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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM __________ TO __________
COMMISSION FILE NUMBER: 0-26436
REDWOOD TRUST, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 68-0329422
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
591 REDWOOD HIGHWAY, SUITE 3100
MILL VALLEY, CALIFORNIA 94941
(Address of principal executive offices) (Zip Code)
(415) 389-7373
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all
documents and reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the Registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes X No
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APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's
classes of stock, as of the last practicable date.
Class B Preferred Stock ($.01 par value) 909,518 as of August 10, 1999
Common Stock ($.01 par value) 9,408,617 as of August 10, 1999
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REDWOOD TRUST, INC.
FORM 10-Q
INDEX
Page
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PART I FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements - Redwood Trust, Inc
Consolidated Balance Sheets at June 30, 1999 and December 31, 1998 ............... 3
Consolidated Statements of Operations for the three and
six months ended June 30, 1999 and June 30, 1998 ................................. 4
Consolidated Statements of Stockholders' Equity for
the three and six months ended June 30, 1999 ..................................... 5
Consolidated Statements of Cash Flows for the three
and six months ended June 30, 1999 and June 30, 1998 ............................. 6
Notes to Consolidated Financial Statements ....................................... 7
Consolidated Financial Statements - RWT Holdings, Inc.
Consolidated Balance Sheets at June 30, 1999 and December 31, 1998................21
Consolidated Statements of Operations for the three
months ended June 30, 1999 and 1998 and for the six
months ended June 30, 1999 and for the period from
April 1, 1998 to June 30, 1998 ...................................................22
Consolidated Statements of Stockholders' Equity for
the three and six months ended June 30, 1999......................................23
Consolidated Statements of Cash Flows for the three
months ended June 30, 1999 and 1998 and for the six
months ended June 30, 1999 and for the period from
April 1, 1998 to June 30, 1998 ...................................................24
Notes to Consolidated Financial Statements........................................25
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations.........................................30
PART II OTHER INFORMATION
Item 1. Legal Proceedings.....................................................................45
Item 2. Changes in Securities.................................................................45
Item 3. Defaults Upon Senior Securities.......................................................45
Item 4. Submission of Matters to a Vote of Security Holders...................................45
Item 5. Other Information.....................................................................46
Item 6. Exhibits and Reports on Form 8-K......................................................46
SIGNATURES ....................................................................................47
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PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
June 30, 1999 December 31, 1998
----------- -----------
ASSETS (Unaudited)
Mortgage loans: held-for-sale
Residential $ 67,452 $ 265,914
Commercial 19,614 8,287
----------- -----------
87,066 274,201
----------- -----------
Mortgage loans: held-for-investment, net
Residential 1,089,778 1,131,300
----------- -----------
1,089,778 1,131,300
----------- -----------
Mortgage securities: trading 941,618 1,257,655
Mortgage securities: available-for-sale, net 7,937 7,707
U.S. Treasury securities -- 48,009
Cash and cash equivalents 66,502 55,627
Restricted cash 8,547 12,857
Interest rate agreements 2,697 2,517
Accrued interest receivable 12,952 18,482
Investment in RWT Holdings, Inc. 18,782 15,124
Loan to RWT Holdings, Inc. 2,000 6,500
Receivable from RWT Holdings, Inc. 209 445
Other assets 2,013 2,024
----------- -----------
$ 2,240,101 $ 2,832,448
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term debt $ 922,745 $ 1,257,570
Long-term debt, net 1,066,976 1,305,560
Accrued interest payable 5,286 10,820
Accrued expenses and other liabilities 2,833 3,022
Dividends payable 687 686
----------- -----------
1,998,527 2,577,658
----------- -----------
Commitments and contingencies (See Note 13)
STOCKHOLDERS' EQUITY
Preferred stock, par value $0.01 per share;
Class B 9.74% Cumulative Convertible
909,518 shares authorized, issued and outstanding
($28,882 aggregate liquidation preference) 26,736 26,736
Common stock, par value $0.01 per share;
49,090,482 shares authorized;
9,929,717 and 11,251,556 issued and outstanding 99 113
Additional paid-in capital 259,184 279,201
Accumulated other comprehensive income (1,918) (370)
Cumulative earnings 16,149 6,412
Cumulative distributions to stockholders (58,676) (57,302)
----------- -----------
241,574 254,790
----------- -----------
$ 2,240,101 $ 2,832,448
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The accompanying notes are an integral part of these consolidated statements.
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REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share data)
(Unaudited)
Three Months Ended June 30, Six Months Ended June 30,
1999 1998 1999 1998
------------ ------------ ------------ ------------
INTEREST INCOME
Mortgage loans: held-for-sale
Residential $ 1,427 $ -- $ 5,714 $ --
Commercial 293 -- 369 --
1,720 -- 6,083 --
------------ ------------ ------------ ------------
Mortgage loans: held-for-investment
Residential 16,545 29,905 32,830 55,715
------------ ------------ ------------ ------------
16,545 29,905 32,830 55,715
Mortgage securities: trading 16,090 -- 35,064 --
Mortgage securities: available-for-sale 859 23,423 1,662 51,090
U.S. Treasury securities 380 -- 913 --
Cash and cash equivalents 497 455 1,270 839
------------ ------------ ------------ ------------
Total interest income 36,091 53,783 77,822 107,644
------------ ------------ ------------ ------------
INTEREST EXPENSE
Short-term debt (11,880) (33,282) (26,630) (61,285)
Long-term debt (16,657) (16,887) (35,398) (34,981)
------------ ------------ ------------ ------------
Total interest expense (28,537) (50,169) (62,028) (96,266)
------------ ------------ ------------ ------------
Net interest rate agreements expense (737) (1,624) (1,070) (3,002)
------------ ------------ ------------ ------------
NET INTEREST INCOME 6,817 1,990 14,724 8,376
Net unrealized and realized gains (losses) on assets 1,413 -- 3,582 (723)
Provision for credit losses (371) (763) (716) (1,364)
Equity in earnings (losses) of RWT Holdings, Inc. (3,757) (581) (6,241) (581)
Operating expenses (939) (589) (1,653) (2,514)
Other income 33 139 41 139
------------ ------------ ------------ ------------
NET INCOME (LOSS) 3,196 196 9,737 3,333
Cash dividends on Class B preferred stock (687) (687) (1,374) (1,374)
------------ ------------ ------------ ------------
NET INCOME (LOSS) AVAILABLE TO COMMON STOCKHOLDERS $ 2,509 $ (491) $ 8,363 $ 1,959
============ ============ ============ ============
EARNINGS PER SHARE:
Basic $ 0.25 $ (0.03) $ 0.80 $ 0.14
Diluted $ 0.25 $ (0.03) $ 0.79 $ 0.14
Weighted average shares of common stock and
common stock equivalents:
Basic 10,051,565 14,106,828 10,412,855 14,115,342
Diluted 10,172,960 14,255,858 10,523,329 14,368,616
The accompanying notes are an integral part of these consolidated statements.
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REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In thousands, except share data)
(Unaudited)
Class B Accumulated
Preferred stock Common stock Additional other Cumulative
------------------------------------ paid-in comprehensive Cumulative distributions
Shares Amount Shares Amount capital income earnings to stockholders Total
Balance, December 31, 1998 909,518 $26,736 11,251,556 $ 113 $ 279,201 $ (370) $ 6,412 $(57,302) $ 254,790
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Comprehensive income:
Income before
preferred dividend -- -- -- -- -- -- 6,541 -- 6,541
Net unrealized loss on
assets available-for-sale -- -- -- -- -- (412) -- -- (412)
---------
Total comprehensive income -- -- -- -- -- -- -- -- 6,129
Issuance of common stock -- -- 12,361 -- 1 -- -- -- 1
Repurchase of common stock -- -- (1,077,600) (11) (16,024) -- -- -- (16,035)
Dividends declared:
Preferred -- -- -- -- -- -- -- (687) (687)
Common -- -- -- -- -- -- -- -- --
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Balance, March 31, 1999 909,518 26,736 10,186,317 102 263,178 (782) 12,953 (57,989) 244,198
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Comprehensive income:
Income before
preferred dividend -- -- -- -- -- -- 3,196 -- 3,196
Net unrealized loss on
assets available-for-sale -- -- -- -- -- (1,136) -- -- (1,136)
---------
Total comprehensive income -- -- -- -- -- -- -- -- 2,060
Repurchase of common stock -- -- (256,600) (3) (3,994) -- -- -- (3,997)
Dividends declared:
Preferred -- -- -- -- -- -- -- (687) (687)
Common -- -- -- -- -- -- -- -- --
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, June 30, 1999 909,518 $26,736 9,929,717 $ 99 $ 259,184 $(1,918) $16,149 $(58,676) $ 241,574
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The accompanying notes are an integral part of these consolidated statements.
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REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
1999 1998 1999 1998
--------- --------- --------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) available to common stockholders $ 2,509 $ (491) $ 8,363 $ 1,959
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,868 12,715 4,389 22,425
Provision for credit losses 371 763 716 1,364
Equity in (earnings) losses of RWT Holdings, Inc. 3,757 581 6,241 581
Net unrealized and realized (gains) losses on assets (1,413) -- (3,582) 723
Purchases of mortgage loans: held-for-sale (65,343) -- (71,755) --
Proceeds from sales of mortgage loans: held-for-sale 7,509 -- 50,138 --
Principal payments on mortgage loans: held-for-sale 19,990 -- 55,239 --
Purchases of mortgage securities: trading (3,725) -- (3,725) --
Proceeds from sales of mortgage securities: trading 7,668 -- 7,668 --
Principal payments on mortgage securities: trading 146,019 -- 315,001 --
Purchases of U.S. Treasury securities -- -- (45,844) --
Proceeds from sales of U.S. Treasury securities 32,077 -- 90,519 --
Purchases of interest rate agreements (224) -- (633) --
Proceeds from sales of interest rate agreements 1,121 -- 1,121 --
Decrease in accrued interest receivable 2,460 2,332 5,530 1,565
(Increase) decrease in other assets 906 (2,235) (81) (3,006)
Increase (decrease) in accrued interest payable (409) 1,463 (5,534) (801)
Increase (decrease) in accrued expenses and other liabilities 1,222 395 (189) 20
--------- --------- --------- ---------
Net cash provided by operating activities 156,363 15,523 413,582 24,830
--------- --------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of mortgage loans: held-for-investment -- (525,510) -- (967,472)
Principal payments on mortgage loans: held-for-investment 84,487 169,766 191,849 288,472
Purchases of mortgage securities: available-for-sale (934) (69,326) (934) (231,167)
Proceeds from sales of mortgage securities: available-for-sale -- -- -- 9,296
Principal payments on mortgage securities: available-for-sale 72 255,526 130 442,931
Purchases of interest rate agreements -- (1,127) -- (2,024)
Net decrease in restricted cash 2,944 4,174 4,310 3,097
Investment in RWT Holdings, Inc., net of dividends received (9,900) -- (9,900) (9,900)
Repayments from RWT Holdings, Inc. 11,700 -- 4,500 --
(Increase) decrease in receivable from RWT Holdings, Inc. (67) (831) 236 (831)
--------- --------- --------- ---------
Net cash provided by (used in) investing activities 88,302 (167,328) 190,191 (467,598)
--------- --------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of (repayments on) short-term debt (110,897) (351,860) (334,825) 21,633
Proceeds (costs) from issuance of long-term debt (337) 635,193 (337) 635,193
Repayments on long-term debt (103,570) (123,238) (237,706) (214,918)
Net proceeds from issuance of common stock -- 1,588 1 1,588
Repurchases of common stock (3,997) (1,183) (20,032) (5,458)
Increase in dividends payable - preferred -- -- 1 --
Dividends paid on common stock -- (3,809) -- (8,808)
--------- --------- --------- ---------
Net cash provided by (used in) financing activities (218,801) 156,691 (592,898) 429,230
--------- --------- --------- ---------
Net increase (decrease) in cash and cash equivalents 25,864 4,886 10,875 (13,538)
Cash and cash equivalents at beginning of period 40,638 6,468 55,627 24,892
--------- --------- --------- ---------
Cash and cash equivalents at end of period $ 66,502 $ 11,354 $ 66,502 $ 11,354
========= ========= ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 28,946 $ 48,818 $ 67,562 $ 97,237
========= ========= ========= =========
The accompanying notes are an integral part of these consolidated statements.
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REDWOOD TRUST, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999
(UNAUDITED)
NOTE 1. THE COMPANY
Redwood Trust, Inc. ("Redwood Trust") was incorporated in Maryland on April 11,
1994 and commenced operations on August 19, 1994. During 1997, Redwood Trust
formed Sequoia Mortgage Funding Corporation ("Sequoia"), a special-purpose
finance subsidiary. Redwood Trust acquired an equity interest in RWT Holdings,
Inc. ("Holdings"), a taxable affiliate of Redwood Trust, during the first
quarter of 1998. For financial reporting purposes, references to the "Company"
mean Redwood Trust, Sequoia and Redwood Trust's equity interest in Holdings.
Redwood Trust, together with its affiliates, is a finance company specializing
in mortgage assets ("Mortgage Assets") which may be acquired as whole loans
("Mortgage Loans") or as mortgage securities representing interests in or
obligations backed by pools of mortgage loans ("Mortgage Securities"). Its
primary activity is the financing of high quality residential mortgage loans
with funds raised through long-term debt issuance. The Company also finances
commercial mortgage loans and residential mortgage securities. Through its
affiliate operations, the Company is developing its ability to create mortgage
assets of significant value for its own portfolio and for sale to institutional
mortgage investors.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Redwood Trust and
Sequoia. Substantially all of the assets of Sequoia are pledged or subordinated
to support long-term debt in the form of collateralized mortgage bonds
("Long-Term Debt") and are not available for the satisfaction of general claims
of the Company. The Company's exposure to loss on the assets pledged as
collateral is limited to its net investment, as the Long-Term Debt is
non-recourse to the Company. All significant inter-company balances and
transactions with Sequoia have been eliminated in the consolidation of the
Company. Certain amounts for prior periods have been reclassified to conform to
the 1998 presentation.
During March 1998, the Company acquired an equity interest in Holdings, which
originates, acquires, accumulates, services and sells residential and commercial
Mortgage Loans. The Company owns all of the preferred stock and has a
non-voting, 99% economic interest in Holdings. As the Company does not own the
voting common stock of Holdings or control Holdings, its investment in Holdings
is accounted for under the equity method. Under this method, original equity
investments in Holdings are recorded at cost and adjusted by the Company's share
of earnings or losses and decreased by dividends received.
USE OF ESTIMATES
The preparation of financial statements in conformity with Generally Accepted
Accounting Principles requires management to make estimates and assumptions that
affect the reported amounts of certain assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of certain revenues and expenses during the reported
period. Actual results could differ from those estimates. The primary estimates
inherent in the accompanying consolidated financial statements are discussed
below.
Fair Value. Management estimates the fair value of its financial instruments
using available market information and other appropriate valuation
methodologies. The fair value of a financial instrument, as defined by Statement
of Financial Accounting Standards ("SFAS") No. 107, Disclosures about Fair Value
of Financial Instruments, is the amount at which the instrument could be
exchanged in a current transaction between willing parties, other than in a
forced liquidation sale. Management's estimates are inherently subjective in
nature and involve matters of uncertainty and judgement to interpret relevant
market and other data. Accordingly, amounts realized in actual sales may differ
from the fair values presented in Notes 3, 7 and 10.
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Reserve for Credit Losses. A reserve for credit losses is maintained at a level
deemed appropriate by management to provide for known, future losses as well as
potential losses inherent in its Mortgage Asset portfolio. The reserve is based
upon management's assessment of various factors affecting its Mortgage Assets,
including current and projected economic conditions, delinquency status and
credit protection. In determining the reserve for credit losses, the Company's
credit exposure is considered based on its credit risk position in the mortgage
pool. These estimates are reviewed periodically and, as adjustments become
necessary, they are reported in earnings in the periods in which they become
known. The reserve is increased by provisions, which are charged to income from
operations. When a loan or portions of a loan are determined to be
uncollectible, the portion deemed uncollectible is charged against the reserve
and subsequent recoveries, if any, are credited to the reserve. The Company's
actual credit losses may differ from those estimates used to establish the
reserve. Summary information regarding the Reserve for Credit Losses is
presented in Note 4.
