UNITED STATES SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549Form 10-Q
REDWOOD TRUST, INC.FORM 10-Q
PART I. FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTSREDWOOD TRUST, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS
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REDWOOD TRUST, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME
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REDWOOD TRUST, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
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REDWOOD TRUST, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY For the Three Months Ended March 31, 2006:
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REDWOOD TRUST, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS
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REDWOOD TRUST, INC. AND SUBSIDIARIESNOTES TO FINANCIAL STATEMENTSMarch 31, 2006(Unaudited)NOTE 1. REDWOOD TRUSTRedwood Trust, Inc., together with its subsidiaries (Redwood, we, or us), is a specialty finance company that invests in, credit-enhances, and securitizes residential and commercial real estate loans and securities. In general, we invest in real estate loans by acquiring and owning asset-backed securities backed by these loans. Our primary focus is investing in first-loss and second-loss credit-enhancement securities issued by real estate loan securitizations, thereby partially guaranteeing (credit-enhancing) the credit performance of residential or commercial real estate loans owned by the issuing securitization entity.As a real estate investment trust (REIT), we are required to distribute to stockholders as dividends at least 90% of our REIT taxable income, which is our income as calculated for tax purposes, exclusive of income earned in non-REIT subsidiaries. In order to meet our dividend distribution requirements we have been paying both a regular quarterly dividend and a year-end special dividend. We expect our special dividend amount to be highly variable and we may not pay a special dividend in every year. Our dividend policies and distribution practices are determined by our Board of Directors and may change over time.Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. Our executive offices are at One Belvedere Place, Suite 300, Mill Valley, California 94941.NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIESBasis of PresentationThe accompanying consolidated financial statements are unaudited. The unaudited interim consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and, in our opinion, reflect all adjustments necessary for a fair statement of our financial position, results of operations, and cash flows. These consolidated financial statements and notes thereto should be read in conjunction with our audited consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2005. The results for the three months ended March 31, 2006 are not necessarily indicative of the expected results for the year ended December 31, 2006. Certain amounts for prior periods have been reclassified to conform to the March 31, 2006 presentation.The consolidated financial statements presented herein are for March 31, 2006 and December 31, 2005 and for the three month periods ended March 31, 2006 and 2005. These consolidated financial statements include the accounts of Redwood and its wholly-owned subsidiaries, Sequoia Mortgage Funding Corporation, Acacia CDO 1, Ltd. through Acacia CDO 9, Ltd., Acacia CDO CRE1, Ltd., RWT Holdings, Inc. (Holdings), and Holdings’ wholly-owned subsidiaries, including Sequoia Residential Funding, Inc. and Madrona LLC. References to Sequoia mean Sequoia Mortgage Funding Corporation and Sequoia Residential Funding, Inc. References to Acacia mean all of the aforementioned Acacia CDO entities. References to the Redwood REIT mean Redwood exclusive of its taxable subsidiaries. The taxable subsidiaries of Redwood are Holdings and Holdings’ wholly owned subsidiaries and the Acacia entities. All significant inter-company balances and transactions have been eliminated.Use of EstimatesThe preparation of financial statements in conformity with generally accepted accounting principles in the United States of America (GAAP) requires us to make a significant number of estimates in the preparation of financial statements. These include fair value of certain assets, amount and timing of credit losses, prepayment assumptions, and other items that affect the reported amounts of certain assets and liabilities as of the date of the consolidated financial statements and the reported amounts of certain revenues and
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expenses during the reported period. It is likely that changes in these estimates (e.g., market values due to changes in supply and demand, credit performance, prepayments, interest rates, or other reasons; yields due to changes in credit outlook and loan prepayments) will occur in the near term. Our estimates are inherently subjective in nature and actual results could differ from our estimates and the differences may be material.Sequoia and Acacia SecuritizationsWe treat the securitizations we sponsor as financings under the provisions of Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities(FAS 140) as under these provisions we have retained effective control over these loans and securities. Control is maintained through our active management of the assets in the securitization entities, our retained asset transfer discretion, our ability to direct certain servicing decisions, or a combination of the foregoing. Accordingly, the underlying loans owned by the Sequoia entities are shown on our Consolidated Balance Sheets under residential real estate loans and the Sequoia ABS issued to third parties are shown on our Consolidated Balance Sheets under ABS issued. Assets owned by the Acacia entities are shown on our Consolidated Balance Sheets either in our securities portfolio (residential real estate backed securities rated BBB and above, commercial real estate securities, collateralized debt obligation (CDO), and REIT corporate debt) or our residential loan credit-enhancement securities (CES) (below investment grade rated residential real estate securities). ABS issued by the Acacia entities are shown on our Consolidated Balance Sheets as ABS issued. In our Consolidated Statements of Income, we record interest income on the loans and securities and interest expense on the ABS issued. Any Sequoia ABS (CES, investment grade, or IO security) acquired by Redwood or Acacia from Sequoia entities and any Acacia ABS acquired by Redwood for its own portfolio are eliminated in consolidation and thus are not shown separately on our Consolidated Balance Sheets.Earning AssetsEarning assets (as consolidated for GAAP purposes) consist primarily