan securitization entities we sponsor are called Sequoia and the CDO securitization entities we sponsor are called Acacia. These securitization entities are bankruptcy-remote from us, so that our liabilities cannot become liabilities of the securitization entities and the ABS issued by the securitization entities cannot become obligations of Redwood. Nevertheless, since, according to accounting definitions, we are deemed to control these securitization entities, we show both the assets and liabilities of these entities on our consolidated balance sheet.
At March 31, 2008, our consolidated balance sheet included $6.8 billion of loans reported at cost owned by Sequoia securitization entities and funded with $6.5 billion Sequoia ABS issued that is also reported at cost on our consolidated balance sheet. At March 31, 2008, our consolidated balance sheets included $1.1 billion of securities reported at fair value owned by Acacia securitization entities and funded with $1.0 billion Acacia ABS issued also reported at fair value. In total, the consolidated assets of these two programs represent 95% of our total consolidated assets and their ABS issued represent 99% of our total consolidated liabilities.
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The following table provides detail on the activity for asset-backed securities for the three months ended March 31, 2008.
Table 34 ABS Issued by Sequoia and Acacia — Activity
| | | | | | | | | | | | | | |
| (In Thousands) | | December 31,
2007 | | New
Issuance | | Paydowns | | FAS 159
Adjustments | | Market
Valuation
Adjustments | | Amortization | | March 31,
2008 |
| Sequoia ABS issued with principal value, net | | $ | 6,910,946 | | | $ | — | | | $ | (393,788 | ) | | $ | — | | | $ | — | | | $ | (2,183 | ) | | $ | 6,514,975 | |
| Sequoia ABS interest only issued | | | 35,220 | | | | — | | | | — | | | | — | | | | — | | | | (5,704 | ) | | | 29,516 | |
| Total Sequoia ABS Issued | | | 6,946,166 | | | | — | | | | (393,788 | ) | | | — | | | | — | | | | (7,887 | ) | | | 6,544,491 | |
| Acacia issued ABS with principal value, net | | | 3,359,406 | | | | — | | | | (37,440 | ) | | | (1,468,345 | ) | | | (807,890 | ) | | | — | | | | 1,045,731 | |
| Acacia ABS CES issued | | | 23,707 | | | | — | | | | — | | | | (21,327 | ) | | | (1,951 | ) | | | — | | | | 429 | |
| Total Acacia ABS Issued | | | 3,383,113 | | | | — | | | | (37,440 | ) | | | (1,489,672 | ) | | | (809,841 | ) | | | — | | | | 1,046,160 | |
| Total ABS Issued | | $ | 10,329,279 | | | $ | — | | | $ | (431,228 | ) | | $ | (1,489,672 | ) | | $ | (809,841 | ) | | $ | (7,887 | ) | | $ | 7,590,651 | |
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 is paid off upon securitization.
Subordinated Notes
In 2006, we issued $100 million of subordinated notes (trust preferred securities) through Redwood Capital Trust I, a 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.
In May 2007, we issued $50 million of subordinated notes which 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 July 30, 2037. The earliest optional redemption date without a penalty is July 30, 2012.
In our internal risk-adjusted capital calculations we include these subordinated notes in our capital base.
Derivative Financial Instruments
We currently have two kinds of derivative instruments: interest rate agreements and credit default swaps. All derivatives are reported on our balance sheet at fair value. Changes in the fair values of derivatives are either recorded through our consolidated statements of income (loss) 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, 2008, Redwood was party to interest rate agreements with an aggregate notional value of $300 million and a net fair value of negative $6 million. These are all accounted for as trading instruments and all changes in value and any net payments and receipts are recognized through our income statement through market valuation adjustments.
At March 31, 2008 the Acacia entities were party to interest rate agreements with an aggregate notional value of $1.8 billion and a net negative fair value of $52 million. On January 1, 2008, we elected to account for these derivatives under the fair value option of FAS 159. These derivatives had previously been accounted
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for as cash flow hedges under FAS 133. As a result of the de-designation of cash flow hedges at the beginning of this year, the fair value of these derivatives at that time (negative $33 million) was retained in accumulated other comprehensive income. This amount will be amortized as interest expense over the remaining lives of the Acacia liabilities and $1 million was amortized in the first quarter of 2008. Any changes in the fair value of these derivatives and any net payments and receipts subsequent to January 1, 2008 are recognized through market valuation adjustments on our consolidated statements of income. Interest rate agreements owned by Acacia decreased in value by $35 million during the first quarter of 2008.