ADOPTION OF SFAS NO. 133
The Company adopted SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities, effective July 1, 1998. In accordance with the transition
provisions of SFAS No. 133, the Company recorded a net-of-tax
cumulative-effect-type transition adjustment of $10.1 million (loss) in earnings
to recognize at fair value the ineffective portion of all interest rate
agreements that were previously designated as part of a hedging relationship.
The Company, upon its adoption of SFAS No. 133, also reclassified $1.53 billion
of mortgage securities from available-for-sale to trading. This reclassification
resulted in an $11.9 million reclassification loss adjustment, which was
transferred from other comprehensive income to current earnings effective July
1, 1998. Under the provisions of SFAS No. 133, such a reclassification does not
call into question the Company's intent to hold current or future debt
securities to their maturity. Immediately after the adoption of SFAS No. 133 and
the reclassification, the Company elected to not seek hedge accounting for any
of the Company's interest rate agreements.
MORTGAGE ASSETS
The Company's Mortgage Assets consist of Mortgage Loans and Mortgage Securities.
Interest is recognized as revenue when earned according to the terms of the
loans and when, in the opinion of management, it is collectible. Discounts and
premiums relating to Mortgage Assets are amortized into interest income over the
lives of the Mortgage Assets using methods that approximate the effective yield
method. Gains or losses on the sale of Mortgage Assets are based on the specific
identification method.
Mortgage Loans: Held-for-Sale
Effective September 30, 1998, the Company elected to reclassify certain
short-funded Mortgage Loans from held-for-investment to held-for-sale. These
Mortgage Loans are carried at the lower of cost or aggregate market value
("LOCOM"). Realized and unrealized gains and losses on these loans are
recognized in "Net unrealized and realized gains (losses) on assets" on the
Consolidated Statements of Operations.
Some of the Mortgage Loans purchased by the Company for which securitization or
sale is contemplated are committed for sale by the Company to Holdings, or a
subsidiary of Holdings, under a Master Forward Commitment Agreement. As the
forward commitment is entered into on the same date that the Company commits to
purchase the loans, the price under the forward commitment is the same as the
price that the Company paid for the Mortgage Loans, as established by the
external market. Fair value is therefore equal to the commitment price, which is
the carrying value of the Mortgage Loans. Accordingly, no gain or loss is
recognized on the subsequent sales of these Mortgage Loans to Holdings or
subsidiaries of Holdings.
Mortgage Loans: Held-for-Investment
Mortgage Loans held-for-investment are carried at their unpaid principal balance
adjusted for net unamortized premiums or discounts, and net of the related
allowance for credit losses.
Mortgage Securities: Trading
Effective July 1, 1998, concurrent with the adoption of SFAS No. 133, the
Company elected to reclassify all of its short-funded Mortgage Securities from
available-for-sale to trading. Mortgage Securities classified as trading are
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accounted for in accordance with SFAS No. 115, Accounting for Certain
Investments in Debt and Equity Securities. Accordingly, such securities are
recorded at their estimated fair market value. Unrealized and realized gains and
losses on these securities are recognized as a component of "Net unrealized and
realized gains (losses) on assets" on the Consolidated Statements of Operations.
Mortgage Securities: Available-for-Sale
Prior to the adoption of SFAS No. 133, the Company, in accordance with SFAS No.
115, classified all of its Mortgage Securities as available-for-sale investments
as the Company, from time to time, sold some of its Mortgage Securities as part
of its overall management of its balance sheet. Effective July 1, 1998, the
Company reclassified all of its short-funded Mortgage Securities as trading
investments, while all equity-funded Mortgage Securities remained in the
available-for-sale classification. All Mortgage Securities classified as
available-for-sale are carried at their estimated fair value. Current period
unrealized gains and losses are excluded from net income and reported as a
component of Other Comprehensive Income in Stockholders' Equity with cumulative
unrealized gains and losses classified as Accumulated Other Comprehensive Income
in Stockholders' Equity.
Unrealized losses on Mortgage Securities classified as available-for-sale that
are considered other-than-temporary, are recognized in income and the carrying
value of the Mortgage Security is adjusted. Other-than-temporary unrealized
losses are based on management's assessment of various factors affecting the
expected cash flow from the Mortgage Securities, including an
other-than-temporary deterioration of the credit quality of the underlying
mortgages and/or the credit protection available to the related mortgage pool
and a significant change in the prepayment characteristics of the underlying
collateral.
U.S. TREASURY SECURITIES
U.S. Treasury securities include notes issued by the U.S. Government. Interest
is recognized as revenue when earned according to the terms of the Treasury
securities. Discounts and premiums are amortized into interest income over the
life of the security using methods that approximate the effective yield method.
U.S. Treasury securities are classified as trading and, accordingly, are
recorded at their estimated fair market value with unrealized gains and losses
recognized as a component of "Net unrealized and realized gains (losses) on
assets" on the Consolidated Statements of Operations.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand and highly liquid investments
with original maturities of three months or less. At June 30, 1999 and December
31, 1998, cash equivalents included $32 million and $25 million in repurchase
agreements, respectively.
RESTRICTED CASH
Restricted cash of the Company includes principal and interest payments on
mortgage loans held as collateral for the Company's Long-Term Debt, and cash
pledged as collateral on certain interest rate agreements.
INTEREST RATE AGREEMENTS
The Company maintains an overall interest-rate risk-management strategy that
incorporates the use of derivative interest rate agreements to minimize
significant unplanned fluctuations in earnings that are caused by interest-rate
volatility. Interest rate agreements that are used as part of the Company's
interest-rate risk management strategy include interest rate options, swaps,
options on swaps, futures contracts, and options on futures contracts
(collectively "Interest Rate Agreements"). On the date an Interest Rate
Agreement is entered into, the Company designates the interest rate agreement as
(1) a hedge of the fair value of a recognized asset or liability or of an
unrecognized firm commitment ("fair value" hedge), (2) a hedge of a forecasted
transaction or of the variability of cash flows to be received or paid related
to a recognized asset or liability ("cash flow" hedge), or (3) held for trading
("trading" instruments). Concurrent with the adoption of SFAS No. 133, the
Company has elected to designate all of its existing Interest Rate Agreements as
trading instruments.
Net premiums on interest rate options are amortized as a component of net
interest income over the effective period of the interest rate option using the
effective interest method. The income and/or expense related to interest rate
options and swaps are recognized on an accrual basis.
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Interest Rate Agreements Classified as Trading
Interest Rate Agreements that are designated as trading are not linked to
specific assets and liabilities or to a forecasted transaction, or otherwise are
not designated and, therefore do not qualify for hedge accounting. Accordingly,
interest rate agreements classified as trading are reported at their estimated
fair value with changes in their fair value reported in current-period earnings
in "Net unrealized and realized gains (losses) on assets" on the Consolidated
Statements of Operations.
Interest Rate Agreements Classified as Hedges
Interest Rate Agreements that are designated as hedges are linked to specific
assets and liabilities on the balance sheet or to a forecasted transaction, or
otherwise qualify for hedge accounting. The Company currently does not have any
Interest Rate Agreements classified as hedges.
Prior to the adoption of SFAS No. 133, Interest Rate Agreements that were
hedging Mortgage Securities available-for-sale were carried at fair value with
unrealized gains and losses reported as a component of Accumulated Other
Comprehensive Income in stockholders' equity, consistent with the reporting of
unrealized gains and losses on the related securities. Similarly, Interest Rate
Agreements that were used to hedge Mortgage Loans, Short-Term Debt or Long-Term
Debt were carried at amortized cost. Realized gains and losses from the
settlement or early termination of Interest Rate Agreements were deferred and
amortized into net interest income over the remaining term of the original
Interest Rate Agreement, or, if shorter, over the remaining term of the
associated hedged asset or liability, as adjusted for estimated future principal
repayments.
DEBT
Short-Term and Long-Term Debt are carried at their unpaid principal balances,
net of any unamortized discount or premium and any unamortized deferred bond
issuance costs. The amortization of any discount or premium is recognized as an
adjustment to interest expense using the effective interest method based on the
maturity schedule of the related borrowings. Bond issuance costs incurred in
connection with the issuance of Long-Term Debt are deferred and amortized over
the estimated lives of the Long-Term Debt using the interest method adjusted for
the effects of prepayments.
INCOME TAXES
The Company has elected to be taxed as a Real Estate Investment Trust ("REIT")
under the Internal Revenue Code (the "Code") and the corresponding provisions of
State law. In order to qualify as a REIT, the Company must annually distribute
at least 95% of its taxable income to stockholders and meet certain other
requirements. If these requirements are met, the Company generally will not be
subject to Federal or state income taxation at the corporate level with respect
to the taxable income it distributes to its stockholders. Because the Company
believes it meets the REIT requirements and also intends to distribute all of
its taxable income, no provision has been made for income taxes in the
accompanying consolidated financial statements.
Under the Code, a dividend declared by a REIT in October, November or December
of a calendar year and payable to shareholders of record as of a specified date
in such month, will be deemed to have been paid by the Company and received by
the shareholders on the last day of that calendar year, provided the dividend is
actually paid before February 1st of the following calendar year, and provided
that the REIT has any remaining undistributed taxable income on the record date.
The Company expects to pay a total of $3.4 million of preferred dividends in
1999 from 1999 taxable income. The Company will not declare a common stock
dividend until the 1999 taxable income exceeds the preferred dividend
requirements.
NET INCOME PER SHARE
Net income per share for the three and six months ended June 30, 1999 and 1998
is shown in accordance with SFAS No. 128, Earnings Per Share. Basic net income
per share is computed by dividing net income available to common stockholders by
the weighted average number of common shares outstanding during the period.
Diluted net income per share is computed by dividing the net income available to
common stockholders by the weighted average number of common shares and common
equivalent shares outstanding during the period. The common equivalent shares
are calculated using the treasury stock method, which assumes that all dilutive
common stock
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equivalents are exercised and the funds generated by the exercise are used to
buy back outstanding common stock at the average market price during the
reporting period.
The following tables provide reconciliations of the numerators and denominators
of the basic and diluted net income per share computations.
(IN THOUSANDS, EXCEPT SHARE DATA) THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
1999 1998 1999 1998
------------ ------------ ------------ ------------
NUMERATOR:
Numerator for basic and diluted earnings per share--
Net income $ 3,196 $ 196 $ 9,737 $ 3,333
Cash dividends on Class B preferred stock (687) (687) (1,374) (1,374)
============ ============ ============ ============
Basic and Diluted EPS - Income available
to common stockholders $ 2,509 $ (491) $ 8,363 $ 1,959
============ ============ ============ ============
DENOMINATOR:
Denominator for basic earnings per share--
Weighted average number of common shares
outstanding during the period 10,051,565 14,106,828 10,412,855 14,115,342
Net effect of dilutive stock options 121,395 149,030 110,474 253,274
------------ ------------ ------------ ------------
Denominator for diluted earnings per share-- 10,172,960 14,255,858 10,523,329 14,368,616
============ ============ ============ ============
Net earnings per share--basic $ 0.25 $ (0.03) $ 0.80 $ 0.14
============ ============ ============ ============
Net earnings per share--diluted $ 0.25 $ (0.03) $ 0.79 $ 0.14
============ ============ ============ ============
COMPREHENSIVE INCOME
SFAS No. 130, Reporting Comprehensive Income, requires the Company to classify
items of "other comprehensive income" by their nature in a financial statement
and display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in capital in the equity section of
the balance sheet. In accordance with SFAS No. 130, current period unrealized
gains and losses on assets available-for-sale are reported as a component of
Comprehensive Income on the Statement of Stockholders' Equity with cumulative
unrealized gains and losses classified as Accumulated Other Comprehensive Income
in Stockholders' Equity. At June 30, 1999 and December 31, 1998, the only
component of Accumulated Other Comprehensive Income was unrealized gains and
losses on assets available-for-sale.
NOTE 3. MORTGAGE ASSETS
At June 30, 1999 and December 31, 1998, investments in Mortgage Assets consisted
of interests in adjustable-rate, hybrid or fixed-rate mortgages on residential
and commercial properties. The hybrid mortgages have an initial fixed coupon
rate for three to ten years followed by annual adjustments. Agency Mortgage
Securities ("Agency Securities") represent securitized interests in pools of
adjustable-rate mortgages from the Federal Home Loan Mortgage Corporation and
the Federal National Mortgage Association. The Agency Securities are guaranteed
as to principal and interest by these United States government-sponsored
entities. The original maturity of the majority of the Mortgage Assets is thirty
years; the actual maturity is subject to change based on the prepayments of the
underlying mortgage loans.
At June 30, 1999 and December 31, 1998, the average annualized effective yield
after taking into account the amortization expense due to prepayments on the
Mortgage Assets was 6.51% and 6.95%, respectively, based on the reported cost of
the assets. Of the Mortgage Assets owned by the Company at June 30, 1999, 74%
were adjustable-rate mortgages, 22% were hybrid mortgages and 4% were fixed-rate
mortgages. The coupons on 69% of the adjustable-rate Mortgage Assets are limited
by periodic caps (generally interest rate adjustments are limited to no more
than 1% every six months or 2% every year) while another 31% are not limited by
such periodic caps. Most of the coupons on the adjustable-rate and hybrid
Mortgage Assets owned by the Company are limited by
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lifetime caps. At June 30, 1999 and December 31, 1998, the weighted average
lifetime cap on the adjustable-rate Mortgage Assets was 11.77% and 11.81%,
respectively.
At June 30, 1999 and December 31, 1998, Mortgage Assets consisted of the
following:
MORTGAGE LOANS: HELD-FOR-SALE
(IN THOUSANDS) JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
Current Face $ 88,963 $ 274,630
Unamortized Discount (1,897) (1,099)
Unamortized Premium 0 670
======== =========
Carrying Value $ 87,066 $ 274,201
======== =========
During the three and six months ended June 30, 1999, the Company recognized net
gains of $110,675 and $85,846 as a result of LOCOM adjustments on Mortgage Loans
held-for-sale, respectively. Also during the three and six months ended June 30,
1999, the Company sold Mortgage Loans held-for-sale for proceeds of $7.5 million
and $50.1 million, resulting in net gains of $9,777 and $27,718, respectively.
Additionally, as a result of the call and subsequent restructuring of a portion
of the Long-Term Debt, the Company reclassified $154 million of Mortgage Loans
held-for-sale to Mortgage Loans held-for-investment (see Note 9). The LOCOM
adjustments and net gains on sales are reflected as a component of "Net
unrealized and realized gains (losses) on assets" on the Consolidated Statements
of Operations. There were no LOCOM adjustments or sale transactions on
held-for-sale Mortgage Loans for the three and six months ended June 30, 1998,
as the Mortgage Loans were not reclassified to held-for-sale until September 30,
1998.
MORTGAGE LOANS: HELD-FOR-INVESTMENT
(IN THOUSANDS) JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
Current Face $ 1,079,971 $ 1,118,375
Unamortized Premium 14,293 16,709
----------- -----------
Amortized Cost 1,094,264 1,135,084
Allowance for Credit Losses (4,487) (3,784)
=========== ===========
Carrying Value $ 1,089,777 $ 1,131,300
=========== ===========
There were no sales of Mortgage Loans held-for-investment for the three and six
months ended June 30, 1999 and 1998. During the second quarter of 1999, as a
result of the call and subsequent restructuring of a portion of the Long-Term
Debt, the Company reclassified $154 million of Mortgage Loans held-for-sale to
Mortgage Loans held-for-investment (see Note 9).