of residential and commercial real estate loans and securities. Coupon interest is recognized as revenue when earned according to the terms of the loans and securities and when, in our opinion, it is collectible. Purchase discounts and premiums related to earning assets are amortized into interest income over their estimated lives, considering the actual and future estimated prepayments of the earning assets using the interest method (i.e., using an effective yield method). Gains or losses on the sale of earning assets are based on the specific identification method.Residential and Commercial Real Estate Loans: Held-for-InvestmentReal estate loans held-for-investment are carried at their unpaid principal balances adjusted for net unamortized premiums or discounts and net of any allowance for credit losses. The majority of consolidated residential real estate loans are classified as held-for-investment because the consolidated securitization entities that own these assets have the ability and intent to hold these loans to maturity. We may sell real estate loans from time to time to third-parties other than the securitization entities we sponsor. Residential loans include home equity lines of credit (HELOCs).Commercial real estate loans for which we have the ability and intent to hold to maturity are classified as held-for-investment and are carried at their unpaid balances adjusted for unamortized premium or discounts and net of any allowance for credit losses.Pursuant to Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Cost of Leases (FAS 91), we use the interest method to determine an effective yield and amortize the premium or discount on loans. For loans acquired prior to July 1, 2004, we use coupon interest rates as they change over time and anticipated principal payments to determine an effective yield to amortize the premium or discount. For loans acquired after July 1, 2004, we use the initial coupon interest rate of the loans (without regard to future changes in the underlying indices) and anticipated principal payments to calculate an effective yield to amortize the premium or discount.
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Residential and Commercial Real Estate Loans: Held-for-SaleResidential and commercial real estate loans that we are marketing for sale are classified as real estate loans held-for-sale. These are carried at the lower of cost or market value on a loan-by-loan basis. Any market valuation adjustments on these loans are recognized in net recognized gains (losses) and valuation adjustments in our Consolidated Statements of Income.Residential and Commercial Loan Credit-Enhancement Securities and Securities Portfolio: Available-for-SaleResidential and commercial loan credit-enhancement securities and securities in our securities portfolio are classified as available-for-sale (AFS) and are carried at their estimated fair values. Cumulative unrealized gains and losses are reported as a component of accumulated other comprehensive income in our Consolidated Statements of Stockholders’ Equity.When recognizing revenue on AFS securities, we employ the interest method to account for purchase premiums, discounts, and fees associated with these securities. For securities rated AAA or AA, we use the interest method as prescribed under FAS 91, while for securities rated A or lower we use the interest method as prescribed under the Emerging Issues Task Force of the Financial Accounting Standards Board 99-20,Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets(EITF 99-20).The use of these methods requires us to project cash flows over the remaining life of each asset. These projections include assumptions about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. We review and make adjustments to our cash flow projections on an ongoing basis and monitor these projections based on input and analyses received from external sources, internal models, and our own judgment and experience. There can be no assurance that our assumptions used to estimate future cash flows or the current period’s yield for each asset would not change in the near term.Redwood monitors its AFS securities for other-than-temporary impairment. We use the guidelines prescribed under EITF 99-20, Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (FAS 115), and Staff Accounting Bulletin No. 5(m), Other-Than-Temporary Impairment for Certain Investments in Debt and Equity Securities(SAB 5(m)). Any other-than-temporary impairments are reported under net recognized gains (losses) and valuation adjustments in our Consolidated Statements of Income.Credit ReservesFor consolidated residential and commercial real estate loans held-for-investment, we establish and maintain credit reserves based on estimates of credit losses inherent in these loan portfolios as of the reporting date. To calculate the credit reserve, we assess inherent losses by determining loss factors (defaults, the timing of defaults, and loss severities upon defaults) that can be specifically applied to each of the consolidated loans, loan pools, or individual loans. We follow the guidelines of Staff Accounting Bulletin No. 102,Selected Loan Loss Allowance Methodology and Documentation(SAB 102), and Statement of Financial Accounting Standards No. 5, Accounting for Contingencies(FAS 5), in setting credit reserves for our residential and commercial loans.The following factors are considered and applied in such determinations: •On-going analyses of the pool of loans — including, but not limited to, the age of loans, underwriting standards, business climate, economic conditions, geographical considerations, and otherobservable data; •Historical loss rates and past performance of similar loans; •Relevant environmental factors; •Relevant market research and publicly available third-party reference loss rates; •Trends in delinquencies and charge-offs; •Effects and changes in credit concentrations; and, •Prepayment assumptions.Once we determine applicable default amounts, the timing of the defaults, and severities of losses upon the defaults, we estimate expected losses for each pool of loans over its expected life. We then estimate the timing of these losses and the losses probable to occur over an effective loss confirmation period. This period is defined as the range of time between the probable occurrence of a credit loss (such as the