Acacia entered into credit default swaps in the first quarter of 2007. At March 31, 2008, these had a $79 million notional balance with a fair value of negative $72 million. At December 31, 2007, these credit default swaps had the same notional balance and a fair value of negative $57 million. The decrease in fair value on these swaps is included in the market valuation adjustments on our consolidated statements of income.
Stockholders’ Equity
Our reported book value at March 31, 2008 was $17.89 per share, a decrease from $23.18 per share at the beginning of the year, after the adoption of FAS 159. Our book value per share decreased over this period primarily as a result of declines in the fair value of the assets consolidated on our balance sheets.
Cash Requirements, Sources of Cash, and Liquidity
We use capital to fund our operations, invest in earning assets which are primarily credit sensitive and illiquid, fund working capital, and to meet lender capital requirements with respect to collateralized borrowings. Through our internal risk-adjusted capital policy, we set aside a prudent level of reserve capital for our earning assets to meet liquidity needs that may arise. In most cases, the amount of capital set aside is equal to 100% of the fair value of the asset. Any capital that exceeds our risk-adjusted capital guideline amount is excess capital that can be invested to support business growth.
When we think about capital, we analyze it from the perspective of the amount of “economic capital” we have to manage, which is the amount we have set aside for our earning assets (at fair value) and the amount of excess capital (or cash) we have available to invest in new assets. Economic capital is calculated by taking our GAAP equity and adjusting for any differences between the fair value of our investments in Sequoia and Acacia and the GAAP reported values, subtracting the net other assets and liabilities, and adding our long term debt.
At March 31, 2008, our total available capital, defined as the sum of our excess capital plus our invested capital, amounted to $660 million, compared to $793 million at December 31, 2007. The decline reflects market value adjustments on our employed capital. Our total available capital of $660 million differs from our GAAP capital (equity plus long-term debt) of $735 million because we adjust our GAAP capital for “economic” value changes to our investments in Sequoia and Acacia and we deduct net other assets and liabilities.
Capital employed decreased in the first quarter by $83 million to $413 million mainly as a result of market value changes which was partially offset by $65 million of new acquisitions. Declines in the fair values of assets do not have a large effect on excess capital, as asset value declines reduce equally both available capital and capital required for these investments.
At March 31, 2008, we had $247 million of excess capital, a decrease from $282 million at December 31, 2007. The decrease in excess capital reflects our investment activity in the first quarter.
Our net liquid assets at March 31, 2008 totaled $263 million and, as presented in the table below, included $257 of unrestricted cash, $4 million unsecuritized residential real estate loans at fair value, and $4 million of AAA-rated securities at fair value, less $2 million of Redwood debt.
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Table 35 Liquidity Position
| | |
| (In Millions) | | March 31, 2008 |
| Unrestricted cash | | $ | 257 | |
| Unsecuritized residential loans | | | 4 | |
| AAA-rated residential securities | | | 4 | |
| Liquid assets | | | 265 | |
| Redwood debt | | | (2 | ) |
| Net Liquidity Position | | $ | 263 | |
We are well aware of the depressed prices the market currently places on securities we hold. We are long term investors and we fund most of our investments with equity. We acquire our securities at discounts, and in many cases substantial discounts to face value, and we model a range of expected cash flows that we expect to collect over the life of each security. To the extent the fair values our securities are lower or higher from time to time is of modest consequence to us as long-term investors — provided the cash flows remain within our range of expectations.
It is important to note that the high level of excess capital and liquidity over the past several quarters resulted, in part, from our efforts to maintain a strong balance sheet during a time of market distress. It also resulted, in part, from our strategic decision to sell lower-yielding, higher-rated assets to position us to opportunistically acquire higher yielding assets that could provide us with more upside return. Over time, we expect our excess capital and net liquidity to decline. We have less need to maintain a large liquidity position, however, as most of our investments are funded with equity.