MORTGAGE SECURITIES: TRADING
JUNE 30, 1999 DECEMBER 31, 1998
(IN THOUSANDS) AGENCY NON-AGENCY TOTAL AGENCY NON-AGENCY TOTAL
----------------------------------- ---------------------------------------
Current Face $484,554 $ 448,379 $ 932,933 $ 609,826 $ 640,923 $ 1,250,749
Unamortized Discount 0 (3,098) (3,098) (5) (3,084) (3,089)
Unamortized Premium 9,281 2,502 11,783 7,602 2,393 9,995
======== ========= ========= ========= ========= ===========
Carrying Value $493,835 $ 447,783 $ 941,618 $ 617,423 $ 640,232 $ 1,257,655
======== ========= ========= ========= ========= ===========
For the three and six months ended June 30, 1999, the Company recognized a
mark-to-market gain of $0.3 million and $5.1 million on Mortgage Securities
classified as trading and sold Mortgage Securities classified as trading for
proceeds of $7.7 million, respectively. As the Company did not reclassify all of
its short-funded
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Mortgage Securities from available-for-sale to trading until July 1, 1998 (see
Note 2), there were no such mark-to-market adjustments for the three and six
months ended June 30, 1998. The mark to market adjustments are reflected as a
component of "Net unrealized and realized gains (losses) on assets" on the
Consolidated Statements of Operations.
MORTGAGE SECURITIES: AVAILABLE-FOR-SALE
JUNE 30, 1999 DECEMBER 31, 1998
(IN THOUSANDS) NON-AGENCY NON-AGENCY
------------- -----------------
Current Face $ 18,156 $ 17,281
Unamortized Discount (7,294) (8,015)
-------- --------
Amortized Cost 10,862 9,266
Allowance for Credit Losses (1,007) (1,189)
Gross Unrealized Gains 3 313
Gross Unrealized Losses (1,921) (683)
======== ========
Carrying Value $ 7,937 $ 7,707
======== ========
No sales or write-downs of Mortgage Securities available-for-sale occurred
during the three and six months ended June 30, 1999. During the six months ended
June 30, 1998, the Company sold Mortgage Securities available-for-sale with an
amortized cost of $9.3 million for proceeds of $9.3 million, resulting in a net
gain of $5,689. The Company also recognized a $0.7 million loss on the
write-down of certain Mortgage Securities available-for-sale during the six
months ended June 30, 1998. The gains and losses on the sales and write-downs of
Mortgage Securities available-for-sale are reflected as a component of "Net
unrealized and realized gains (losses) on assets" on the Consolidated Statements
of Operations.
NOTE 4. RESERVE FOR CREDIT LOSSES
The following table summarizes the Reserve for Credit Losses activity:
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
(IN THOUSANDS) 1999 1998 1999 1998
------- ------- ------- -------
Balance at beginning of period $ 5,197 $ 5,484 $ 4,973 $ 4,931
Provision for credit losses 371 763 716 1,364
Charge-offs (74) (463) (195) (511)
------- ------- ------- -------
Balance at end of period $ 5,494 $ 5,784 $ 5,494 $ 5,784
======= ======= ======= =======
The Reserve for Credit Losses is reflected as a component of Mortgage Assets on
the Consolidated Balance Sheets.
NOTE 5. U.S. TREASURY SECURITIES
At June 30, 1999 and December 31, 1998 U.S. Treasury securities consisted of the
following:
(IN THOUSANDS) JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
Current Face -- $45,000
Unamortized Premium -- 3,009
---- -------
Carrying Value -- $48,009
==== =======
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For the three and six months ended June 30, 1999, the Company recognized
mark-to-market losses of $1.4 million and $3.3 million on U.S. Treasury
securities and sold U.S. Treasury securities for proceeds of $32.1 million and
$90.5 million, respectively. The mark to market adjustments are reflected as a
component of "Net unrealized and realized gains (losses) on assets" on the
Consolidated Statements of Operations.
NOTE 6. COLLATERAL FOR LONG-TERM DEBT
The Company has pledged collateral in order to secure the Long-Term Debt issued
in the form of collateralized mortgage bonds ("Bond Collateral"). This Bond
Collateral consists primarily of adjustable-rate and hybrid, conventional,
30-year mortgage loans secured by first liens on one- to four-family residential
properties. All Bond Collateral is pledged to secure repayment of the related
Long-Term Debt obligation. All principal and interest (less servicing and
related fees) on the Bond Collateral is remitted to a trustee and is available
for payment on the Long-Term Debt obligation. The Company's exposure to loss on
the Bond Collateral is limited to its net investment, as the Long-Term Debt is
non-recourse to the Company.
During the second quarter of 1999, as a result of the call and subsequent
restructuring of a portion of the Long-Term Debt, the Company reclassified $154
million of Mortgage Loans held-for-sale to Mortgage Loans held-for-investment
(see Note 9).
The components of the Bond Collateral are summarized as follows:
(IN THOUSANDS) JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
Mortgage loans: held-for-sale $ 0 $ 197,646
Mortgage loans: held-for-investment, net 1,089,778 1,131,300
Restricted cash 8,035 12,857
Accrued interest receivable 6,073 7,707
---------- ----------
$1,103,886 $1,349,510
========== ==========
For presentation purposes, the various components of the Bond Collateral
summarized above are reflected in their corresponding line items on the
Consolidated Balance Sheets.
NOTE 7. INTEREST RATE AGREEMENTS
At June 30, 1999 and December 31, 1998, all of the Company's Interest Rate
Agreements were classified as trading, and therefore, reported at fair value.
During the three and six months ended June 30, 1999, the Company recognized net
gains of $2.4 million and $1.6 million, respectively, as a result of
mark-to-market adjustments on interest rate agreements classified as trading. As
the Company did not classify its interest rate agreements as trading instruments
until July 1, 1998 (see Note 2), there were no related mark-to-market
adjustments recognized during the three and six months ended June 30, 1998. The
mark-to-market gains are reflected as a component of "Net unrealized and
realized gains (losses) on assets" on the Consolidated Statements of Operations.
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The following table summarizes the aggregate notional amounts of all of the
Company's Interest Rate Agreements as well as the credit exposure related to
these instruments.
NOTIONAL AMOUNTS CREDIT EXPOSURE(a)
(IN THOUSANDS) JUNE 30, 1999 DECEMBER 31, 1998 JUNE 30, 1999 DECEMBER 31, 1998
------------- ----------------- ------------- -----------------
Interest Rate Options
Purchased $3,261,900 $3,569,200 -- --
Interest Rate Swaps 410,000 440,000 $6,976 $8,673
Interest Rate Futures 325,000 -- 512 --
---------- ---------- ------ ------
Total $3,996,900 $4,009,200 $7,488 $8,673
========== ========== ====== ======
(a) Reflects the fair market value of all cash and collateral of the Company
held by counterparties.
Interest Rate Options purchased (written), which may include caps, floors, call
and put corridors, options on futures and swaption collars (collectively,
"Options"), are agreements which transfer, modify or reduce interest rate risk
in exchange for the payment (receipt) of a premium when the contract is
initiated. Purchased interest rate cap agreements provide cash flows to the
Company to the extent that a specific interest rate index exceeds a fixed rate.
Conversely, purchased interest rate floor agreements produce cash flows to the
Company to the extent that the referenced interest rate index falls below the
agreed upon fixed rate. Purchased call (put) corridors will cause the Company to
incur a gain (loss) to the extent that the yield of the specified index is below
(above) the strike rate at the time of the option expiration. [The maximum gain
or loss on a call (put) corridor is established at the time of the transaction
by establishing a minimum (maximum) index rate]. The Company will receive cash
on the purchased options on futures if the futures price exceeds (is below) the
call (put) option strike price at the expiration of the option. For the written
options on futures, the Company receives an up-front premium for selling the
option, however, the Company will pay cash on the written option if the futures
price exceeds (is below) the call (put) option strike price at the expiration of
the option. Purchased receiver (payor) swaption collars will cause the Company
to incur a gain (loss) should the index rate be below (above) the strike rate as
of the expiration date. [The maximum gain or loss on a receiver (payor) swaption
is established at the time of the transaction by establishing a minimum
(maximum) index rate]. The Company's credit risk on the purchased Options is
limited to the carrying value of the Options agreements. The credit risk on
options on futures is limited due to the fact that the exchange and its members
are required to satisfy the obligations of any member that fails to perform.
Interest Rate Swaps ("Swaps") are agreements in which a series of interest rate
flows are exchanged over a prescribed period. The notional amount on which the
interest payments are based is not exchanged. Most of the Company's Swaps
involve the exchange of either fixed interest payments for floating interest
payments or the exchange of one floating interest payment for another floating
interest payment based on a different index. Most of the Swaps require that the
Company provide collateral, such as Mortgage Securities, to the counterparty.
Should the counterparty fail to return the collateral, the Company would be at
risk for the fair market value of that asset.
Interest Rate Futures ("Futures") are contracts for the delivery of securities
or cash in which the seller agrees to deliver on a specified future date, a
specified instrument (or the cash equivalent), at a specified price or yield.
Under these agreements, if the Company has sold (bought) the futures, the
Company will generally receive additional cash flows if interest rates rise
(fall). Conversely, the Company will generally pay additional cash flows if
interest rates fall (rise). Similar to options on futures, the credit risk on
futures is limited by the requirement that the exchange and its members make
good on obligations of any member that fails to perform.
In general, the Company has incurred credit risk to the extent that the
counterparties to the Interest Rate Agreements do not perform their obligations
under the Interest Rate Agreements. If one of the counterparties does not
perform, the Company would not receive the cash to which it would otherwise be
entitled under the Interest Rate Agreement. In order to mitigate this risk, the
Company has only entered into Interest Rate Agreements that
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are either a) transacted on a national exchange or b) transacted with
counterparties that are either i) designated by the U.S. Department of the
Treasury as a "primary government dealer", ii) affiliates of "primary government
dealers", or iii) rated BBB or higher. Furthermore, the Company has entered into
Interest Rate Agreements with several different counterparties in order to
diversify the credit risk exposure.
NOTE 8. SHORT-TERM DEBT
The Company has entered into reverse repurchase agreements and other forms of
collateralized short-term borrowings (collectively, "Short-Term Debt") to
finance acquisitions of a portion of its Mortgage Assets. This Short-Term Debt
is collateralized by a portion of the Company's Mortgage Assets and U.S.
Treasury securities.
At June 30, 1999, the Company had $923 million of Short-Term Debt outstanding
with a weighted-average borrowing rate of 5.30% and a weighted average remaining
maturity of 232 days. This debt was collateralized with $961 million of Mortgage
Assets. At December 31, 1998, the Company had $1.3 billion of Short-Term Debt
outstanding with a weighted average borrowing rate of 5.62% and a weighted
average remaining maturity of 48 days. This debt was collateralized with $1.3
billion of Mortgage Assets and U.S. Treasury securities.
At June 30, 1999 and December 31, 1998, the Short-Term Debt had the following
remaining maturities:
(IN THOUSANDS) JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
Within 30 days $ 98,642 $ 428,292
30 to 90 days 22,244 714,114
Over 90 days 801,859 115,164
-------- ----------
Total Short-Term Debt $922,745 $1,257,570
======== ==========
For the three and six months ended June 30, 1999, the average balance of
Short-Term Debt was $0.9 billion and $1.0 billion with a weighted average
interest cost of 5.07% and 5.10%, respectively. For the three and six months
ended June 30, 1998, the average balance of Short-Term Debt was $2.3 billion and
$2.1 billion with a weighted average interest cost of 5.88% and 5.83%,
respectively. The maximum balance outstanding during the six months ended June
30, 1999 and 1998 was $1.3 billion and $1.0 billion, respectively.
NOTE 9. LONG-TERM DEBT
Long-Term Debt in the form of collateralized mortgage bonds is secured by a
pledge of Bond Collateral. As required by the indentures relating to the
Long-Term Debt, the Bond Collateral is held in the custody of trustees. The
trustees collect principal and interest payments on the Bond Collateral and make
corresponding principal and interest payments on the Long-Term Debt. The
obligations under the Long-Term Debt are payable solely from the Bond Collateral
and are otherwise non-recourse to the Company.
Each series of Long-Term Debt consists of various classes of bonds at variable
rates of interest. The maturity of each class is directly affected by the rate
of principal prepayments on the related Bond Collateral. Each series is also
subject to redemption according to the specific terms of the respective
indentures. As a result, the actual maturity of any class of a Long-Term Debt
series is likely to occur earlier than its stated maturity.
During the second quarter of 1999, the Company exercised its right to call the
Long-Term Debt of Sequoia Mortgage Trust 1 ("Sequoia 1"), a series of debt
issued by Sequoia. This Long-Term Debt was called on May 4, 1999. In conjunction
with this call, the Company restructured and contributed the Sequoia 1 debt to
Sequoia Mortgage Trust 1A ("Sequoia 1A"), a newly formed trust, and Sequoia 1A
issued Long-Term Debt collateralized by Sequoia 1 debt. Under the terms of this
new structure, the Sequoia 1A debt is not likely to be called within the next
twelve months. As a result, the $154 million of Bond Collateral in the form of
Mortgage Loans held-for-sale
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was reclassified to Mortgage Loans held-for-investment to reflect the shift in
the expected holding period of the Mortgage Assets.
The components of the Long-Term Debt at June 30, 1999 and December 31, 1998
along with selected other information are
summarized below:
(IN THOUSANDS) JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
Long-Term Debt $ 1,065,700 $ 1,303,405
Unamortized premium on Long-Term Debt 4,580 5,783
Deferred bond issuance costs (3,304) (3,628)
----------- -----------
Total Long-Term Debt $ 1,066,976 $ 1,305,560
=========== ===========
Range of weighted-average interest rates, by series 5.36% to 6.47% 5.75% to 6.55%
Stated maturities 2017 - 2029 2017 - 2029
Number of series 3 3
For the three and six months ended June 30, 1999, the average effective interest
cost for Long-Term Debt, as adjusted for the amortization of bond premium,
deferred bond issuance costs and other related expenses, was 5.96% and 6.00%,
respectively. For the three and six months ended June 30, 1998, the average
effective interest cost for Long-Term Debt, as adjusted for the amortization of
bond premium, deferred bond issuance costs and other related expenses, was 6.45%
and 6.44%, respectively. At June 30, 1999 and December 31, 1998, interest
payable on Long-Term Debt was $3.2 million and $4.2 million, respectively, and
is reflected as a component of Accrued Interest Payable on the Consolidated
Balance Sheets.
NOTE 10. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying values and estimated fair values of
the Company's financial instruments at June 30, 1999 and December 31, 1998.
(IN THOUSANDS) JUNE 30, 1999 DECEMBER 31, 1998
CARRYING VALUE FAIR VALUE CARRYING VALUE FAIR VALUE
--------------------------- ---------------------------
Assets
Mortgage Loans: held-for-sale $ 87,066 $ 87,066 $ 274,201 $ 274,302
Mortgage Loans: held-for-investment $1,089,778 $1,081,407 $1,131,300 $1,120,376
Mortgage Securities: trading $ 941,611 $ 941,611 $1,257,655 $1,257,655
Mortgage Securities: available-for-sale $ 7,944 $ 7,944 $ 7,707 $ 7,707
U.S. Treasury Securities -- -- $ 48,009 $ 48,009
Interest Rate Agreements $ 2,697 $ 2,697 $ 2,517 $ 2,517
Investment in RWT Holdings, Inc. $ 18,782 $ 19,261 $ 15,124 $ 15,124
Liabilities
Long-Term Debt $1,066,976 $1,058,450 $1,305,560 $1,302,330
The carrying values of all other balance sheet accounts as reflected in the
financial statements approximate fair value because of the short-term nature of
these accounts.
NOTE 11. STOCKHOLDERS' EQUITY
CLASS B 9.74% CUMULATIVE CONVERTIBLE PREFERRED STOCK
On August 8, 1996, the Company issued 1,006,250 shares of Class B Preferred
Stock ("Preferred Stock"). Each share of the Preferred Stock is convertible at
the option of the holder at any time into one share of Common Stock. After
September 30, 1999, the Company can either redeem or, under certain
circumstances, cause a
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conversion of the Preferred Stock. The Preferred Stock pays a dividend equal to
the greater of (i) $0.755 per quarter or (ii) an amount equal to the quarterly
dividend declared on the number of shares of the Common Stock into which the
Preferred Stock is convertible. The Preferred Stock ranks senior to the
Company's Common Stock as to the payment of dividends and liquidation rights.