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initial deterioration of the borrower’s financial condition) and the confirmation of that loss (the actual impairment or charge-off of the loan). The losses expected to occur within the effective loss confirmation period are the basis of our credit reserves because we believe those losses exist as of the reported date of the financial statements. We re-evaluate the level of our credit reserves on at least a quarterly basis, and we record provision, charge-offs, and recoveries monthly.Additionally, if a loan becomes real estate owned (REO) or is reclassified as held-for-sale, valuations specific to that loan also include analyses of the underlying collateral.The setting of the reserve for credit losses for the commercial real estate loan portfolio includes detailed analyses of each loan and the underlying property. The following factors are considered and applied in such determinations: •On-going analyses of each individual loan — including, but not limited to, the age of loans, underwriting standards, business climate, economic conditions, geographical considerations, and other observable data; •On-going evaluations of fair values of collateral using current appraisals and other valuations; •Discounted cash flow analyses; and, •Borrowers’ ability to meet obligations.We follow the guidelines of Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (FAS 114), in determining impairment on commercial real estate loans.Cash and Cash EquivalentsCash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less.Other AssetsRestricted CashRestricted cash includes principal and interest payments from real estate loans and securities owned by consolidated securitization entities that are collateral for, or payable to, owners of ABS issued by those entities and cash pledged as collateral on interest rate agreements. Restricted cash may also include cash retained in Acacia or Sequoia securitization trusts prior to purchase of residential and commercial real estate loans and securities. See Note 7 for additional information on restricted cash.Deferred Tax AssetsNet deferred tax assets represent the net benefit of net operating loss carry forwards, real estate asset basis differences, recognized tax gains on whole loan securitizations, interest rate agreement basis differences, and other temporary GAAP and tax timing differences. These temporary timing differences will be recognized under GAAP through the financial statements in future periods.Deferred Asset-Backed Securities Issuance CostsDeferred ABS issuance costs are costs associated with the issuance of ABS from securitization entities we sponsor. These costs typically include underwriting, rating agency, legal, accounting, and other fees. Deferred ABS issuance costs are reported on our Consolidated Balance Sheets as deferred charges and are amortized as an adjustment to consolidated interest expense using the interest method based on the actual and estimated repayment schedules of the related ABS issued under the principles prescribed in Accounting Practice Bulletin 21, Interest on Receivables and Payables(APB 21).Other AssetsOther assets on our Consolidated Balance Sheets include REO, fixed assets, purchased interest, and other prepaid expenses. REO is reported at the lower of cost or market value.Accrued Interest Receivable and Principal ReceivableAccrued interest receivable and principal receivable represents principal and interest that is due and payable to us. These are generally received within the next month.
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Interest Rate AgreementsWe enter into interest rate agreements to help manage our interest rate risks. We report our interest rate agreements at fair value. Those with a positive value to us are reported as an asset. Those with a negative value to us are reported as a liability. We may elect hedge accounting treatment under Statement of Financial Accounting Standards No. 133,Accounting for Derivative Instruments and Hedging Activities, (FAS 133), or we may account for these as trading instruments. See Note 5 for a further discussion on interest rate agreements.Redwood DebtRedwood debt is short-term debt collateralized by loans and securities held temporarily for future sale to securitization entities. We carry this debt on our Consolidated Balance Sheets at its unpaid principal balance.Asset-Backed Securities IssuedThe majority of the liabilities reported on our Consolidated Balance Sheets represent ABS issued by bankruptcy-remote securitization entities sponsored by Redwood. These ABS issued are carried at their unpaid principal balances net of any unamortized discount or premium. Our exposure to loss from consolidated securitization entities (such as Sequoia and Acacia) is limited (except, in some circumstances, for limited loan repurchase obligations) to our net investment in securities we have acquired from these entities. As required by the governing documents related to each series of ABS, Sequoia and Acacia assets are held in the custody of trustees. Trustees collect principal and interest payments (less servicing and related fees) from the assets and make corresponding principal and interest payments to the issued ABS. ABS obligations are payable solely from the assets of these entities and are non-recourse to Redwood.Other LiabilitiesAccrued Interest PayableAccrued interest payable represents interest due and payable on Redwood debt and ABS issued. It is generally paid within the next month with the exception of interest due on Acacia ABS which is settled quarterly.Accrued Expenses and Other LiabilitiesAccrued expenses and other liabilities on our Consolidated Balance Sheets include cash held back from borrowers, derivatives margin liability, accrued employee bonuses, executive deferred compensation, dividend equivalent rights (DERs) payable, excise and income taxes, and accrued legal, accounting, consulting, and other miscellaneous expenses.Dividends PayableDividends payable reflect any dividend declared by us but not yet distributed to our stockholders as of the financial statement date.TaxesWe have elected to be taxed as a REIT under the Internal Revenue Code and the corresponding provisions of state law. In order to qualify as a REIT, we must distribute at least 90% of our annual REIT taxable income (this does not include taxable income retained in our taxable subsidiaries) to stockholders within the time frame set forth in the tax rules and we must meet certain other requirements. If these requirements are met, we generally will not be subject to Federal or state income taxation at the corporate level with respect to the REIT taxable income we distribute to our stockholders. We may retain up to 10% of our REIT taxable income and pay corporate income taxes on this retained income while continuing to maintain our REIT status.The taxable income of Holdings and its subsidiaries is not included in REIT taxable income, and is subject to state and Federal income taxes at the applicable statutory rates. Deferred income taxes, to the extent they exist, reflect estimated future tax effects of temporary differences between the amounts of taxes