Contractual Obligations and Commitments
The table below presents our contractual obligations and commitments as of March 31, 2008, as well as the obligations of the securitization entities that we sponsor and are consolidated on our balance sheets. The operating leases are commitments that are expensed based on the terms of the related contracts.
Table 36 Contractual Obligations and Commitments as of March 31, 2008
| | | | | | | | | | |
| | Payments Due or Commitment Expiration by Period |
| (In Thousands) | | Total | | Less Than
1 Year | | 1 to 3
Years | | 3 to 5
Years | | After 5
Years |
Redwood Obligations:
| |
| Redwood debt | | $ | 2,086 | | | $ | 2,086 | | | $ | — | | | $ | — | | | $ | — | |
| Subordinated notes | | | 150,000 | | | | — | | | | — | | | | — | | | | 150,000 | |
| Anticipated interest payments on Subordinated notes | | | 309,923 | | | | 7,277 | | | | 15,166 | | | | 19,262 | | | | 268,218 | |
| Accrued interest payable | | | 1,423 | | | | 1,423 | | | | — | | | | — | | | | — | |
| Operating leases | | | 15,094 | | | | 1,292 | | | | 3,397 | | | | 3,713 | | | | 6,692 | |
| Purchase commitments | | | — | | | | — | | | | — | | | | — | | | | — | |
| Total Redwood Obligations and Commitments | | $ | 478,526 | | | $ | 12,078 | | | $ | 18,563 | | | $ | 22,975 | | | $ | 424,910 | |
Obligations of Securitization Entities:
| | | | | | | | | | | | | | | | | | | | |
| Consolidated ABS(1) | | $ | 7,590,651 | | | $ | — | | | $ | — | | | $ | — | | | $ | 7,590,651 | |
| Anticipated interest payments on ABS(2) | | | 6,847,947 | | | | 305,886 | | | | 801,854 | | | | 928,401 | | | | 4,811,806 | |
| Accrued interest payable | | | 42,460 | | | | 42,460 | | | | — | | | | — | | | | — | |
| Total obligations of securitization entities | | $ | 14,481,058 | | | $ | 348,346 | | | $ | 801,854 | | | $ | 928,401 | | | $ | 12,402,457 | |
| Total Consolidated Obligations and Commitments | | $ | 14,959,584 | | | $ | 360,424 | | | $ | 820,417 | | | $ | 951,376 | | | $ | 12,827,367 | |
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| (1) | All consolidated ABS issued are collateralized by real estate loans and securities. Although the stated maturity is as shown, the ABS obligations will pay down as the principal of these real estate loans or securities pay down. The amount shown is the face value of the ABS issued and not necessarily the value reported in our consolidated financial statements. |
| (2) | The anticipated interest payments on consolidated ABS issued is calculated based on the contractual maturity of the ABS and therefore assumes no prepayments of the principal outstanding as of March 31, 2008. |
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 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 continues to increase. We also own $4 million residential real estate loans 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 may 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 (and a few are subprime 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.
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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 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 owned by Acacia are generally 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 downgraded, could suffer decreases in fair 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 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 market valuation adjustments. For example, amortization income from discount assets may not necessarily offset amortization expense from premium
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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 securities backed by residential mortgage loans (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, in the short-term, increases in ARM prepayment rates could result in 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 Value and Liquidity Risks
Some of the securities are accounted for as available-for-sale and are generally marked-to-market through our balance sheets and not through our income statement. These assets are credit sensitive and generally illiquid. Fair value fluctuations of these assets can affect reported stockholders’ equity. Most of these securities are owned by securitization entities we sponsor and fair value fluctuations on these securities do not have an impact on our liquidity. Fair 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 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 values are reported through our income statement. See also Mark-to-Market Adjustments Discussion earlier in this document.
Beginning in the first quarter of 2007, we classified other real estate investments as trading instruments. Changes in the fair values of these investments are recognized through our income statement. Thus, changes in fair 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.