The liquidation preference entitles the holders of the Preferred Stock to
receive $31.00 per share plus any accrued dividends before any distribution is
made on the Common Stock.
As of June 30, 1999 and December 31, 1998, 96,732 shares of the Preferred Stock
have been converted into 96,732 shares of the Company's Common Stock. At June
30, 1999 and December 31, 1998, there were 909,518 shares of the Preferred Stock
outstanding.
STOCK OPTION PLAN
The Company has adopted a Stock Option Plan for executive officers, employees
and non-employee directors (the "Plan"). The Plan authorizes the Board of
Directors (or a committee appointed by the Board of Directors) to grant
"incentive stock options" as defined under Section 422 of the Code ("ISOs"),
options not so qualified ("NQSOs"), deferred stock, restricted stock,
performance shares, stock appreciation rights and limited stock appreciation
rights ("Awards") and dividend equivalent rights ("DERs") to such eligible
recipients other than non-employee directors. Non-employee directors are
automatically provided annual grants of NQSOs with DERs pursuant to a formula
under the Plan.
The number of shares of Common Stock available under the Plan for options and
Awards, subject to certain anti-dilution provisions, is 15% of the Company's
total outstanding shares of Common Stock. The total outstanding shares are
determined as the highest number of shares outstanding prior to any stock
repurchases. At June 30, 1999 and December 31, 1998, 304,784 and 273,312 shares
of Common Stock, respectively, were available for grant. Of the shares of Common
Stock available for grant, no more than 500,000 shares of Common Stock shall be
cumulatively available for grant as ISOs. At June 30, 1999 and December 31,
1998, 384,970 and 381,298 ISOs had been granted, respectively. The exercise
price for ISOs granted under the Plan may not be less than the fair market value
of shares of Common Stock at the time the ISO is granted. All stock options
granted under the Plan vest no earlier than ratably over a four-year period from
the date of grant and expire within ten years after the date of grant.
The Company's Plan permits certain stock options granted under the plan to
accrue stock DERs. There were no stock DERs accrued for the three and six months
ended June 30, 1999. For the three and six months ended June 30, 1998, the stock
DERs accrued on NQSOs that had a stock DER feature resulted in charges to
operating expenses of $1,994 and $55,222, respectively. Stock DERs represent
shares of stock which are issuable to holders of stock options when the holders
exercise the underlying stock options. The number of stock DER shares accrued is
based on the level of the Company's dividends and on the price of the stock on
the related dividend payment date.
A summary of the status of the Company's Plan as of June 30, 1999 and changes
during the periods ending on that date is presented below.
THREE MONTHS ENDED SIX MONTHS ENDED
---------------------------- ----------------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
(IN THOUSANDS, EXCEPT SHARE DATA) SHARES EXERCISE PRICE SHARES EXERCISE PRICE
---------------------------- ----------------------------
Outstanding options at beginning of period 1,627,905 $ 23.16 1,739,787 $ 23.58
Options granted 91,300 $ 16.62 133,300 $ 15.95
Options exercised -- -- (12,361) $ 0.11
Options canceled (23,252) $ 20.03 (164,772) $ 27.70
--------- ---------
Outstanding options at end of period 1,695,953 $ 22.75 1,695,953 $ 22.75
========== =========
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STOCK REPURCHASES
Since September 1997, the Company's Board of Directors has approved the
repurchase of 6,455,000 shares of the Company's Common Stock. Pursuant to this
repurchase program, the Company repurchased 256,600 and 1,334,200 shares of its
Common Stock for $4.0 million and $20.0 million during the three and six months
ended June 30, 1999, respectively. At June 30, 1999, there were 1,149,300 shares
available for repurchase. The repurchased shares have been returned to the
Company's authorized but unissued shares of Common Stock.
NOTE 12. RELATED PARTY TRANSACTIONS
SALE OF MORTGAGE LOANS
During the three and six months ended June 30, 1999, the Company sold $0 and $8
million, respectively, of commercial mortgage loans to Redwood Commercial
Funding ("RCF"), a subsidiary of Holdings. Pursuant to the Master Forward
Commitment Agreement, the Company sold the Mortgage Loans to RCF at the same
price for which the Company acquired the Mortgage Loans. Similarly, the Company
purchased or committed to purchase $21 million and $24 million of commercial
mortgage loans during the three and six months ended June 30, 1999,
respectively, and, under the terms of the Master Forward Commitment Agreement,
committed to sell the Mortgage Loans to RCF during the second half of 1999.
During June 1999, the Company purchased $49 million of residential mortgage
loans. Pursuant to the Master Forward Commitment Agreement with Redwood
Residential Funding ("RRF"), a subsidiary of Holdings, the Company committed to
sell the Mortgage Loans to RRF during the third quarter of 1999.
OTHER
Under a revolving credit facility arrangement, the Company may loan funds to
Holdings to finance certain Mortgage Loans owned by Holdings. These loans are
typically unsecured and are repaid within six months. Such loans bear interest
at a rate of 3.5% over the London Interbank Offered Rate ("LIBOR"). At June 30,
1999 and December 31, 1998, the Company had loaned $2.0 million and $6.5
million, respectively, to Holdings in accordance with the provisions of this
arrangement. During the three and six months ended June 30, 1999, the Company
earned $0.2 million and $0.4 million, respectively in interest on loans to
Holdings. During both the three and six months ended June 30, 1998, the Company
earned $15,243 in interest on loans to Holdings.
The Company shares many of the operating expenses of Holdings, including
personnel and related expenses, subject to full reimbursement by Holdings.
During the three and six months ended June 30, 1999, $0.8 million and $1.5
million, respectively, of Holdings' operating expenses were paid by the Company.
For both the three and six months ended June 30, 1998, the Company paid $0.7
million of Holdings' expenses.
The Company may provide credit support to Holdings to facilitate Holdings'
financings from third-party lenders and/or hedging arrangements with
counterparties. As part of this arrangement, Holdings is authorized as a
co-borrower under some of the Company's Short-Term Debt agreements subject to
the Company continuing to remain jointly and severally liable for repayment.
Accordingly, Holdings pays the Company credit support fees on borrowings subject
to this arrangement. At June 30, 1999, the Company was providing credit support
on $53.1 million of Holdings' Short-Term Debt. No such arrangements were
outstanding at December 31, 1998. During the three and six months ended June 30,
1999, the Company recognized $32,948 and $40,858 of credit support fees. Credit
support fees for both the three and six months ended June 30, 1998 were
$138,966. Credit support fees are reflected as a component of "Other Income" on
the Consolidated Statements of Operations.
NOTE 13. COMMITMENTS AND CONTINGENCIES
At June 30, 1999, the Company had entered into commitments to purchase $4
million of commercial Mortgage Loans and $3 million of residential Mortgage
Securities for settlement during July 1999. At June 30, 1999, the Company had
also entered into commitments to sell $24 million of commercial Mortgage Loans
to RCF and $49 million of residential Mortgage Loans to RRF for settlement
during the third quarter of 1999.
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20
At June 30, 1999, the Company is obligated under non-cancelable operating leases
with expiration dates through 2001. The future minimum lease payments under
these non-cancelable leases are as follows: 1999 - $140,662; 2000 - $281,324;
2001 - $117,219.
NOTE 14. SUBSEQUENT EVENTS
Through August 10, 1999, pursuant to its stock repurchase program (see Note 11),
the Company repurchased 521,100 shares of the Company's Common Stock for $8.7
million.
On August 10, 1999, Holdings announced that it intends to merge the operations
of its two residential mortgage production subsidiaries, Redwood Financial
Services and Redwood Residential Funding. As a result of this consolidation,
Holdings currently expects to take a one-time third quarter restructuring charge
of up to $2 million. This charge reflects costs to be incurred in connection
with anticipated staff reductions, planned dispositions of certain facilities,
premises and equipment, and other restructuring costs. As the Company accounts
for Holdings under the equity method, the Company's earnings for the third
quarter of 1999 will reflect 99% of Holdings' restructuring charge.
20
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RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
June 30, 1999 December 31, 1998
------------- -----------------
(Unaudited)
ASSETS
Mortgage loans: held-for sale
Residential $ 13,057 $ 12,247
Commercial 8,080 --
-------- --------
21,137 12,247
-------- --------
Mortgage securities: trading 42,128 --
Cash and cash equivalents 8,826 9,711
Accrued interest receivable 143 78
Property, equipment and leasehold improvements, net 2,708 622
Other assets 629 120
-------- --------
$ 75,571 $ 22,778
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term debt $ 53,103 $ --
Loan from Redwood Trust, Inc. 2,000 6,500
Payable to Redwood Trust, Inc. 209 445
Accrued expenses and other liabilities 1,287 557
-------- --------
56,599 7,502
-------- --------
Commitments and contingencies (See Note 9)
STOCKHOLDERS' EQUITY
Series A preferred stock, par value $0.01 per share;
10,000 shares authorized; 5,940 issued and outstanding
($5,940 aggregate liquidation preference) 29,700 19,800
Common stock, par value $0.01 per share;
10,000 shares authorized; 3,000 issued and outstanding -- --
Additional paid-in capital 300 200
Accumulated deficit (11,028) (4,724)
-------- --------
18,972 15,276
-------- --------
$ 75,571 $ 22,778
======== ========
The accompanying notes are an integral part of these
consolidated financial statements.
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RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands)
(Unaudited)
For the period
from April 1, 1998
commencement of
Three Months Ended Six Months Ended operations) to
June 30, 1999 June 30, 1998 June 30, 1999 June 30, 1998
------------- ------------- ------------- -------------
REVENUES
Interest income
Mortgage loans: held-for-sale
Residential $ 253 $ 2,779 $ 307 $ 2,779
Commercial 197 -- 323 --
450 2,779 630 2,779
Mortgage securities: trading 447 -- 654 --
Cash and cash equivalents 107 57 216 57
------- ------- ------- -------
Total interest income 1,004 2,836 1,500 2,836
------- ------- ------- -------
Interest expense
Short-term debt (497) (2,503) (604) (2,503)
Credit support fees (33) (139) (41) (139)
Loans from Redwood Trust, Inc. (196) (15) (355) (15)
------- ------- ------- -------
Total interest expense (726) (2,657) (1,000) (2,657)
------- ------- ------- -------
Net interest income 278 179 500 179
Net unrealized and realized gains on assets 137 22 614 22
Other income (expense) (8) -- 48 --
------- ------- ------- -------
Net revenues 407 201 1,162 201
------- ------- ------- -------
EXPENSES
Compensation and benefits (2,553) (520) (4,812) (520)
General and administrative (1,649) (268) (2,655) (268)
------- ------- ------- -------
Total expenses (4,202) (788) (7,467) (788)
------- ------- ------- -------
NET LOSS $(3,795) $ (587) $(6,305) $ (587)
======= ======= ======= =======
The accompanying notes are an integral part of these
consolidated financial statements.
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RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In thousands, except share data)
(Unaudited)
Series A
Preferred stock Common stock Additional
--------------------------------------- paid-in Accumulated
Shares Amount Shares Amount capital deficit Total
- --------------------------------------------------------------------------------------------------------------
Balance, December 31, 1998 3,960 $19,800 2,000 $-- $200 $ (4,724) $ 15,276
- --------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net loss -- -- -- -- -- (2,509) (2,509)
- --------------------------------------------------------------------------------------------------------------
Balance, March 31, 1999 3,960 19,800 2,000 -- 200 (7,233) 12,767
- --------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net loss -- -- -- -- -- (3,795) (3,795)
Issuance of preferred stock 1,980 9,900 -- -- -- -- 9,900
Issuance of common stock -- -- 1,000 -- 100 -- 100
- --------------------------------------------------------------------------------------------------------------
Balance, June 30, 1999 5,940 $29,700 3,000 $-- $300 $(11,028) $ 18,972
==============================================================================================================
The accompanying notes are an integral part of these
consolidated financial statements.
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RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
For the period
from April 1, 1998
(commencement of
Three Months Ended Six Months Ended operations) to
June 30, 1999 June 30, 1998 June 30, 1999 June 30, 1998
------------- ------------- ------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (3,795) $ (587) $ (6,305) $ (587)
Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:
Depreciation and amortization 93 27 196 27
Net unrealized and realized gains on assets (137) (22) (615) (22)
Purchases of mortgage loans: held for sale (49,839) (531,038) (152,181) (531,038)
Proceeds from sales of mortgage loans: held for sale 26,176 525,418 44,017 525,418
Principal payments on mortgage loans: held for sale 778 5,615 808 5,615
Proceeds from sales of mortgage securities: trading 44,018 -- 54,520 --
Principal payments on mortgage securities: trading 1,825 -- 2,343 --
(Increase) decrease in accrued interest receivable 50 (16) (65) (16)
(Increase) decrease in other assets 817 (18) (418) (18)
Increase (decrease) in amounts due to Redwood Trust 67 831 (236) 831
Increase in accrued expenses and other liabilities 515 41 730 41
-------- --------- --------- ---------
Net cash provided by (used in) operating activities 20,568 251 (57,206) 251
-------- --------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, equipment and leasehold improvements (1,452) (35) (2,282) (35)
-------- --------- --------- ---------
Net cash used in investing activities (1,452) (35) (2,282) (35)
-------- --------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of short-term debt 58,874 519,347 148,179 519,347
Repayments on short-term debt (78,084) (519,347) (95,076) (519,347)
Loans from Redwood Trust, Inc. 46,744 4,000 60,444 4,000
Repayment of loans from Redwood Trust, Inc. (58,444) (4,000) (64,944) (4,000)
Net proceeds from issuance of preferred stock 9,900 9,900 9,900 9,900
Net proceeds from issuance of common stock 100 100 100 100
-------- --------- --------- ---------
Net cash provided by (used in) financing activities (20,910) 10,000 58,603 10,000
-------- --------- --------- ---------
Net increase (decrease) in cash and cash equivalents (1,794) 10,216 (885) 10,216
Cash and cash equivalents at beginning of period 10,620 -- 9,711 --
-------- --------- --------- ---------
Cash and cash equivalents at end of period $ 8,826 $ 10,216 $ 8,826 $ 10,216
======== ========= ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest expense $ 794 $ 2,518 $ 947 $ 2,518
Non-cash transaction:
Securitization of mortgage loans into mortgage securities $ 35,447 $ -- $ 98,290 $ --
======== ========= ========= =========
The accompanying notes are an integral part of these
consolidated financial statements.
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25
RWT HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 1999
(UNAUDITED)
NOTE 1. THE COMPANY
RWT Holdings, Inc. ("Holdings") was incorporated in Delaware on February 13,
1998 and commenced operations on April 1, 1998. Holdings' first fiscal year-end
was December 31, 1998. Holdings originates, acquires, accumulates, services and
sells real estate mortgage assets ("Mortgage Assets") which may be acquired or
sold as whole loans ("Mortgage Loans") or as mortgage securities representing
interests in or obligations backed by pools of mortgage loans ("Mortgage
Securities"). Redwood Trust, Inc. ("Redwood Trust") owns all of the preferred
stock and has a non-voting, 99% economic interest in Holdings. Holdings has
three subsidiaries which are included in the consolidated financial statements.
Redwood Financial Services, Inc. ("RFS") acquires seasoned loan portfolios from
banks and thrifts and sells this product to institutional mortgage investors.
Redwood Residential Funding, Inc. ("RRF") acquires newly-closed residential
loans from mortgage bankers and sells mortgage securities, loans and servicing
to investors. Redwood Commercial Funding, Inc. ("RCF") originates small balance
commercial mortgages and sells them to depository institutions. Holdings and its
subsidiaries currently utilize both debt and equity to finance acquisitions.