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recorded for financial reporting purposes and amounts actually payable currently as measured by tax laws and regulations.We have recorded a provision for income taxes in our Consolidated Statements of Income based upon our estimated liability for Federal and state income tax purposes. These tax liabilities arise from estimated taxable earnings in taxable subsidiaries and from the planned retention of a portion of our estimated REIT taxable income. See Note 8 for a discussion on income taxes.Net Income per ShareBasic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted average number of common shares and potential common shares outstanding during the period. Potential common shares outstanding are calculated using the treasury stock method, which assumes that all dilutive common stock equivalents are exercised and the funds generated by the exercises are used to buy back outstanding common stock at the average market price of the common stock during the reporting period.The following table provides reconciliation of denominators of the basic and diluted net income per share computations.Basic and Diluted Net Income per Share
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awards issued prior to December 31, 2002 under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees(APB 25), and related interpretations. Under APB 25, when we granted option awards we did not include any stock-based employee compensation cost in net income, as all option awards granted had an exercise price equal to the fair market value of the underlying common stock on the date of grant. All other equity awards (deferred stock units and restricted stock), were valued at the grant date and expensed over the vesting period (regardless of when they were granted). Had we also applied Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation(FAS 123) to option awards granted prior to 2003, net income and net income per share would have been the pro-forma amounts indicated in the table below for the three months ended March 31, 2005. There is no pro-forma presentation for the three months ended March 31, 2006 as we adopted Financial Accounting Standards No. 123R, Share-Based Payment(FAS 123R) as of January 1, 2006, as further discussed below.Pro-Forma Net Income under FAS 123
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Recent Accounting PronouncementsOn June 30, 2005, the FASB issued Derivatives Implementation Group (“DIG”) Issue B38, Evaluation of Net Settlement with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option and DIG Issue B39, Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor (DIG B39). DIG B38 addresses an application issue when applying FAS 133, paragraph 12(c), to a put option or call option (including a prepayment option) embedded in a debt instrument. DIG B39 addresses the conditions in FAS 133, paragraph 13(b), as they relate to whether an embedded call option in a hybrid instrument containing a host contract is clearly and closely related to the host contract if the right to accelerate the settlement of debt is exercisable only by the debtor. DIG B38 and DIG B39 became effective for us on January 1, 2006. The adoption of DIG B38 and DIG B39 did not have an impact on our financial statements.In February 2006, the FASB issued Statement 155,Accounting for Certain Hybrid Financial Instruments,(FAS 155) to amend FAS 133 and FAS 140. This Statement simplifies the accounting for certain hybrid financial instruments by allowing an entity to make an irrevocable election on a specific instrument basis for certain financial assets and liabilities that contain embedded derivatives that would otherwise require bifurcation and to recognize and re-measure at fair value these instruments so elected. Thus, under this election, an entity would measure the entire hybrid financial instrument at fair value with changes in fair value recognized in earnings. FAS 155 becomes effective for us as of January 1, 2007. We believe FAS 155 will not have any material impact on our financial statements.In March 2006, the FASB issued Statement 156, Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140, (FAS 156). This Statement amends FAS 140 with respect to the accounting for separately recognized servicing assets and servicing liabilities. FAS 156 requires an entity to either (i) recognize servicing assets or servicing liabilities initially at fair value and amortize this value over the period of servicing, or (ii) measure servicing assets or liabilities at fair value at each reporting date with changes in fair value reported in earnings. FAS 156 becomes effective for us as of January 1, 2007. We believe FAS 156 will not have a material impact on our financial statements.We have recently become aware of a potential technical interpretation of GAAP that differs from our current accounting presentations. We have not changed our accounting treatment for this potential issue. However, if we were to change our current accounting presentations based on this interpretation, we do not believe there would be a material impact on our net income or balance sheets. This issue relates to the accounting for transactions where assets are purchased from a counterparty and simultaneously financed through a repurchase agreement with that same counterparty and whether these transactions create derivatives instead of the acquisition of assets with related financing (which is how we currently present these transactions). This potential technical interpretation of GAAP does not affect the economics of the transactions but may affect how the transactions would be reported in our financial statements. Our cash flows, our liquidity, and our ability to pay a dividend would be unchanged, and we do not believe our taxable income would be affected.NOTE 3. EARNING ASSETSAs of March 31, 2006 and December 31, 2005 our reported earning assets (owned by us or by consolidated securitization entities) consisted of investments in adjustable-rate, hybrid, and fixed-rate residential and commercial real estate loans and securities. Hybrid loans have an initial fixed coupon rate for three to ten years followed by periodic (usually annual or semi-annual) adjustments. The original maturity of the majority of our residential real estate loans and residential real estate securities is usually twenty-five to thirty years. The original maturity of our home equity lines of credit (HELOCs) is generally ten years. The original maturity of our commercial real estate loans and commercial real estate securities is generally ten years. The actual maturity is subject to change based on the prepayments of the underlying loans.For three months ended March 31, 2006 and 2005, the average consolidated balance of earning assets was $15.2 billion, and $24.0 billion, respectively.