On January 1, 2008 we elected the fair value option for certain assets and liabilities under FAS 159. Now for these assets and liabilities, changes in market values will be recorded through our income statement, and it is likely to add to our earnings volatility. Most of these assets and liabilities accounted for in this manner are owned or issued by Acacia and they will have no impact on our liquidity. However, changes in values (or ratings downgrades) on assets owned by an Acacia entity may disrupt the cash flows on certain of our
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investments in Acacia. Such disruptions in cash flow may create additional differences between reported GAAP and taxable income from cash received. We do not currently believe that this will create any liquidity issues for us.
Most of 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 value of the loans do not have an impact on our liquidity. However, changes in fair 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. We may own some real estate loans accounted for as held-for-sale and adverse changes in their value would be recognized through our income statement and may have an impact on our ability to obtain financing for them.
Our consolidated obligations consist primarily of ABS issued. Generally, changes in fair value of ABS issued have no impact on our liquidity. ABS issued by Sequoia are reported at amortized cost as our the residential loans collateralizing these ABS. Beginning January 1, 2008, we report at fair value the ABS issued by Acacia and also report the underlying securities collateralizing the ABS issued at fair value. In either case, the resulting net equity (assets less liabilities) may not necessarily be reflective of the economic value of our interests in these securitization entities. However, since the ABS issued can only look to the cash flows generated by the assets within that securitization for payments of interest and repayments of the face value of the ABS, the changes in fair value do not have an effect on Redwood. Only to the extent that changes in fair values affect the timing of the cash flows we might receive on our investments in the Acacia entities, is there an effect to Redwood from changes in fair values of these securities. There are no such considerations in the Sequoia securitization entities.
We hold some assets funded with short-term debt that is recourse to Redwood. At some point, this may increase our fair 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 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.
Mark-to-Market Adjustments
Accounting and Economics
The rules regarding mark-to-market (MTM) accounting are complex and may not clearly reflect the underlying economics. This accounting and economic discussion is intended to provide investors with a better understanding of the impact of MTM adjustments on our reported financial results.
MTM adjustments can result from changes in fair values caused either by a change in expected cash flows (i.e. increased credit loss estimates reducing expected cash flows), or a change in market discount rates (i.e., the market requires a greater risk premium and/or interest rates rise), or a combination of both.
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All changes in fair value for securities or derivatives accounted for as trading instruments or under the fair value option of FAS 159 flow through the income statement. These adjustments can be either positive or negative from period to period.
Our CES held at Redwood and the real estate securities held at the Opportunity Fund are accounted for as available-for-sale (AFS) securities. We carry AFS securities in our GAAP balance sheet at their fair value. Positive changes in the fair value of AFS securities from period to period are always accounted for as increases to stockholders’ equity and do not flow through our income statement. Accounting for negative changes in the fair value of AFS securities from period to period requires a three-step process involving a combination of quantitative and judgmental evaluations. The ultimate purpose of this process is to determine whether negative MTM adjustments represent “other-than-temporary” (OTT) impairments, which flow through our GAAP income statement, or represent “temporary” impairments, which are recorded as a reduction of stockholders’ equity and do not flow through our income statement.
The diagram below and the narrative discussion that follows address the three-step process for evaluating impairments on AFS securities.
![[GRAPHIC MISSING]](https://capedge.com/proxy/10-Q/0001144204-08-026620/v112843_chrt-flow.jpg)
The first step is to determine whether there has been an adverse change in the underlying cash flows generated by the security. A security is considered OTT impaired even if the change in projected cash flows is small relative to the resulting MTM adjustment. It is difficult to separate with precision how much of the change in fair value is driven by changes in expected cash flows versus changes in market discount rates, but during periods of market illiquidity and uncertainty (as we encountered since late 2007), the market discount rate impact can be significant.
The second step is to determine whether we have the ability and intention to hold the security.
The third step requires us to evaluate whether an impaired security will recover in value within a reasonable period of time. This step is very subjective and time consuming particularly when there is turmoil and uncertainty in the capital markets.
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AFS securities deemed permanently impaired for accounting purposes cannot be written back up through MTM adjustments in our income statement. This does not mean the underlying security could not recover in value. If the value of an impaired security does recover, we would recognize this benefit through higher interest yields over time. Therefore some of the securities classified as OTT impaired during the first quarter of 2008 may eventually prove to have significant value to us.