References to Holdings in the following footnotes refer to Holdings and its
subsidiaries.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Holdings and its
subsidiaries. All significant intercompany balances and transactions with
Holdings' consolidated subsidiaries have been eliminated.
USE OF ESTIMATES
The preparation of financial statements in conformity with Generally Accepted
Accounting Principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reported period. Actual
results could differ from those estimates. The primary estimates inherent in the
accompanying consolidated financial statements are discussed below.
Fair Value. Management estimates the fair value of its financial instruments
using available market information and other appropriate valuation
methodologies. The fair value of a financial instrument, as defined by Statement
of Financial Accounting Standards ("SFAS") No. 107, Disclosures about Fair Value
of Financial Instruments, is the amount at which the instrument could be
exchanged in a current transaction between willing parties, other than in a
forced liquidation sale. Management's estimates are inherently subjective in
nature and involve matters of uncertainty and judgement to interpret relevant
market and other data. Accordingly, amounts realized in actual sales may differ
from the fair values presented in Note 6.
ADOPTION OF SFAS NO. 133
Holdings adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, effective July 1, 1998. Upon the adoption of SFAS No. 133, Holdings
did not record a transition adjustment, as there were no outstanding derivative
instruments. Immediately after the adoption of SFAS No. 133, Holdings elected to
not seek hedge accounting for any of its derivative financial instruments
employed for hedging activities.
MORTGAGE ASSETS
Holdings' Mortgage Assets consist of Mortgage Loans and Mortgage Securities.
Interest is recognized as revenue when earned according to the terms of the
loans and when, in the opinion of management, it is collectible.
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26
Mortgage Loans: Held-for-Sale
Mortgage Loans are recorded at the lower of cost or aggregate market value. Cost
generally consists of the loan principal balance net of any unamortized premium
or discount. Interest income is accrued based on the outstanding principal
amount of the Mortgage Loans and their contractual terms. Realized and
unrealized gains or losses on the loans are based on the specific identification
method and are recognized in "Net unrealized and realized gains on assets" on
the Consolidated Statements of Operations.
Some of the Mortgage Loans purchased by Redwood Trust for which securitization
or sale is contemplated are committed for sale by Redwood Trust to Holdings, or
a subsidiary of Holdings, under a Master Forward Commitment Agreement. As the
forward commitment is entered into on the same date that Redwood Trust commits
to purchase the loans, the price under the forward commitment is the same as the
price Redwood Trust paid for the Mortgage Loans, as established by the external
market.
Mortgage Securities: Trading
Mortgage Securities classified as trading are accounted for in accordance with
SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.
Accordingly, such securities are recorded at their estimated fair market value.
Unrealized and realized gains and losses on these securities are recognized as a
component of "Net unrealized and realized gains on assets" on the Consolidated
Statements of Operations.
LOAN ORIGINATION FEES
Loan fees, discount points and certain direct origination costs are recorded as
an adjustment to the cost of the loan and are recorded in earnings when the loan
is sold.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand and highly liquid investments
with original maturities of three months or less.
DERIVATIVE FINANCIAL INSTRUMENTS
Holdings utilizes various derivative financial instruments to mitigate the risks
that a change in interest rates will result in a change in the value of the
Mortgage Assets. As of June 30, 1999, Holdings has entered into forward
contracts for the sale of mortgage-backed securities. Holdings currently
designates all derivative financial instruments as trading instruments.
Accordingly, such instruments are recorded at their estimated fair market value
with unrealized and realized gains and losses on these instruments recognized as
a component of "Net unrealized and realized gains on assets" on the Consolidated
Statements of Operations. During both the three and six months ended June 30,
1999, Holdings recognized mark-to-market gains on derivative financial
instruments of $0.1 million. There were no derivative financial instruments
outstanding during the three and six months ended June 30, 1998.
INCOME TAXES
Taxable earnings of Holdings are subject to state and federal income taxes at
the applicable statutory rates. Holdings provides for deferred income taxes if
any, to reflect the estimated future tax effects under the provisions of SFAS
No. 109, Accounting for Income Taxes. Under this pronouncement, deferred income
taxes, if any, reflect the estimated future tax effects of temporary differences
between the amount of assets and liabilities for financial reporting purposes
and such amounts as measured by tax laws and regulations.
COMPREHENSIVE INCOME
SFAS No. 130, Reporting Comprehensive Income, requires Holdings to classify
items of "other comprehensive income" by their nature in a financial statement
and display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in capital in the equity section of
the balance sheet. As of June 30, 1999 there was no other comprehensive income.
26
27
NOTE 3. MORTGAGE ASSETS
At June 30, 1999 and December 31, 1998 Mortgage Assets consisted of the
following:
MORTGAGE LOANS: HELD-FOR-SALE
(IN THOUSANDS) JUNE 30, 1999 DECEMBER 31, 1998
------------- -----------------
Current Face $21,601 $12,072
Unamortized Premium (Discount) (464) 175
------- -------
Carrying Value $21,137 $12,247
======= =======
For the three and six months ended June 30, 1999 Holdings recognized a lower of
cost or market loss adjustment of $116,626 and $177,034 on Mortgage Loans
held-for-sale, respectively. This loss is reflected as a component of "Net
unrealized and realized gains on assets" on the Consolidated Statements of
Operations. Also, during the three and six months ended June 30, 1999, Holdings
sold Mortgage Loans held-for-sale for proceeds of $26 million and $44 million,
respectively. For both the three and six months ended June 30, 1998, Holdings
sold Mortgage Loans for proceeds of $525.4 million, resulting in a net gain of
$18,953.
MORTGAGE SECURITIES: TRADING
(IN THOUSANDS) JUNE 30, 1999
-------------
AGENCY
-------------
Current Face $41,819
Unamortized Premium 309
-------
Carrying Value $42,128
=======
For the three and six months ended June 30, 1999, Holdings recognized a
mark-to-market gain of $153,790 and $700,780, respectively, on Mortgage
Securities classified as trading. This gain is reflected as a component of "Net
unrealized and realized gains on assets" on the Consolidated Statements of
Operations. Also during the three and six months ended June 30, 1999, Holdings
sold Mortgage Securities classified as trading for proceeds of $44 million and
$55 million, respectively. Holdings did not own any Mortgage Securities prior to
1999.
NOTE 4. SHORT-TERM DEBT
Holdings has entered into reverse repurchase agreements ("Short-Term Debt") in
order to finance acquisitions of a portion of its Mortgage Assets. The average
balance of Short-Term Debt outstanding during the three and six months ended
June 30, 1999 was $37.6 million and $23.4 million with a weighted average
borrowing rate of 5.29% and 5.17%, respectively. The maximum balance outstanding
during the six months ended June 30, 1999 was $87.6 million. The average balance
of Short-Term Debt outstanding during both the three and six months ended June
30, 1998 was $157.1 million with a weighted-average borrowing rate of 6.37%. The
maximum balance outstanding during the six months ended June 30, 1998 was $367.1
million.
Redwood Trust may provide credit support to Holdings to facilitate Holdings'
financings from third-party lenders and/or hedging arrangements with
counterparties. As part of this arrangement, Holdings is authorized as a
co-borrower under some of Redwood Trust's Short-Term Debt agreements subject to
Redwood Trust continuing to remain jointly and severally liable for repayment.
Accordingly, Holdings pays Redwood Trust credit support fees on borrowings
subject to this arrangement. At June 30, 1999, Redwood Trust was providing
credit support on $53.1 million of Holdings' Short-Term Debt. No such
arrangements were outstanding at December 31, 1998. These expenses are reflected
as "Credit support fees" on the Consolidated Statements of Operations.
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28
NOTE 5. INCOME TAXES
The provision for income taxes for the period from January 1, 1999 through June
30, 1999 amounted to $3,200 and represents minimum California franchise taxes.
No tax provision has been recorded for the six months ended June 30, 1999, as
Holdings reported a loss for the period. Due to the uncertainty of realization
of net operating losses, no tax benefit has been provided against the loss for
the period. In addition, a valuation allowance has been provided to eliminate
the deferred tax asset related to net operating loss carryforwards at June 30,
1999 and December 31, 1998. At June 30, 1999 and December 31, 1998 the valuation
allowance amounted to $4.3 million and $1.8 million, respectively. At December
31, 1998, Holdings had net operating loss carryforwards of approximately $4.6
million for both federal and state income tax purposes. The federal and state
carryforwards expire through 2013 and 2003, respectively.
NOTE 6. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying values and estimated fair values of
Holdings' financial instruments at June 30, 1999 and December 31, 1998.
(IN THOUSANDS) JUNE 30, 1999 DECEMBER 31, 1998
CARRYING VALUE FAIR VALUE CARRYING VALUE FAIR VALUE
---------------------------- ----------------------------
Assets
Mortgage Loans: held-for-sale $21,137 $21,621 $12,247 $12,255
Mortgage Securities: trading $42,128 $42,128 -- --
The carrying amounts of all other balance sheet accounts as reflected in the
financial statements approximate fair value because of the short-term nature of
these accounts.
NOTE 7. STOCKHOLDERS' EQUITY
The authorized capital stock of Holdings consists of Series A Preferred Stock
("Preferred Stock") and Common Stock. Holdings is authorized to issue 10,000
shares of Common Stock, each having a par value of $0.01, and 10,000 shares of
Preferred Stock, each having a par value of $0.01. All voting power is vested in
the common stock.
Holdings has issued a total of 5,940 shares of Preferred Stock to Redwood Trust.
The Preferred Stock entitles Redwood Trust to receive 99% of the aggregate
amount of any such dividends or distributions made by Holdings. The holders of
the Common Stock are entitled to receive the remaining 1% of the aggregate
amount of such dividends or distributions. The Preferred Stock ranks senior to
the Common Stock as to the payment of dividends and liquidation rights. The
liquidation preference entitles the holders of the Preferred Stock to receive
$1,000 per share liquidation preference before any distribution is made on the
Common Stock. After the liquidation preference, the holders of Preferred Stock
are entitled to 99% of any remaining assets.
NOTE 8. RELATED PARTY TRANSACTIONS
PURCHASE OF MORTGAGE LOANS
During the three and six months ended June 30, 1999, RCF purchased $0 and $8
million, respectively, of commercial mortgage loans from Redwood Trust. Pursuant
to the Master Forward Commitment Agreement, RCF purchased the Mortgage Loans
from Redwood Trust at the same price for which Redwood Trust acquired the
Mortgage Loans. Similarly, Redwood Trust purchased, or committed to purchase,
$21 million and $24.0 million of commercial mortgage loans during the three and
six months ended June 30, 1999, respectively. Under
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29
the terms of the Master Forward Commitment Agreement, Redwood Trust committed to
sell the Mortgage Loans to RCF during the second half of 1999.
During June 1999, Redwood Trust purchased $49 million of residential mortgage
loans, and, pursuant to the terms of the Master Forward Commitment Agreement
with RRF, committed to sell the Mortgage Loans to RRF during the third quarter
of 1999.
OTHER
Under a revolving credit facility arrangement, Redwood Trust may loan funds to
Holdings to finance certain Mortgage Assets owned by Holdings. These loans are
typically unsecured and are repaid within six months. Such loans bear interest
at a rate of 3.5% over the London Interbank Offered Rate ("LIBOR"). At June 30,
1999 and December 31, 1998, Holdings had borrowed $2.0 million and $6.5 million,
respectively, from Redwood Trust in accordance with the provisions of this
arrangement. These expenses are reflected as "Loans from Redwood Trust, Inc" on
the Consolidated Statements of Operations.
Redwood Trust shares many of the operating expenses of Holdings, including
personnel and related expenses, subject to full reimbursement by Holdings.
During the three and six months ended June 30, 1999, $0.8 million and $1.5
million, respectively, of Holdings' operating expenses were paid by Redwood
Trust. For both the three and six months ended June 30, 1998, Redwood Trust paid
$0.7 million of Holdings' expenses.
Holdings may borrow under several of Redwood Trust's Short-Term Debt agreements
as a co-borrower. As of June 30, 1999, Holdings had borrowings of $53.1 million
subject to this arrangement. At December 31, 1998, Holdings had no outstanding
borrowings under these agreements (see Note 4).
NOTE 9. COMMITMENTS AND CONTINGENCIES
At June 30, 1999, Holdings is obligated under non-cancelable operating leases
with expiration dates through 2006. The future minimum lease payments under
these non-cancelable leases are as follows: 1999 - $286,532; 2000- $578,526;
2001 - $545,360; 2002 - $377,848; 2003 - $355,950; 2004 through 2006 - $83,388.
Rent expense was $180,283 and $385,712 for the three and six months ended June
30, 1999. For both the three and six months ended June 30, 1998, rent expense
was $53,467.
At June 30, 1999, RCF had entered into commitments to purchase $24 million of
commercial Mortgage Loans from Redwood Trust for settlement during the second
half of 1999. At June 30, 1999, RCF had also entered into a commitment to sell
$0.3 million of commercial Mortgage Loans for settlement in July 1999.
At June 30, 1999, RFS had entered into a commitment to purchase $8 million of
residential Mortgage Loans for settlement in July 1999.
At June 30, 1999, RRF had entered into a commitment to purchase $49 million of
residential Mortgage Loans from Redwood Trust for settlement during the third
quarter of 1999.
NOTE 10. SUBSEQUENT EVENT
On August 10, 1999, Holdings announced that it intends to merge the operations
of RFS into RRF. As a result of this consolidation, Holdings currently expects
to take a one-time third quarter restructuring charge of up to $2 million. This
charge reflects costs to be incurred in connection with anticipated staff
reductions, planned dispositions of certain facilities, premises and equipment,
and other restructuring costs.
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ITEM 2. REDWOOD TRUST, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the Consolidated
Financial Statements and Notes.
SAFE HARBOR STATEMENT
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995: Statements in this discussion regarding Redwood Trust, Inc., or "Redwood
Trust", and our business which are not historical facts are "forward-looking
statements" that involve risks and uncertainties. For a discussion of such risks
and uncertainties, which could cause actual results to differ from those
contained in the forward-looking statements, we refer you to "Risk Factors"
commencing on Page 16 of our 1998 Annual Report.
OVERVIEW
Redwood Trust, together with its affiliates, is a finance company specializing
in real estate lending. Our primary activity is the financing of high-quality
residential mortgage loans with funds raised through issuance of long-term debt.
We also finance commercial mortgage loans and residential mortgage securities.
Through our affiliate operations, we are developing the ability to create
mortgage assets of significant value for our own portfolio and for sale to
institutional mortgage investors.
Our mortgage finance activities are conducted through Redwood Trust, which is a
qualified real estate investment trust ("REIT"). Generally, our REIT status
allows us to avoid corporate income taxes by distributing to our shareholders an
amount equal to at least 95% of taxable income. Our mortgage production
activities are conducted through RWT Holdings, Inc. ("Holdings"), an affiliate
of Redwood Trust. Earnings at Holdings are subject to regular corporate
taxation. Redwood Trust owns a 99% economic interest in Holdings.
Holdings originates, acquires, aggregates and resells mortgage loans and
securities. Holdings is a start-up business, and for the most part its most
important operations are in their early stages of production or will start
production in the third quarter of 1999. Holdings has been conducting its
business through three wholly owned subsidiaries: Redwood Residential Funding,
Inc., Redwood Commercial Funding, Inc., and Redwood Financial Services, Inc. On
August 10, 1999, Holdings integrated the operations of its two residential
mortgage production subsidiaries, Redwood Residential Funding and Redwood
Financial Services. This integration will result in a reduction in overhead and
a third quarter restructuring charge of up to $2 million. Redwood Residential
Funding is the surviving enterprise. Holdings businesses will generally continue
as before, but under the revised corporate structure.