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Residential Real Estate LoansWe acquire residential real estate loans from third party originators for sale to securitization entities sponsored by us under our Sequoia program. We sell these loans to Sequoia securitization entities, which, in turn, issue ABS (that are shown as liabilities on our Consolidated Balance Sheets). The following tables summarize the carrying value of residential loans (which include HELOCs) as reported on our Consolidated Balance Sheets at March 31, 2006 and December 31, 2005.Residential Real Estate Loans Composition between Loans and HELOCs
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The following table provides detail of the activity of reported residential real estate loans for the three months ended March 31, 2006 and 2005.Residential Real Estate Loans Activity
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The table below presents the face value of residential loan CES, the unamortized discount, and the portion of the discount designated as credit protection, unrealized gains and losses, and the carrying value of residential loan CES.Residential Loan CES Carrying Value
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due to other-than-temporary impairments of $0.1 million. These recognized losses are included in net recognized gains (losses) and valuation adjustments in our Consolidated Statements of Income.Gross unrealized gains and losses represent the difference between the net amortized cost and the fair value of individual securities. Gross unrealized losses represent a decline in market value for securities not deemed impaired for GAAP. The following table show the gross unrealized losses, fair value, and length of time that any residential loan CES have been in a continuous unrealized loss position as of March 31, 2006. These unrealized losses are not considered to be other-than-temporary impairments because these losses are not due to adverse changes in cash flows and we have the intent and ability to hold these securities for a period sufficient for these securities to potentially recover their values.Residential Loan CES with Unrealized Losses as of March 31, 2006
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Commercial Real Estate Loans Carrying Value
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Commercial Loan CES Carrying Value
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The following table provides detail of the activity in our commercial loan CES portfolio for the three months ended March 31, 2006 and 2005.Commercial Loan CES Activity
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commercial real estate securities ($160 million), REIT corporate debt ($8 million), and real estate CDOs ($12 million).Other-than-temporary impairments (EITF 99-20) for the three months ended March 31, 2006 and 2005 totaled $3.2 million and $0.4 million, respectively. These other-than-temporary impairments are included as part of net recognized gains (losses) and valuation adjustments in our Consolidated Statements of Income.Gross unrealized gains and losses represent the difference between the net amortized cost and the fair value of individual securities. Gross unrealized losses represent a temporary decline in market values. The following table show the gross unrealized losses, fair value, and length of time that securities have been in a continuous unrealized loss position of all securities portfolio securities as of March 31, 2006. These unrealized losses are not considered to be other-than-temporary impairments because these losses are not due to adverse changes in cash flows and we have the intent and ability to hold these securities for a period sufficient for these securities to potentially recover their values.Securities Portfolio with Unrealized Losses as of March 31, 2006
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Net Recognized Gains (Losses) and Valuation AdjustmentsFluctuations in the market value of certain of our real estate loan and security assets and interest rate agreements may also affect our net income. The table below describes the various components of our net recognized gains (losses) and valuation adjustments reported in income for the three months ended March 31, 2006 and 2005.Net Recognized Gains (Losses) and Valuation Adjustments
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We had no delinquent commercial real estate loans as of March 31, 2006 and December 31, 2005. The following table summarizes the activity in reserves for credit losses for our commercial real estate loans for the three months ended March 31, 2006 and 2005.Commercial Real Estate Loans
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exchange or b) transacted with counterparties that are either i) designated by the U.S. Department of Treasury as a primary government dealer, ii) affiliates of primary government dealers, or iii) rated AA or higher. Furthermore, we generally enter into interest rate agreements with several different counterparties in order to diversify our credit risk exposure and maintain margin accounts with them in case of default.We report our interest rate agreements at fair value as determined using third-party models and confirmed by Wall Street dealers. As of March 31, 2006 and December 31, 2005, the net fair value of interest rate agreements was $47.3 million and $30.7 million, respectively and are summarized in the table below. Our total unrealized gain included in accumulated other comprehensive income on interest rate agreements was $31.1 million and $17.2 million at March 31, 2006 and December 31, 2005, respectively.Interest Rate Agreements