The consolidated Sequoia assets are accounted for on our GAAP balance sheet as held-for-investment and are carried at their unpaid principal balances adjusted for net amortized premiums or discounts and net of any allowances for credit losses. The consolidated Sequoia liabilities are accounted for at their unpaid principal balances net of any amortized premiums or discounts.
Prior to January 1, 2008, we accounted for the consolidated securities held at Acacia entities (the assets) as AFS and the consolidated ABS issued by Acacia entities (the liabilities) at cost. In our opinion, this difference in accounting treatment led to a significant discrepancy in the GAAP carrying value for our investment in Acacia entities and our estimate of economic value. On January 1, 2008, we adopted a new accounting standard, FAS 159, and elected to fair value both the assets and liabilities of the Acacia entities. In accordance with FAS 159, we recorded a one-time, cumulative-effect adjustment to our January 1, 2008 opening balance sheet that decreased the carrying value of Acacia liabilities by $1.5 billion and increased equity. This new standard significantly reduces the disparity that existed between GAAP carrying value and our previous estimates of economic value.
Under FAS 159, we are required to flow through our quarterly income statement any net change in the fair value of Acacia assets and liabilities. As a result of the measurement techniques required by FAS 159, we still expect to encounter some MTM earnings volatility in the future as a result of the consolidation of Acacia entities. We expect this volatility to be significantly less than we encountered in prior periods.
The net GAAP carrying value of our investments in Acacia in our financial statements is derived by subtracting the fair value of the Acacia's liabilities from the fair value of Acacia’s assets. In theory, fair values of Acacia’s assets and liabilities should be reasonably correlated as they are paired within the same legal structure - ABS issued by each Acacia entity will be repaid directly and solely from the cash flows generated by the assets owned by that entity. However, at any given moment, the capital markets may use different discount rates and valuation parameters for Acacia’s collateral assets relative to its ABS issued. On March 31, 2008, for instance, the market values for Acacia’s liabilities were, in our view, depressed relative to the paired collateral assets. As a consequence of this market condition, the derived net GAAP carrying value of our retained Acacia investments was $68 million at March 31, 2008. This value is greater than our $49 million estimate of the fair value of our investments in Acacia based on the net present value of expected cash flows.
As a consequence of adopting FAS 159 as of January 1, 2008, we now also flow through our income statements the relative changes in the fair values of Acacia assets and liabilities as measured in their independent markets. During the first quarter of 2008, the value of our assets and derivatives declined by $837 million and the fair value of our paired liabilities declined by $810 million, for a net change of a negative $27 million. In the first quarter, the market re-priced Acacia assets downward at a slightly faster rate than the Acacia liabilities.
Mark-to-Market Valuation Process
The fair values we use for our assets and liabilities reflect what we believe we would realize if we chose to sell our securities or would have to pay if we chose to buy back our asset-backed securities (ABS) issued (liabilities). Establishing fair values is inherently subjective and is dependent upon many market-based inputs, including observable trades, information on offered inventories, bid lists, and indications of value obtained from dealers. Obtaining fair values for securities is especially difficult for more illiquid securities (such as ours), and is made more difficult when there is limited trading visibility, as was the case in recent months. Where there are observable sales, many of them are from distressed sellers, and their sales tend to further depress asset prices. For these reasons, we expect market valuations to continue to be highly volatile.
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Fair values for our securities and ABS issued are dependent upon a number of market-based assumptions including future interest rates, prepayment rates, discount rates, credit loss rates, and the timing of credit losses. We use these assumptions to generate cash flow estimates and internal values for each individual security.
We request indications of value (marks) from dealers every quarter to assist in the valuation process. For March 31, 2008, we received dealer marks on 71% of our assets and 82% of our liabilities on our consolidated balance sheet. One major dealer that we have used in prior periods provided no marks.
One of the factors we consider in our valuation process is our assessment of the quality of the dealer marks we receive. Dealers remain inundated with requests for quarter-end marks, and there continues to be limited observable trading information for them to rely upon. Thus, their marks were most likely generated by their own pricing models for which they did not share their inputs and we had little insight into their assumptions.