THREE MONTHS ENDED SIX MONTHS ENDED
RESULTS OF OPERATIONS ---------------------------- -----------------------------
(IN THOUSANDS, EXCEPT SHARE DATE) JUNE 30, 1999 JUNE 30, 1998 JUNE 30, 1999 JUNE 30, 1998
------------- ------------- ------------- -------------
Mortgage Finance Income $ 6,953 $ 777 $ 15,978 $ 3,914
Mortgage Production Income (3,757) (581) (6,241) (581)
------- ----- -------- -------
Net Income 3,196 196 9,737 3,333
Preferred Dividends (687) (687) (1,374) (1,374)
------- ----- -------- -------
Net Income to Common Shareholders $ 2,509 $(491) $ 8,363 $ 1,959
======= ===== ======== =======
Earning Per Share $ 0.25 $(0.03) $ 0.79 $ 0.14
Common Dividends Per Share $ 0.00 $0.01 $ 0.00 $ 0.28
Income available to common shareholders totaled $2.5 million in the second
quarter of 1999, or $0.25 per common share, as compared to a $0.5 million loss
or $(0.03) per common share in the second quarter of 1998. Net income for the
first half of 1999 was $8.4 million, or $0.79 per share. In the same period one
year earlier, we earned $2.0 million, or $0.14 per share.
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For more information, please visit our Web site on the Internet at:
http://www.redwoodtrust.com.
FINANCIAL CONDITION
At June 30, 1999, our reported balance sheet had $2.2 billion of assets funded
with $2.0 billion of borrowings and $242 million of equity. The portion of our
balance sheet that is subject to recourse to Redwood Trust is $1.1 billion of
assets, $0.9 billion of borrowings and $242 million of equity. The ratio of
equity to recourse assets was 20.6%. The ratio of recourse liabilities to equity
was 3.8 to 1.0.
Our $1.1 billion of non-recourse assets and liabilities are owned by our three
Sequoia financing trusts. The Sequoia trusts are "bankruptcy-remote" with
respect to Redwood Trust. Although the net earnings of the trusts accrue to
Redwood Trust, Redwood Trust is not responsible for the repayment of Sequoia
debt and Sequoia has no call on the liquidity of Redwood Trust. Our recourse
exposure to Sequoia's mortgage assets is limited to our equity investments in
these trusts. At June 30, 1999, these equity investments had a reported value of
$35 million.
At December 31, 1998, we reported $2.8 billion in assets, of which $1.5 billion
were recourse, and $2.6 billion of liabilities, of which $1.3 billion were
recourse. Equity capital was $255 million. The ratio of equity to recourse
assets was 16.7% and the ratio of recourse liabilities to equity was 4.9 to 1.0.
MORTGAGE LOANS: HELD FOR SALE
RESIDENTIAL
We owned $67 million residential mortgage loans at June 30, 1999. All these
loans are carried on our balance sheet at the lower-of-cost-or-market. At
December 31, 1998, we reported $266 million of residential mortgage loans in
this category, of which $198 million were part of Sequoia Mortgage Trust 1 (see
below) and $68 million were funded with short-term debt and equity.
COMMERCIAL
At June 30, 1999, we owned $20 million of commercial mortgage loans originated
by Redwood Commercial Funding, Inc. and carried on our balance sheet as
"Mortgage Loans: Held for Sale: Commercial". At December 31, 1998, we owned $8
million of commercial mortgage loans.
MORTGAGE LOANS: HELD FOR INVESTMENT
We own $1.1 billion of residential mortgage loans that are financed long-term
through our financing subsidiary, Sequoia Mortgage Funding Corporation
("Sequoia"). The amount of Sequoia long-term debt outstanding amortizes as the
underlying mortgages pay down. As the equity owner of these trusts, we are
entitled to distributions of the net earnings of the trusts, which principally
consist of the interest income earned from mortgages in each trust less the
interest expense of the debt of each trust.
We currently have three series outstanding as discussed below. We consolidate
the assets and liabilities of Sequoia on our balance sheet. Sequoia balance
sheet components appear on our balance sheet as part of "Mortgage Loans: Held
for Investment", "Restricted Cash", "Long-Term Debt", and "Accrued Interest
Receivable".
SEQUOIA MORTGAGE TRUST 1
Sequoia Mortgage Trust 1, "Sequoia 1", owned $146 million in principal value of
adjustable residential mortgage loans and $8 million of cash at June 30, 1999
funded with $149 million of floating-rate collateralized mortgage bonds.
Our credit risk with respect to these loans is limited to our investment in the
equity of Sequoia 1. The reported basis of this investment was $7 million at
June 30, 1999.
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In May 1999, we effectively reduced the cost of our long-term financing
arrangement for Sequoia 1's mortgage loans by exercising our right to call
Sequoia 1's debt. We restructured Sequoia 1's debt and contributed the debt to
Sequoia Mortgage Trust 1A ("Sequoia 1A"), a newly formed trust. Sequoia 1A
issued lower-cost long-term debt collateralized by Sequoia 1 debt.
At December 31, 1998, the principal value of Sequoia 1's loans totaled $197
million. We also reported $13 million of cash owned by Sequoia 1 as "Restricted
Cash". Total Sequoia 1 debt was $202 million.
SEQUOIA MORTGAGE TRUST 2
Sequoia Mortgage Trust 2, "Sequoia 2", owned $494 million of principal value of
adjustable-rate residential mortgage loans at June 30, 1999 funded with $489
million of floating-rate collateralized mortgage bonds.
Our credit risk with respect to these loans is limited to our investment in the
equity of Sequoia 2. The reported basis of this equity interest was $18 million.
We will have the right to call Sequoia 2's debt and re-acquire Sequoia 2's loans
when the underlying mortgage loans collateral has been paid down to less than
25% of its initial balance. As of June 30, 1999, the balance was at 64% of its
initial level and it most likely will be several years before we gain the right
to call this debt.
At December 31, 1998, Sequoia 2's loans totaled $579 million and total Sequoia 2
debt was $571 million.
SEQUOIA MORTGAGE TRUST 3
Sequoia Mortgage Trust 3, "Sequoia 3", owned $439 million of principal value of
residential mortgage loans at June 30, 1999 funded with $429 million of
long-term debt. Both the mortgage loans and debt of Sequoia 3 are fixed rate
until December 2002 and then become floating rate.
Our credit risk with respect to these loans is limited to our investment in the
equity of Sequoia 3. This investment had a reported basis of $10 million.
We will have the right to call Sequoia 3's debt and re-acquire Sequoia 3's loans
beginning in December 2002.
At December 31, 1998, Sequoia 3's loans totaled $540 million and total Sequoia 3
debt was $530 million.
MORTGAGE SECURITIES: TRADING
At June 30, 1999 and December 31, 1998, all our mortgage securities represented
interests in pools of residential mortgage loans. Our mortgage securities
portfolio is marked-to-market for income statement purposes except for the 1% of
mortgage securities we own that is rated "A" or below. For the mark-to-market
securities, the estimated bid-side market value was $0.9 billion at June 30,
1999. These appear on our balance sheet as "Mortgage Securities: Trading." We
owned $1.3 billion in market value of these securities at December 31, 1998. For
a discussion of our investments in lower-rated mortgage securities we refer you
to the section titled "Mortgage Securities: Available for Sale" below.
At June 30, 1999, 51.6% of our mark-to-market residential mortgage securities
portfolio consisted of residential adjustable-rate mortgage securities issued
and credit-enhanced by Fannie Mae or Freddie Mac and effectively rated "AAA".
These securities totaled $0.5 billion at June 30, 1999 and $0.6 billion at
December 31, 1998.
At June 30, 1999, 38.5% of this residential mortgage securities portfolio
consisted of residential adjustable-rate mortgage securities issued by
private-label security issuers. These securities were credit-enhanced through
subordination or other means and were rated "AAA" or "AA". The value of these
securities was $0.4 billion at June 30, 1999 and $0.6 billion at December 31,
1998.
At June 30, 1999, 6.0% of this residential mortgage securities portfolio
consisted of mortgage securities rated "AAA" or "AA" which were backed by home
equity loans, or "HEL". The value of these securities was $56 million at June
30, 1999; floating-rate HEL securities were $55 million and fixed-rate HEL
securities were $1
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million. The value of these securities was $71 million at December 31, 1998;
floating-rate HEL securities were $68 million and fixed-rate HEL securities were
$3 million.
At June 30, 1999, 1.8% of this residential mortgage securities portfolio
consisted of fixed-rate, private label collateralized mortgage obligations.
These are commonly referred to as CMO's. They are rated "AAA" or "AA" and have
average lives of 1 to 2 years. The value of these securities was $17 million at
June 30, 1999 and $19 million at December 31, 1998.
At June 30, 1999, 1.3% of this residential mortgage securities portfolio
consisted of fixed-rate, private label mortgage securities rated "AA" and backed
by residential mortgage loans with loan-to-value ratios in excess of 100%. The
value of these securities was $12 million at June 30, 1999 and $12 million at
December 31, 1998.
At June 30, 1999, 0.8% of this residential mortgage securities portfolio
consisted of floating-rate CMO's issued by Fannie Mae or Freddie Mac and
effectively rated "AAA". These securities totaled $8 million at June 30, 1999
and $17 million at December 31, 1998.
At June 30, 1999, 0.03% of this residential mortgage securities portfolio
consisted of interest-only mortgage securities rated "AAA" or "AA". The value of
these securities was $0.2 million at June 30, 1999 and $0.4 million at December
31, 1998.
MORTGAGES SECURITIES: AVAILABLE FOR SALE
In 1994 and 1995, we acquired a portfolio of subordinated mortgage securities.
These securities were interests in pools of residential mortgage loans that
served as the credit-enhancement for the "AAA" and other securities issued from
those pools. Through ownership of these securities, we assumed most of the
credit risk of the underlying mortgage loans. These securities were either not
rated or were rated "A" through "B". We sold these subordinated securities to a
trust, SMFC 97-A, in December 1997. SMFC 97-A issued mortgage securities to fund
its acquisition of this portfolio.
We acquired from SMFC 97-A certain subordinated interests. At June 30, 1999,
these securities effectively bore most of the credit risk related to $0.4
billion of underlying mortgages. Changes in market valuations of SMFC 97-A are
not included in our income statement as these assets are funded with equity. The
reported value of SMFC 97-A was $7 million at June 30, 1999 and $8 million at
December 31, 1998. Our credit risk from SMFC 97-A is limited to our investment.
In the second quarter of 1999, we resumed the acquisition of lower-rated
mortgage securities with the acquisition of one fixed-rate security, rated "B",
at a cost of $0.9 million. This security is reported at cost for income
statement purposes with mark-to-market adjustments included on the balance
sheet. We also began providing for potential credit losses from this security
and we will continue to add to its credit reserve over time. At December 31,
1998, we did not own any such securities. We generally intend to acquire
additional subordinated mortgage securities in the future, both from Holdings
and from other mortgage market participants.
U.S. TREASURY SECURITIES
At December 31, 1998, we owned $48 million of ten-year U.S. Treasury securities
as part of our asset/liability management and hedging program. We sold our
ten-year U.S. Treasury securities during the first half of 1999.
CASH
We had $67 million of unrestricted cash at June 30, 1999 and $56 million at
year-end 1998.
Sequoia owned cash totaling $8 million at June 30, 1999 and $13 million at
year-end 1998. In consolidating Sequoia assets on our balance sheet, we reflect
this cash as restricted cash since it will be used for the specific purpose of
making payments to Sequoia bondholders and is not available for general
corporate purposes.
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INTEREST RATE AGREEMENTS
Our interest rate agreements are carried on our balance sheet at estimated
market value, which was $2.7 million at June 30, 1999 and $2.5 million at
December 31, 1998. Please see "Note 2. Summary of Significant Accounting
Policies", "Note 7. Interest Rate Agreements" and "Note 10. Fair Value of
Financial Instruments" in the Notes to Consolidated Financial Statements for
more information.
INVESTMENT IN RWT HOLDINGS, INC.
We do not consolidate the assets and liabilities of Holdings on our balance
sheet. We reflect the net book value of our individual investment in one line
item on our balance sheet labeled "Investment in RWT Holdings, Inc."
Through June 30, 1999, we have invested $29.7 million in the preferred stock of
Holdings. Our share of the operating losses at Holdings has reduced the carrying
value of this investment. The carrying value was $18.8 million at June 30, 1999
and $15.1 million at December 31, 1998.
At June 30, 1999, our assets also included a loan to Holdings of $2.0 million
and a receivable from Holdings of $0.2 million. At December 31, 1998, loans to
Holdings totaled $6.5 million and receivables from Holdings were $0.4 million.
OTHER ASSETS
Our other assets include accrued interest receivables, other receivables, fixed
assets, leasehold improvements and prepaid expenses. These totaled $15 million
at June 30, 1999 and $21 million at December 31, 1998.
SHORT-TERM DEBT
Short-term borrowings totaled $923 million at June 30, 1999. We pledged a
portion of our mortgage securities portfolio, mortgage loan portfolio, and other
investments to secure this debt. Short-term debt totaled $1.3 billion at
December 31, 1998. Maturities on this debt typically range from one month to one
year. The interest rate on most of this debt typically adjusts monthly to a
spread over or under the one month LIBOR interest rate.
LONG-TERM DEBT
At June 30, 1999, we had a total of $1.1 billion in long-term mortgage-backed
debt outstanding, net of unamortized premiums on bonds and deferred bond
issuance costs. Sequoia 1 debt of $149 million and Sequoia 2 debt of $489
million is floating rate debt. Sequoia 3 debt of $429 million is fixed-rate
until December 2002 after which time it becomes floating rate debt.
At December 31, 1998, Sequoia 1 had $202 million, Sequoia 2 had $574 million,
and Sequoia 3 had $530 million of long-term mortgage-backed debt outstanding net
of unamortized premiums on bonds and deferred bond issuance costs, for a total
outstanding of $1.3 billion.
Sequoia debt is non-recourse to Redwood Trust. The debt is consolidated on our
balance sheet and is reflected as long-term debt, which is carried at historical
amortized cost. The original scheduled maturity of this debt was approximately
thirty years. Since these debt balances are retired over time as principal
payments are received on the underlying mortgages, the expected average life of
this debt is two to six years.
OTHER LIABILITIES
Our other liabilities include accrued interest payable, accrued expenses, and
dividends payable. The net balance of these accounts totaled $9 million at June
30, 1999 and $15 million at December 31, 1998. Most of the accrued interest
payable is related to the Sequoia trusts discussed above.
STOCKHOLDERS' EQUITY
Total equity capital was $242 million at June 30, 1999. Preferred stock equity
was $27 million. Reported common equity totaled $215 million, or $21.64 per
common share outstanding.
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In reporting equity at June 30, 1999, we marked-to-market all earning assets and
interest rate agreements except mortgage loans that were financed to maturity
(Sequoia). In accordance with Generally Accepted Accounting Principles, no
liabilities were marked-to-market.
If we had marked-to-market all of our assets and liabilities, equity capital
would have been reported as $241 million at June 30, 1999. After subtracting out
the preference value of the preferred stock, common equity on a full
mark-to-market basis was $214 million and the net mark-to-market value per
common share was $21.56.
Reported equity capital was $255 million at December 31, 1998. Reported common
equity was $228 million, or $20.27 per common share outstanding. Mark-to-market
common equity was $220 million, or $19.53 per common share.
Real shareholder wealth increased from $19.53 to $21.56 per share, an increase
of 10% or $2.03 per share, during the first half of 1999 due to net asset
appreciation, retained earnings, and the effects of our stock repurchase
program.
We acquired 1,334,200 shares of our common stock in the first half of 1999 at an
average price of $15.01 per share. In the third quarter of 1999 through August
10, 1999, we acquired an additional 521,100 shares at an average price of $16.62
per share.
RESULTS OF OPERATIONS
Our operating results include all of the reported income of our mortgage finance
operations plus, as one line item on our income statement, 99% of the after-tax
results of mortgage production operations at Holdings. Detailed results at
Holdings are discussed separately below.