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The effective portion of the change in the fair value of an interest rate agreement designated as a cash flow hedge is recorded in accumulated other comprehensive income. For reasons discussed below, there are certain balances that may be reclassified into our Consolidated Statements of Income over time. For the three months ended March 31, 2006 and 2005, the amount reclassified from other comprehensive income to interest expense totaled positive $0.3 million and negative $0.1 million, respectively.Should we choose to terminate a cash flow hedge, the value of that hedge will be reclassified from accumulated other comprehensive income into earnings over time. The timing of the reclassification will depend on the status of the hedged or forecasted transaction. If the hedged transaction no longer exists, or the forecasted transaction is no longer expected to occur, then the reclassification occurs immediately. During the three months ended March 31, 2006 and 2005, no such events occurred. If the hedged transaction still exists, or the forecasted transaction is still expected to occur, then the reclassification occurs over the original period of such transaction. To date we have terminated several cash flow hedges where the hedged transaction still exists or is still expected to occur. As a result, included in accumulated other comprehensive income at March 31, 2006, was a net gain balance of $2.6 million related to these terminated cash flow hedges to be reclassified into earnings over the original period of the transaction. This net gain consisted of $8.5 million of hedges terminated at a gain and $5.9 million of hedges terminated at a loss. At March 31, 2006, the maximum length of time over which we are hedging our exposure to the variability of future cash flows for forecasted transactions is ten years, and all forecasted transactions are expected to occur within the next year. Of this net amount of $2.6 million, a net of $0.1 million will be recognized as interest income on our Consolidated Statements of Income over the next twelve months.Also included in our interest expense in our Consolidated Statements of Income is the net cash receipts on interest rate agreements designated as cash flow hedges. For the three months ended March 31, 2006 and 2005, the net cash receipts credited to interest expense totaled $2.2 million and $1.2 million, respectively.NOTE 6. SHORT-TERM DEBTRedwood debt is currently all short-term debt, although at March 31, 2006 we had no outstanding debt. We generally enter into repurchase agreements, bank borrowings, and other forms of collateralized short-term borrowings (short-term debt) to finance assets under accumulation for future sale to securitization entities. We also have a $10 million unsecured line of credit available and have a commercial paper facility (discussed below). The table below summarizes Redwood debt by collateral type as of March 31, 2006 and December 31, 2005.Redwood Debt
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As of March 31, 2006 and December 31, 2005, Redwood debt had the following remaining maturities.Redwood Debt
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NOTE 7. ASSET-BACKED SECURITIES ISSUEDSecuritization entities sponsored by us issue ABS to raise the funds to acquire assets from us and others. Each series of ABS consists of various classes that pay interest at variable and fixed rates. Substantially all of the ABS is indexed to one-, three- or six-month LIBOR. A lesser amount of the ABS are fixed for a term and then adjust to a LIBOR rate (hybrid ABS) or are fixed for their entire term. Some of the ABS (IO) securities issued have a fixed spread, while others earn a coupon based on the spread between collateral owned and the ABS issued by the securitized entity. The maturity of each class is directly affected by the rate of principal prepayments on the assets of the issuing entity. Each series is also subject to redemption (call) according to the specific terms of the respective governing documents. As a result, the actual maturity of any class of ABS is likely to occur earlier than its stated maturity.The components of ABS issued by consolidated securitization entities as of March 31, 2006 and December 31, 2005, along with other selected information, are summarized in the table below.Asset-Backed Securities Issued
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Sequoia entities did not issue any ABS during the three months ended March 31, 2006. During the three months ended March 31, 2005, Sequoia entities issued $0.8 billion of Sequoia ABS to fund Sequoia’s acquisitions of residential real estate loans. During both the three months ended March 31, 2006 and 2005, Acacia entities issued $0.3 billion of Acacia ABS. No commercial ABS issuances or payoffs occurred during the three months ended March 31, 2006. During the three months ended March 31, 2005, we issued $4.3 million of commercial ABS and paid off commercial ABS in full of $4.0 million.The carrying value components of the collateral for ABS issued and outstanding as of March 31, 2006 and December 31, 2005 are summarized in the table below:Collateral for Asset-Backed Securities Issued
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The following table summarizes the tax provisions for Redwood REIT and Holdings for the three months ended March 31, 2006 and 2005.Provision for Income Tax
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a component of operating expenses on our Consolidated Statements of Income. As of March 31, 2006 and December 31, 2005, accrued excise tax payable was $0.3 million and $1.2 million, respectively, and was reflected as a component of accrued expenses and other liabilities on our Consolidated Balance Sheets.NOTE 9. FAIR VALUE OF FINANCIAL INSTRUMENTSWe estimate the fair value of our financial instruments using available market information and other appropriate valuation methodologies. These fair value estimates generally incorporate discounted future cash flows at current market discount rates for comparable investments. We validate our fair value estimates on a quarterly basis by obtaining fair value estimates from dealers who make a market in these financial instruments. We believe the estimates we use reasonably reflect the values we may be able to receive should we choose to sell them. Many factors must be considered in order to estimate market values, including, but not limited to interest rates, prepayment rates, amount and timing of credit losses, supply and demand, liquidity, and other market factors. Accordingly, our estimates are inherently subjective in nature and involve uncertainty and judgment to interpret relevant market and other data. Amounts realized in actual sales may differ from the fair values presented.The following table presents the carrying values and estimated fair values of our financial instruments as of March 31, 2006 and December 31, 2005.Fair Value of Financial Instruments