Furthermore, the dealers continue to heavily qualify the information they send to us. The qualifications include statements that the markets are very volatile and are characterized by limited trading volume and poor price transparency, and in many cases, an increasing number of valuations are model-based due to a lack of observable trades.
Our valuation process relied on our internal values to estimate the fair values of our securities at March 31, 2008. In the aggregate, our internal valuations of the securities on which we received dealer marks were 29% lower than the aggregate dealer marks at March 31, 2008. Our internal valuations of our ABS issued on which we received dealer marks were 14% lower than the aggregate dealer marks at March 31, 2008.
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 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 as short-term rates increased beginning in 2004 and through the first half of 2007, the amount of 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 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 values.
Credit Reserves on 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 (loss) income. The reserves consist of estimates of specific loan impairment and estimates of collective losses on pools of loans with similar characteristics.
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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.
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 Issued Premium
We apply the effective yield method in determining amortization for the premium and deferred asset-backed securities issuance cost for ABS issued. ABS premium is recognized through our income statement as a reduction in interest expense and under APB 21 issuance costs are amortized as additional interest expense over the life of the ABS issued. Similar to our calculation of amortization on assets, the use of this method requires us to project cash flows over the remaining life of each liability. These projections are primarily affected 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 net premium at a faster rate, thereby 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 net premium. For the deferred
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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.
Other-than-Temporary Impairments
For accounting purposes, securities are deemed impaired if the fair value is below amortized cost. An assessment is then required as to whether the impairment is temporary and is reflected as unrealized losses in the balance sheet, or is other-than-temporary and realized through the income statement as market valuation adjustments. The assessment of the other-than-temporary impairments requires a determination of whether there has been an adverse change in the underlying cash flows generated by a security, whether we have the intent and ability to hold the security, and whether we believe the impaired security will recover its value within a reasonable period of time. This is a highly complex and subjective evaluation.
If, based on our assessment, we have an other-than-temporary impairment, then the basis of the asset is written down to fair value through our consolidated statements of (loss) income. Market valuation adjustments of this type could be substantial, reducing GAAP income and causing a loss. However, for securitized assets, reductions in fair 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.
Accounting Under the Fair Value Option
Effective January 1, 2008, we adopted FAS 159 giving us the option to elect to measure eligible financial assets, financial liabilities, and firm commitments at fair value (i.e., the fair value option or FVO), on an instrument-by-instrument basis, that are otherwise not permitted to be accounted for at fair value under other accounting standards. The election to use the FVO is available when an entity first recognizes a financial asset or financial liability or upon entering into a firm commitment. Subsequent changes in fair value are recorded in earnings. Additionally, FAS 159 allows for a one-time election for existing positions upon adoption, this transition adjustment recorded to beginning retained earnings. One of the chief objectives of this standard was to provide better matching of the accounting results to the economic activities underlying them. For example, there may be assets or liabilities that are measured under the historical cost models while related transactions (e.g. hedging derivatives or offsetting transactions) are at fair value. We have elected FVO on the assets and liabilities of Acacia. For the Acacia assets this will mean that the ongoing changes in fair value will be reported through earnings instead of an adjustment to other comprehensive income. Any unrealized gains or losses on Acacia assets at January 1, 2008 were reclassified to retained earnings from other comprehensive income. For the Acacia liabilities, the mark-to-market to fair value on January 1, 2008 from the historical cost basis was also recorded in retained earnings at January 1, 2008. We expect to elect the FVO for any future Acacia assets and liabilities. As a result of the adoption of FAS 159, we recorded a cumulative effect adjustment of $1.5 billion to stockholders’ equity as of January 1, 2008.
Accounting for Derivative Instruments
We use derivative instruments to manage certain risks such as interest rate risk. We may also acquire derivative financial instruments as investments. Derivative instruments are reported on our consolidated balance sheets at their fair value. If a derivative instrument has a positive fair value, it is reported as an asset. If the fair value is negative, the instrument is reported as a liability.