INTEREST INCOME
In the second quarter of 1999, interest income generated by our mortgage finance
operations, including consolidated Sequoia assets, was $36 million. Our
portfolio had average earning assets of $2.2 billion and earned an average yield
of 6.54%. During this quarter, the average coupon rate, or the cash-earning rate
on mortgage principal, was 6.82%. The reported value of assets included a net
purchase premium of 0.80% of mortgage principal totaling $17 million. We write
off this premium balance as an expense over the life of the asset. Net premium
amortization expense for the quarter was $1.6 million, which reduced earning
asset yield by 0.23%. The prepayment rate on our mortgage assets, which drives
the rate at which we write off premium balances, was at a 30% Conditional
Prepayment Rate ("CPR") during the quarter. Other factors reduced the earning
asset yield by 0.05%.
In the first quarter of 1999, interest income was $42 million. Our portfolio had
average earning assets of $2.6 billion and earned an average yield of 6.55%. The
coupon rate was 6.99%. The reported value of assets included a 0.71% net
premium, or $18 million. Net premium amortization expense was $2.3 million,
which reduced earning asset yield by 0.37%. Prepayments during the quarter were
at a 33% CPR. Other factors reduced the earning asset yield by 0.07%.
Interest income declined from the first quarter of 1999 to the second quarter of
1999 as we continued reducing our earning asset balances in order to free
capital to fund the start-up operations at Holdings and to support our stock
repurchase program. Earning asset yields remained stable as lower coupon rates
were offset by the effect of slower prepayment rates.
In the second quarter of 1998, interest income was $54 million. The portfolio
had average earning assets of $3.5 billion and earned an average yield of 6.10%.
The coupon rate was 7.52%. The reported value of assets included 1.98% of net
premium, or $68 million. Net premium amortization expense was $11.0 million,
which reduced earning asset yield by 1.26%. Prepayments during the quarter were
at a 34% CPR. Other factors reduced the earning asset yield by 0.16%.
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From the second quarter of 1998 to the second quarter of 1999, we reduced our
earning asset balances in order to reduce our exposure to accelerating mortgage
prepayment rates, free capital to fund the start-up operations at Holdings and
fund our stock repurchases. In the third quarter of 1998, we began reporting
many of our assets at market value for income statement purposes. This served to
decrease our outstanding premium balance thereby reducing the effect prepayments
had on our earning asset yields.
In the first six months of 1999, interest income was $78 million. The portfolio
had average earning assets of $2.4 billion and earned an average yield of 6.54%.
The coupon rate was 6.92%. The reported value of assets included a 0.75% net
premium, or $17 million. Net premium amortization expense was $3.9 million,
which reduced earning asset yield by 0.30%. Prepayments during the period were
at a 31% CPR. Other factors reduced the earning asset yield by 0.08%.
In the first six months of 1998, interest income was $108 million. The portfolio
had average earning assets of $3.4 billion and earned an average yield of 6.29%.
The coupon rate was 7.58%. The reported value of assets included a 2.09% net
premium, or $69 million. Net premium amortization expense was $19.2 million,
which reduced earning asset yield by 1.13%. Prepayments during the period were
30% CPR. Other factors reduced the earning asset yield by 0.16%.
INTEREST EXPENSE
Interest expense in the second quarter of 1999 was $29 million. We funded our
mortgage finance portfolio and other assets with an average of $243 million of
equity and $2.1 billion of borrowings, including consolidated Sequoia debt. We
paid an average cost of funds of 5.55% for these borrowings. Short-term debt
averaged 46% of total debt and cost us 5.07%. Long-term debt averaged 54% of
total debt and cost us 5.96%.
In the first quarter of 1999, interest expense was $33 million. We funded our
mortgage finance portfolio with an average of $250 million of equity and $2.4
billion of borrowings. We paid an average cost of funds of 5.59% for these
borrowings. Short-term debt averaged 48% of total debt and cost us 5.12%.
Long-term debt averaged 52% of total debt and cost us 6.03%.
From the first quarter of 1999 to the second quarter of 1999, total interest
expense decreased as the size of our portfolio has decreased. Our cost of funds
fell slightly as the average short-term rates declined. We refinanced the
long-term debt of Sequoia 1; this also contributed to a lower overall cost of
funds.
In the second quarter of 1998, interest expense was $50 million. We funded our
mortgage finance portfolio with an average of $329 million of equity and $3.3
billion of borrowings. We paid an average cost of funds of 6.06% for these
borrowings. Short-term debt averaged 68% of total debt and cost us 5.88%.
Long-term debt averaged 32% of total debt and cost us 6.45%.
From the second quarter of 1998 to the second quarter of 1999, total interest
expense was lower due to a reduction in the size of the portfolio. The cost of
funds decreased as short-term interest rates fell. Our borrowing costs did not
fall by the full amount of the decrease in short-term interest rates during this
period, as we utilized an increasing percentage of more expensive long-term
debt.
In the first six months of 1999, interest expense was $62 million. We funded our
portfolio with an average of $247 million of equity and $2.2 billion of
borrowings. We paid an average cost of funds of 5.58% for these borrowings.
Short-term debt averaged 47% of total debt and cost us 5.10%. Long-term debt
averaged 53% of total debt and cost us 6.00%.
In the first six months of 1998, interest expense was $96 million. We funded our
mortgage finance portfolio with an average of $329 million of equity and $3.2
billion of borrowings. We paid an average cost of funds of 6.04% for these
borrowings. Short-term debt averaged 66% of total debt and cost us 5.83%.
Long-term debt averaged 34% of total debt and cost us 6.44%.
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INTEREST RATE AGREEMENTS EXPENSE
We hedge using interest rate agreements in order to strengthen our balance
sheet, increase liquidity, and dampen potential earnings volatility. Net
interest rate agreements expense was $0.7 million in the second quarter of 1999,
or 0.14% of average borrowings. In the first quarter of 1999, interest rate
agreement expense was $0.3 million or 0.06% of average borrowings. In the second
quarter of 1998, interest rate agreement expense was $1.6 million or 0.19% of
average borrowings.
In adopting mark-to-market accounting for our interest rate agreements in the
third quarter of 1998 through the early adoption of SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities, we wrote down our basis in our
interest rate agreements. This market value adjustment had the effect of
reducing interest rate agreement amortization expense on an on-going basis.
Total interest rate agreement expense has also fallen as the size of our balance
sheet decreased. We refer you to "Note 7. Interest Rate Agreements" in the Notes
to Consolidated Financial Statements for additional details.
Net interest rate agreements expense was $1.1 million in the first six months of
1999, or 0.19% of average borrowings. In the first six months of 1998, interest
rate agreements expense was $3.0 million or 0.10% of average borrowings.
NET INTEREST INCOME
Net interest income, which equals interest income less interest expense less
interest rate agreements expense, was $6.8 million in the second quarter of
1999. Our interest rate spread, which equals the yield on earning assets less
the cost of funds and hedging, was 0.85%. Our net interest margin, which equals
net interest income divided by average assets, was 1.18% during this period.
In the first quarter of 1999, net interest income was $7.9 million, the interest
rate spread was 0.90%, and the net interest margin was 1.19%. Net interest
income was lower in the second quarter of 1999 than in the first quarter of 1999
due to a lower average portfolio balance during the later period.
In the second quarter of 1998, net interest income was $2.0 million, the
interest rate spread was negative 0.15%, and the net interest margin was 0.22%.
Our spread and margin increased in 1999 due to our efforts to reduce mortgage
prepayment risk.
In the first six months of 1999, net interest income was $14.7 million, the
interest rate spread was 0.87%, and the net interest margin was 1.19. In the
first six months of 1998, net interest income was $8.4 million, the interest
rate spread was 0.06%, and the net interest margin was 0.47%.
NET UNREALIZED AND REALIZED GAINS AND LOSSES ON ASSETS
In the second quarter of 1999, the net appreciation income on our portfolio
assets that were marked-to-market for income statement purposes was $1.4
million. This net gain consisted of a $0.4 million market value gain on mortgage
assets, a $1.4 million market value loss on U.S. Treasury securities, and a $2.4
million market value gain on interest rate agreements. Market values for our
assets changed as interest rates rose and anticipated future prepayments speeds
fell.
In the first quarter of 1999, total net asset appreciation income was $2.2
million. This included a $4.9 million gain on mortgage assets, a $1.9 million
loss on U.S. Treasury securities, and a $0.8 million market value loss on
interest rate agreements.
In the second quarter of 1998, we had not yet adopted mark-to-market accounting.
As a result, most of the unrealized market value gains and losses incurred
during that quarter were not recognized in earnings. Since we did not sell any
assets in this quarter, there were no realized gains or losses during the
period.
In the first six months of 1999, the net gain on asset market valuations was
$3.6 million. In the first six months of 1998, prior to adopting mark-to-market
accounting, asset value losses were $0.7 million.
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PROVISION FOR CREDIT LOSSES
In the second quarter of 1999, credit provisions were $0.4 million. In the first
quarter of 1999, credit provisions totaled $0.3 million. In the second quarter
of 1998, credit provisions were $0.8 million. Actual realized credit losses
totaled $0.1 million in the second quarter of 1999, $0.1 million in the first
quarter of 1999 and $0.3 million in the second quarter of 1998.
In the first six months of 1999, total credit provisions were $0.7 million. In
the first six months of 1998, total credit provisions were $1.4 million. Credit
provision expenses have declined over time as the portfolio of assets requiring
such reserve has decreased in size from mid-1998 to mid-1999.
We establish a credit reserve through credit provisions to cover estimated
future losses from mortgage loans and securities. We take these provisions for
residential mortgage loans held for investment and for mortgage securities rated
lower than "BBB".
OPERATING EXPENSES
In the second quarter of 1999, total operating expenses for our mortgage finance
operations were $0.9 million. Total operating expenses for the first quarter of
1999 were $0.7 million. Total operating expenses for the second quarter of 1998
were $0.6 million.
On-going operating expenses as a percentage of assets were 0.16% in the second
quarter of 1999, 0.11% in the first quarter of 1999, and 0.06% in the second
quarter of 1998. Operating expenses as a percentage of equity were 1.54% in the
second quarter of 1999, 1.14% in the first quarter of 1999, and 0.69% in the
second quarter of 1998. These ratios have increased over time as we have
decreased the size of our portfolio and reduced our equity through the
repurchase of stock. In addition, operating expenses have risen as we prepare
for future growth.
Total operating expenses for the mortgage finance operations for the first six
months of 1999 were $1.7 million. Total operating expenses for the first six
months of 1998 were $2.5 million.
Operating expenses as a percentage of assets were 0.13% in the first six months
of 1999 and 0.14% in the first six months of 1998. Operating expenses as a
percentage of equity were 1.47% in the first six months of 1999, and 1.34% in
the first six months of 1998.
NET EARNINGS FROM MORTGAGE FINANCE OPERATIONS
Net earnings from mortgage finance operations, which equals net operating
revenue less operating expenses, were $7.0 million in the second quarter of
1999. In the first quarter of 1999, net earnings were $9.0 million. In the
second quarter of 1998, net earnings were $0.8 million.
In the first six months of 1999, net earnings totaled $16.0 million. In the
first six months of 1998, net earnings were $3.9 million.
EQUITY IN EARNINGS (LOSSES) OF RWT HOLDINGS, INC.
Our share of the losses generated by start-up operations at Holdings, our
mortgage production affiliate, was $3.8 million in the second quarter of 1999.
We recognized losses from Holdings of $2.5 million in the first quarter of 1999
and a loss of $0.6 million in the second quarter of 1998.
In the first six months of 1999, our share of losses from Holdings was $6.3
million. During the first six months of 1998, our share of losses was $0.6
million.
We refer you to Holdings' "Consolidated Financial Statements and Notes" and
Holdings' "Management's Discussion and Analysis" below for more information on
Holdings.
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NET INCOME
Net income for all of our operations was $3.2 million in the second quarter of
1999. After preferred dividends of $0.7 million, net income available to common
stockholders was $2.5 million.
In the first quarter of 1999, net income from all of our operations was $6.6.
After preferred dividends of $0.7 million, net income available to common
shareholders was $5.9 million.
In the second quarter of 1998, our net income was $0.2 million. After preferred
dividends of $0.7 million, the net loss was $0.5 million.
In the first six months of 1999, net income for all of our operations was $9.7
million. After preferred dividends of $1.4 million, net income available to
common stockholders was $8.4 million.
In the first six months of 1998, net income for all of our operations was $3.3
million. After preferred dividends of $1.4 million, net income available to
common stockholders was $2.0 million.
EARNINGS PER SHARE
Average diluted common shares outstanding were 10.2 million in the second
quarter of 1999, 10.9 million in the first quarter of 1999, and 14.3 million in
the second quarter of 1998. Diluted earnings per share were $0.25 in the second
quarter of 1999, $0.54 in the first quarter of 1999, and negative $0.03 in the
second quarter of 1998.
Average diluted common shares outstanding were 10.5 million in the first six
months of 1999 compared to 14.4 million in the first six months of 1998. Diluted
earnings per share were $0.79 in the first six months of 1999 and $0.14 in the
first six months of 1998.
Shares outstanding declined as a result of our common stock repurchase program.
DIVIDENDS
We paid no common stock dividends for the first half of 1999. We paid common
stock dividends totaling $0.28 per share in the first six months of 1998.
Under the minimum REIT dividend distribution rules, we were not required to
declare a common stock dividend in the first or second quarter of 1999. While we
had more than ample liquidity and balance sheet strength to pay a dividend in
those quarters, we chose to retain our capital for use in our operations and our
common stock repurchase program.
RISK MANAGEMENT
MARKET VALUE RISK
The market value of our assets can fluctuate due to changes in interest rates,
prepayment rates, liquidity, financing, supply and demand, credit and other
factors. These fluctuations affect our earnings.
At June 30, 1999, we owned mortgage securities and loans totaling $1.0 billion
that we account for on a mark-to-market basis or, in the case of mortgage loans,
on a lower-of-cost-or-market basis. Of these assets, 92% had adjustable-rate
coupons and 8% had fixed-rate coupons.
Our interest rate agreements hedging program may offset some asset market value
fluctuations due to interest rate changes. All of our $4 billion in notional
amounts of interest rate agreements are marked-to-market for income statement
purposes.
Market value fluctuations of as assets and interest rate agreements, especially
to the extent assets are funded with short-term borrowings, can also affect our
access to liquidity.
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INTEREST RATE RISK
At June 30, 1999, we, including Sequoia, owned $2.2 billion of assets and had
$2.0 billion of liabilities. The majority of the assets are adjustable-rate, as
are a majority of the liabilities.
Fixed-rate assets and hybrid mortgage assets (with fixed-rate coupons for 3 to 7
years and adjustable-rate coupons thereafter) totaled $0.5 billion, or 25% of
total assets. We had debt that had interest rate reset characteristics matched
to these hybrid mortgages totaling $0.4 billion.
We owned interest rate agreements with a notional face of $4 billion.
On average, our cost of funds has the ability to rise or fall more quickly as a
result of changes in short-term interest rates than does our earning rate on the
assets. In the case of a large increase in short-term interest rates, periodic
and lifetime caps for a portion of our assets could limit increases in interest
income. The risk of reduced earnings in a rising interest rate environment is
mitigated to some extent by our interest rate agreements hedging program.
Our net income may vary somewhat as the yield curve between one-month interest
rates and six- and twelve-month interest rates varies. At June 30, 1999, we
effectively owned $0.8 billion of adjustable-rate mortgages assets with interest
rates that adjust every six or twelve months off of interest rates of the same
maturity funded with $0.8 billion of our debt that has an interest rate that
adjusts monthly off of one-month LIBOR interest rates.
Adjustable-rate assets with earnings rates dependent on U.S. Treasury rates
totaled $0.6 billion at June 30, 1999. Liabilities with a cost of funds
dependent on U.S. Treasury rates totaled $0.4 billion at that time. As part of
our hedging program, we also had $0.3 billion notional amount of basis swaps
that, in effect, increased our U.S. Treasury-based liabilities to $0.7 billion.
Thus, at June 30, 1999, we had little earnings risk with respect to the risk of
U.S. Treasury rates deviating from LIBOR market rates.
Changes in interest rates affect prepayment rates (see below) and influence
other factors that may affect our results.