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Real estate securities •Residential and commercial real estate securities fair values are determined by discounted cash flow analyses and other valuation techniques using market pricing assumptions confirmed by third party dealer/pricing indications.Interest rate agreements •Fair values on interest rate agreements are determined by third party vendor modeling software and from valuations provided by dealers active in derivative markets.Cash and cash equivalents •Includes cash on hand and highly liquid investments with original maturities of three months or less. Fair values equal carrying values.Restricted cash •Includes interest earning cash balances in ABS entities for the purpose of distribution to bondholders and reinvestment. Due to the short-term nature of the restrictions, fair values approximate carrying values.Accrued interest receivable and payable •Includes interest due and receivable on assets and due and payable on our liabilities. Due to the short-term nature of when these interest payments will be received or paid, fair values approximate carrying values.Redwood debt •All Redwood debt is adjustable and matures within one year; fair values approximate carrying values.Asset-backed securities issued •Fair values are determined by discounted cash flow analyses and other valuation techniques confirmed by third party/dealer pricing indications.Commitments to purchase •The fair values of purchase commitments were negligible and are thus not listed in this table. See Note 11 for a further discussion of our commitments.NOTE 10. STOCKHOLDERS’ EQUITYStock Option PlanIn March 2004, we amended the previously approved 2002 Redwood Trust, Inc. Incentive Stock Plan (ISP) for executive officers, employees, and non-employee directors. This amendment was approved by our stockholders in May 2004. The ISP authorizes our Board of Directors (or a committee appointed by our Board of Directors) to grant incentive stock options as defined under Section 422 of the Code (ISOs), options not so qualified (NQSOs), deferred stock, restricted stock, performance shares, stock appreciation rights, limited stock appreciation rights (awards), and DERs to eligible recipients other than non-employee directors. ISOs and NQSOs awarded to employees have a maximum term of ten-years and generally vest ratably over a four-year period. NQSOs awarded to non-employee directors have a maximum term of ten years and generally vest immediately or ratably over a three- or four-year period. Non-employee directors are automatically provided annual awards under the ISP. The ISP has been designed to permit the Compensation Committee of our Board of Directors to grant and certify awards that qualify as performance-based and otherwise satisfy the requirements of Section 162(m) of the Code; however, not all awards may so qualify. As of March 31, 2006 and December 31, 2005, 212,351 and 315,866 shares of common stock, respectively, were available for grant.ISOsOf the total shares of common stock available for grant, no more than 963,637 shares of common stock are cumulatively available for grant as ISOs. As of both March 31, 2006 and December 31, 2005,
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551,697 ISOs had been granted. The exercise price for ISOs granted under the ISP may not be less than the fair market value of shares of common stock at the time the ISO is granted.DERsRedwood has granted stock options that accrue and pay cash or stock DERs. Cash DERs per applicable option are cash payments made that are equal to the per share dividends paid on common stock to our shareholders. In 2005 and earlier, prior to our adoption of FAS 123R on January 1, 2006, we expensed the cash DERs paid on options granted prior to January 1, 2003. These expenses were included in operating expenses in our Consolidated Statements of Income for the years 2005 and earlier. For the three months ended March 31, 2005, we accrued cash DER expenses of $1.8 million. For 2005 and earlier years, stock options granted between January 1, 2003 and December 31, 2005 that provided for cash DERs were accounted for under the provisions of FAS 123; thus, there are no DER expenses associated with these options as future DERs were included in the valuation of the stock options at the grant date. For the three months ended March 31, 2005, we accrued stock option expenses of $0.4 million. With the adoption of FAS 123R on January 1, 2006, the grant date fair value of all remaining unvested stock options are expensed on the Consolidated Statements of Income over the remaining vesting period of each option. For the three months ended March 31, 2006, stock option expense of $0.6 million was recorded on our Consolidated Statements of Income. As of March 31, 2006, there was $2.8 million of unrecognized compensation cost related to nonvested stock options. These costs will be expensed over a weighted-average period of 1.5 years. As of March 31, 2006 and December 31, 2005, there were 1,394,303 and 1,491,403 unexercised options with cash DERs, respectively. As of March 31, 2006 and December 31, 2005, there were 113,654 and 57,009 of unexercised options with no DERs, respectively. Options with cash DERs are participating securities under EITF 03-6 and were determined to be antidilutive in all reported periods.Stock DERs represent shares of stock that are issuable when the holders exercise the underlying stock options, the amount of which is based on prior dividends paid per share on common stock and the market value of the stock on the various dividend payable dates. In November 2005, all options with stock DERs were converted to options with cash DERs to comply with Internal Revenue Code Section 409A deferred compensation rules. At March 31, 2006 and December 31, 2005, there were no unexercised options with stock DERs. For the three months ended March 31, 2005, income of $0.1 million was recorded related to stock options with stock DERs for awards that were considered variable awards under APB 25.A summary of the stock option activity during the three months ended March 31, 2006 and 2005 is presented below.Note 2 provides a discussion on the assumptions used to value stock options at the grant date.Stock Option Activity
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The following table summarizes information about stock options outstanding at March 31, 2006.Stock Option Exercise Prices as of March 31, 2006