Changes in fair values of derivative instruments are reported either through the income statement or through our equity. For derivatives accounted for as trading instruments or under the FVO of FAS 159, all changes in the fair 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 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 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.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
Information concerning market risk is incorporated herein by reference to Item 7A of our Annual Report on Form 10-K for the year ended December 31, 2007, as supplemented by the information under Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Risks above. With the exception of developments described under Management’s Discussion and Analysis of Financial Condition and Results of Operations above, including changes in the fair values of our assets, there have been no material changes in our quantitative or qualitative exposure to market risk since December 31, 2007.
Item 4. Controls and Procedures
In connection with the completion of the audited financial statements for December 31, 2007, we concluded that a material weakness in our internal control over financial reporting resulted from the fact that we were unable to obtain the necessary evidence under Staff Accounting Bulletin 59,“Accounting for Noncurrent Marketable Equity Securities” (SAB 59) to support our initial conclusion that a material portion of unrealized losses were recoverable as of December 31, 2007.
To address this material weakness we completed the additional analysis required under SAB 59 and implemented enhancements in our internal control over financial reporting that are designed to ensure that we continue to perform the requisite analysis on a quarterly basis.
Other than the enhancements and remediation steps described above, there have been no changes in our internal control over financial reporting during the quarter ended March 31, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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PART II
Item 1. Legal Proceedings
We are not a party to any material pending legal proceedings.
Item 1A. Risk Factors
There have been no material changes to the risk factors previously disclosed under Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2007.
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, 2008 | | | 1,672 | | | $ | 34.24 | | | | — | | | | — | |
| February 1 – February 29, 2008 | | | — | | | | — | | | | — | | | | — | |
| March 1 – March 31, 2008 | | | — | | | | — | | | | — | | | | — | |
| Total | | | 1,672 | | | $ | 34.24 | | | | — | | | | 5,000,000 | |
The 1,672 shares purchased for the three months ended March 31, 2008 represent shares required to satisfy tax withholding requirements on the vesting of restricted shares. We announced a new stock repurchase plan on November 5, 2007 for the repurchase of up to a total of 5,000,000 shares. This plan replaced all previous share repurchase plans and has no expiration date. There were no repurchases under the new stock repurchase plan during 2007, or during the first quarter of 2008 and as of March 31, 2008, there remained 5,000,000 shares available for repurchase under this plan.
Item 3. Defaults Upon Senior Securities
None
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits
| | |
Exhibit
Number | | Exhibit |
3.1
| | Redwood Trust, Inc. Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.1 to our Current Report on Form 8-K filed on March 11, 2008.) |
10.1
| | Amendment to Employment Agreement, by and between Redwood Trust, Inc. and Martin S. Hughes, dated as of January 16, 2008 (Incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed on January 18, 2008.) |
10.2
| | Amendment to Employment Agreement, by and between Redwood Trust, Inc. and Harold F. Zagunis, dated as of January 16, 2008 (Incorporated by reference to Exhibit 10.2 to our Current Report on Form 8-K filed on January 18, 2008.) |
| 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 |
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TABLE OF CONTENTS
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.
| | |
| Date: May 7, 2008 | | By: /s/Douglas B. Hansen
Douglas B. Hansen
President
(authorized officer of registrant) |
| Dated: May 7, 2008 | | By: /s/Martin S. Hughes
Martin S. Hughes
Chief Financial Officer and Secretary
(principal financial officer) |
| Dated: May 7, 2008 | | By: /s/Raymond S. Jackson
Raymond S. Jackson
Managing Director and Controller
(principal accounting officer) |
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TABLE OF CONTENTS
INDEX TO EXHIBITS
| | |
Exhibit
Number | | Exhibit |
3.1
| | Redwood Trust, Inc. Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.1 to our Current Report on Form 8-K filed on March 11, 2008.) |
10.1
| | Amendment to Employment Agreement, by and between Redwood Trust, Inc. and Martin S. Hughes, dated as of January 16, 2008 (Incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed on January 18, 2008.) |
10.2
| | Amendment to Employment Agreement, by and between Redwood Trust, Inc. and Harold F. Zagunis, dated as of January 16, 2008 (Incorporated by reference to Exhibit 10.2 to our Current Report on Form 8-K filed on January 18, 2008.) |
| 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 |
32.2
| | Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
101
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