LIQUIDITY RISK
Our primary liquidity risk arises from financing long-term mortgage assets with
short-term debt. Even if the interest rate adjustments of these assets and
liabilities are well matched, maturities may not be matched. In addition, trends
in the liquidity of the U.S. capital markets in general may affect our ability
to roll-over short-term debt.
The assets that we pledge to secure short-term borrowings are high-quality,
liquid assets. As a result, we have not had difficulty refinancing our
short-term debt as it matures, even during the financial market liquidity crisis
in late 1998. Still, changes in the market values of our assets, in our
perceived credit worthiness, and in the capital markets, can impact our access
to liquidity.
At June 30, 1999, we had $134 million of highly liquid assets which were
unpledged and available to meet margin calls on short-term debt that could be
caused by asset value declines or changes in lender over-collateralization
requirements. These assets consisted of unrestricted cash and unpledged "AAA"
rated mortgage securities. Total available liquidity equaled 15% of our
short-term debt balances.
We have entered into borrowings with maturities beyond December 31, 1999 which
fund the substantial majority of our assets in order to avoid the need to
roll-over debt in advance of the beginning of the Year 2000.
PREPAYMENT RISK
As we receive repayments of mortgage principal, we amortize into income our
mortgage premium balances as an expense and our mortgage discount balances as
income. Mortgage premium balances arise when we acquire mortgage assets at a
price in excess of the principal value of the mortgages. Premium balances are
also created when an asset appreciates and is marked-to-market at a price above
par. Mortgage discount balances arise when
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we acquire mortgage assets at a price below the principal value of the
mortgages, or when an asset depreciates in market value and is marked-to-market
at a price below par. At June 30, 1999, mortgage premium balances were $26
million and mortgage discount balances were $12 million. Net mortgage premium
was $14 million.
Sequoia's long-term debt has associated deferred bond issuance costs. These
capitalized costs are amortized as an expense as the bonds are paid off with
mortgage principal receipts. These deferred costs totaled $3 million at June 30,
1999. In addition, premium received from the issuance of bonds at prices over
principal value is amortized as income as the bond issues pay down. These
balances totaled $5 million at June 30, 1999. The combined effect of these two
items was to reduce our effective mortgage-related premium by $1 million.
Our net premium at June 30, 1999 for assets and liabilities affected by the rate
of mortgage principal receipts was $13 million. This net premium equaled 5.2% of
total common equity. Amortization expense and income will vary as prepayment
rates on mortgage assets vary. In addition, changes in prepayment rates will
effect the market value of our assets and our earnings. Changes in the value of
our assets, to the extent they are incorporated into the basis of our assets,
will also affect future amortization expense.
CREDIT RISK
Our principal credit risk comes from mortgage loans owned by Sequoia, mortgage
loans held in portfolio, and our lower-rated mortgage securities. We also have
credit risk with counter-parties with whom we do business.
Not including Sequoia, we owned $67 million in residential mortgage loans at
June 30, 1999. Of these, $0.4 million were seriously delinquent (delinquent over
90 days, in foreclosure, in bankruptcy, or real estate owned). We also owned $20
million in commercial mortgage loans. These commercial mortgage loans were all
current at June 30, 1999.
The three Sequoia trusts owned $1.1 billion in residential mortgage loans at
June 30, 1999. Our total credit risk from these trusts is limited to our equity
investment in these trusts. These equity investments had a reported value of $35
million at June 30, 1999. At that time, $6.3 million of the underlying loans, or
0.58%, were seriously delinquent.
At June 30, 1999, we had $4.5 million loan of credit reserves to provide for
potential future credit losses from our mortgage loans. Total seriously
delinquent loans had a loan balance of $6.7 million. To date, our realized
credit losses from defaulted residential mortgage loans have averaged 8% of the
loan balance of the defaulted loans. Loss severity may increase in the future,
however, particularly if real estate values decline.
We believe our current level of reserve and credit provision policy is
reasonable and we will continue to increase our credit reserve over time in
anticipated of future potential losses.
At June 30, 1999, we also had $1.0 million credit reserves for our lower rated
mortgage securities. Our total potential credit exposure from these securities
(after this credit reserve) was $8 million. We believe this reserve is likely to
be sufficient to cover currently foreseen credit losses. As we acquire
additional subordinated securities, we will continue to build up this reserve in
anticipation of future potential losses.
CAPITAL RISK
Our capital levels, and thus our access to borrowings and liquidity, may be
tested, particularly if the market value of our assets securing short-term
borrowings declines.
Through our risk-adjusted capital policy, we assign a guideline capital adequacy
amount, expressed as a guideline equity-to-assets ratio, to each of our mortgage
assets. For short-term funded assets, this ratio will fluctuate over time, based
on changes in that asset's credit quality, liquidity characteristics, potential
for market value fluctuation, interest rate risk, prepayment risk, and the
over-collateralization requirements for that asset set by our collateralized
short-term lenders. Capital requirements for equity interests in Sequoia trusts
and for lower rated mortgage securities generally equal our net investment. The
sum of the capital adequacy amounts for all of our mortgage assets is our
aggregate guideline capital adequacy amount.
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The total guideline equity-to-assets ratio capital amount has declined over the
last few years as we have eliminated some of the risks of short-term debt
funding through issuing long-term debt. In the most recent quarters, however,
the total guideline ratio has increased as we have acquired new types of assets
such as commercial loans.
We do not expect that our actual capital levels will always exceed the guideline
amount. If interest rates were to rise in a significant manner, our capital
guideline amount would rise. As the potential interest rate risk of our
mortgages would increase, at least on a temporary basis, due to periodic and
life caps and slowing prepayment rates. We measure all of our mortgage assets
funded with short-term debt at estimated market value for the purpose of making
risk-adjusted capital calculations. Our actual capital levels, as determined for
the risk-adjusted capital policy, would likely fall as rates increase as the
market values of our mortgages, net of mark-to-market gains on hedges,
decreased. (Such market value declines may be temporary as well, as future
coupon adjustments on adjustable-rate mortgage loans may help to restore some of
the lost market value.)
In this circumstance, or any other circumstance in which our actual capital
levels decreased below our capital adequacy guideline amount, we would generally
cease the acquisition of new mortgage assets until capital balance was restored
through prepayments, interest rate changes, or other means. In certain cases
prior to a planned equity offering or other circumstances, the Board of
Directors has authorized management to acquire mortgage assets in a limited
amount beyond the usual constraints of our risk-adjusted capital policy.
Growth in assets and earnings may be limited when our access to new equity
capital is limited. Holdings can benefit over time from the re-investment of
retained earnings at Holdings. Our mortgage finance operations, however, are
generally required to distribute at least 95% of taxable income as dividends.
INFLATION RISK
Virtually all of our assets and liabilities are financial in nature. As a
result, interest rates, 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 Generally Accepted
Accounting Principles and our dividends are generally determined based on our
REIT net income as calculated for tax purposes. In each case, our activities and
balance sheet are measured with reference to historical cost or fair market
value without considering inflation.
YEAR 2000 READINESS DISCLOSURE
In 1998, we established a Year 2000 Project. The goal of this on-going project
is to ensure that our communications, data, and information systems are ready
for the Year 2000 and to employ prudent management to minimize any potential
negative impact of the Year 2000 on our business partners and our investors.
Senior management has taken an active role in the Year 2000 Project and provides
updates to the Board of Directors as necessary.
Our definition of "Readiness for the Year 2000" includes testing 100% of our
internal systems (hardware and software) to ensure that Year 2000 dates are
retained and correctly roll from December 31, 1999 to January 1, 2000 and from
February 28, to February 29, to March 1, 2000. It also includes having an
enterprise-wide contingency and disaster recovery plan for any known Year 2000
issues (and to the extent possible, other unforeseeable circumstances).
Our project management strategies include system risk assessment, system
upgrades or workarounds, and contingency planning. We believe we are devoting
the necessary resources to address all appropriate Year 2000 issues. We do not
currently anticipate incurring costs related to the Year 2000 issue that would
be material to our financial position, results of operations, or cash flows in
future periods.
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We commenced operations within the past five years and have built our internal
systems on a client-server model. Thus, we are not aware of any internal
"legacy" computer systems or software issues.
Existing internal computer systems have been successfully tested and any
additions to the existing systems and new systems are tested upon installation.
Hardware testing included forward date testing of the December 31, 1999 to
January 1, 2000 rollover and leap year 2000. Critical software applications used
to manage our businesses were also successfully tested.
As systems are modified or new hardware or software systems are implemented in
the normal course of business, our policy is to receive certification of Year
2000 compliance and to test for Year 2000 compliance upon installation.
We continue to gather and assess information regarding our business partners'
Year 2000 readiness. We solicited Year 2000 disclosures directly through our own
questionnaire and initiated direct discussions with certain key business
partners. A majority of questionnaire responses was received prior to July 1999.
No significant year 2000 issues have been identified through this process. We
will continue to monitor public disclosures by key business partners into the
Year 2000.
Business partners that provide information or services through externally
controlled or externally coordinated systems have been identified. Joint testing
of certain systems has been initiated. External joint testing is targeted for
completion by September 30, 1999.
We, together with our affiliates, are developing contingency plans and
workaround systems for critical systems. Workarounds may include substituting
compliant business partners for those who are non-compliant. The benefit of this
contingency plan is likely to be limited due to our lack of control on external
vendors and inability to replace certain business partners efficiently.
We believe we are devoting the necessary technical and management resources to
address the Year 2000 issues over which we have control. While it is inherently
difficult to assess the impact our vendors and their vendors may have on us in
the event they are unable to successfully manage their own year 2000 issues, we
believe we are on plan to reach our Year 2000 Project goals by October 1999.
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RWT HOLDINGS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
RWT Holdings, Inc., or "Holdings" was incorporated in Delaware in February 1998
and commenced operations on April 1, 1998. Holdings' start-up operations have
been funded primarily by Redwood Trust, which has a significant investment in
Holdings through the ownership of all of Holdings' preferred stock. We refer you
to "Note 1. The Company" in the Notes to the Consolidated Financial Statements
of RWT Holdings, Inc. and Subsidiaries for additional information on Holdings'
initial capitalization.
At June 30, 1999, Holdings owned $13 million of residential mortgage loans, $8
million of commercial mortgage loans, and $42 million of residential mortgage
securities. Holdings also had $9 million in cash and $4 million in other assets,
for total assets of $76 million. Holdings had commitments to acquire $24 million
of commercial loans and $49 million of residential mortgage loans from Redwood
Trust.
The loans owned by Holdings were funded with short-term borrowings and equity.
Short-term debt was $53 million, loans from Redwood Trust were $2 million, and
other liabilities totaled $2 million. Total equity at June 30, 1999 was $19
million.
At December 31, 1998, Holdings owned $12 million of residential mortgage loans,
$10 million in cash, and $1 million in other assets, for total assets of $23
million. Loans from Redwood Trust totaled $7 million and other liabilities were
$1 million. Equity at this time totaled $15 million.
In the second quarter of 1999, net operating revenue totaled $0.4 million,
including interest income of $1.0 million, net asset appreciation income of $0.1
million, and interest expenses of $0.7 million. Operating expenses at Holdings
totaled $4.2 million in the second quarter of 1999. Holdings' net loss in the
second quarter of 1999 was $3.8 million.
In the first quarter of 1999, net operating revenue totaled $0.4 million,
including interest income of $1.0 million, net asset appreciation income of $0.1
million, and interest expenses of $0.7 million. In the first quarter of 1999,
operating expenses at Holdings totaled $3.3 million and Holdings' net loss was
$2.5 million.
In the second quarter of 1998, net operating revenue totaled $0.2 million,
including interest income of $2.9 million, minimal net asset appreciation
income, and interest expenses of $2.7 million. In the second quarter of 1998,
operating expenses at Holdings totaled $0.8 million and Holdings' net loss was
$0.6 million.
In the first six months of 1999, net operating revenue totaled $1.2 million,
including interest income of $1.5 million, net asset appreciation income of $0.6
million, and interest expenses of $1.0 million. Operating expenses at Holdings
totaled $7.5 million in the first six months of 1999. Holdings' net loss during
this six-month period was $6.3 million.
In the first six months of 1998, net operating revenue totaled $0.2 million,
including interest income of $2.9 million, minimal net asset appreciation
income, and interest expenses of $2.7 million. In the first six months of 1998,
operating expenses at Holdings totaled $0.8 million and Holdings' net loss was
$0.6 million.
Holdings pre-tax loss as reported for GAAP currently equals its after-tax loss.
Due to the start-up nature of its operations, Holdings is not able to accrue a
tax benefit relating to its operating losses for GAAP at this time. Each of the
Holdings' operations is still in start-up mode. Holdings currently expects these
operations to become profitable in the first half of year 2000.
On August 10, 1999, we announced our intention to consolidate the operations of
our two residential mortgage production subsidiaries, RFS and RRF. The sales,
marketing, trading, technology, and securitization operations of these two units
will be integrated together. Overall headcount will be reduced. In connection
with this consolidation, Holdings expects to take a restructuring charge of up
to $2 million in the third quarter of 1999.
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PART II OTHER INFORMATION
Item 1. Legal Proceedings
At June 30, 1999, there were no pending legal proceedings to which the
Company was a party or of which any of its property was subject.
Item 2. Changes in Securities
In May, 1999, the Bonds issued pursuant to the Indenture, dated as of
June 1, 1997, between Sequoia Mortgage Trust 1 and First Union National
Bank, as Trustee, were redeemed, restructured and contributed to
Sequoia Mortgage Trust 1A, interests in which were then privately
placed with investors.
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
(a) The Annual Meeting of Shareholders of the Company was held on May
6, 1999.
(b) The following matters were voted on at the Annual Meeting:
Votes
-----------------------------
For Against Abstain
-----------------------------
1. Election of Directors
Thomas F. Farb 9,746,601 1,000 --
Douglas B. Hansen 9,747,601 -- --
Charles J. Toeniskoetter 9,688,701 58,900 --
Thomas C. Brown 9,746,099 1,502 --
The following Directors' terms of office continue after the meeting:
George E. Bull
Mariann Byerwalter
Dan A. Emmett
Nello Gonfiantini
Votes
-------------------------------
For Against Abstain
-------------------------------
2. Approval of amendment to the
Company's Stock Option Plan. 8,982,773 747,722 59,028
Votes
-----------------------------------
For Against Abstain
-----------------------------------
3. Ratification of PricewaterhouseCoopers LLP
as the Company's independent
public accountants for the fiscal
year ending December 31, 1999. 9,765,618 12,131 11,774
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Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 4.4 - In May, 1999, the Bonds issued pursuant to the
Indenture, dated as of June 1, 1997, between Sequoia
Mortgage Trust 1 and First Union National Bank, as
Trustee, were redeemed, restructured and contributed
to Sequoia Mortgage Trust 1A, interests in which were
then privately placed with investors.
Exhibit 4.4.2 - Sequoia Mortgage Trust 1A Trust Agreement,
dated as of May 4, 1999 between Sequoia Mortgage
Trust 1 and First Union National Bank.
Exhibit 11.1 to Part I - Computation of Earnings Per Share
for the three and six months ended June 30, 1999 and
June 30, 1998.
Exhibit 27 - Financial Data Schedule
(b) Reports
None
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
REDWOOD TRUST, INC.
Dated: August 10, 1999 By: /s/ Douglas B. Hansen
--------------------------------------
Douglas B. Hansen
President
(authorized officer of registrant)
Dated: August 10, 1999 By: /s/ Martin S. Hughes
--------------------------------------
Martin S. Hughes
Chief Financial Officer
(principal accounting officer)
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REDWOOD TRUST, INC.
INDEX TO EXHIBIT
Sequentially
Exhibit Numbered
Number Page
------- ------------
4.4.2 Sequoia Mortgage Trust 1A Trust Agreement, dated as of May 4, 1999
between Sequoia Mortgage Trust 1 and First Union National Bank............ 49
11.1 Computations of Earnings per Share........................................ 98
27 Financial Data Schedule.................................................. 100
48