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March 31, 2006 and 2005, accrued interest of $0.3 million was credited to participants under the EDCP. During the three months ended March 31, 2006, DSUs of $0.2 million were purchased. There were no withdrawals made from the EDCP during the three months ended March 31, 2006 and 2005.The following table provides detail on changes in participants’ accounts in the EDCP for the three months ended March 31, 2006 and 2005.EDCP Activity
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Deferred Stock Units Activity
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Equity OfferingsWe did not complete any secondary equity offerings during the three months ended March 31, 2006 and 2005.Accumulated Other Comprehensive IncomeCertain assets are marked to market through accumulated other comprehensive income on our Consolidated Balance Sheets. These adjustments affect our book value but not our net income. As of March 31, 2006 and December 31, 2005, we reported net accumulated other comprehensive income of $81.6 million and $73.7 million, respectively. Changes in this account reflect increases or decreases in the fair value of our earning assets or interest rate agreements during the period, and also reflect changes due to calls of our securities, write downs to fair value of a portion of our securities, premium or discount amortization of our securities, and amortization of realized gains or losses on our interest rate agreements.The following table provides reconciliation of accumulated other comprehensive income as of March 31, 2006 and December 31, 2005.Accumulated Other Comprehensive Income
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The table below shows our commitments to purchase loans and securities as of March 31, 2006. The loan purchase commitments represent derivative instruments under FAS No. 149 Amendment of Statement 133 on Derivative Instruments and Hedging Activities(FAS 149). The fair value of these commitments was negligible as of March 31, 2006.Commitments to Purchase
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Item 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS CAUTIONARY STATEMENT This Form 10-Qcontains forward-looking statements within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Statements that are not historical in nature, including the words “anticipated,” “estimated,” “should,” “expect,” “believe,” “intend,” and similar expressions, are intended to identify forward-looking statements. These forward-looking statements are subject to risks and uncertainties, including, among other things, those described in our Annual Report on Form 10-K for the year ended December 31, 2005 under the caption “Risk Factors.” Other risks, uncertainties, and factors that could cause actual results to differ materially from those projected are detailed from time to time in reports filed by us with the Securities and Exchange Commission (SEC), including Forms 10-K, 10-Q, and 8-K. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. In light of these risks, uncertainties, and assumptions, the forward-looking events mentioned, or discussed in, or incorporated by reference into, this Form 10-Q might not occur. Accordingly, our actual results may differ from our current expectations, estimates, and projections. Important factors that may impact our actual results include changes in interest rates and market values; changes in prepayment rates; general economic conditions, particularly as they affect the price of earning assets and the credit status of borrowers; the level of liquidity in the capital markets as it affects our ability to finance our real estate asset portfolio; and other factors not presently identified. This Form 10-Q contains statistics and other data that in some cases have been obtained from, or compiled from information made available by, servicers and other third-party service providers. SUMMARY AND OUTLOOK Our primary source of revenue is interest income paid to us from the securities and loans we own, which in turn consists of the monthly loan payments made by homeowners (and to a lesser degree, commercial property owners) on their real estate loans. Our primary product focus is credit-enhancing residential and commercial loans that are high quality. “High quality” means real estate loans that typically have features such as relatively lowerloan-to-value ratios, borrowers with strong credit histories, and other indications of the likelihood the loan will be paid off or the value of the collateral will be sufficient to pay the loan in full, relative to the range of loans within U.S. real estate markets as a whole. We currently sponsor the securitization through our Sequoia program of all the residential real estate loans we acquire. We also sponsor the re-securitization through our Acacia CDO (collateralized debt obligations) program of investment-grade (and, to a lesser degree, non-investment grade) real estate securities. We seek to invest in assets that have the potential to provide for high cash flow returns over a long period of time to help support our goal of maintaining steady dividends over time. Our reported GAAP net income was $28 million ($1.09 per share) for the first quarter of 2006. In the first quarter of 2005, GAAP net income was $61 million ($2.42 per share). Our results for 2006 were not as strong as the results we achieved in 2005, but are still at a level that we consider acceptable. Our GAAP return on equity was 12% for the first quarter of 2006 compared to 27% for the first quarter of 2005. Better than expected credit results on the loans we credit-enhance has been the primary driver of our continued strong earnings results. For the residential real estate loans we credit-enhance, delinquencies remain at historically low levels and annual credit losses continue to be less than one basis point (0.01%) of the current balance of these loans. Credit results for the commercial real estate loans we credit-enhance have also been excellent.
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Table 1 Net Income
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our residential conduit brings multiple benefits to our business as a whole and is an excellent source of assets for us to invest in. In the longer term, we expect our residential conduit to develop in a manner that will once again generate attractive returns for our shareholders. We continue to be large and active investors in the market for residential credit-enhancement securities created by others, and we continue to allocate the greater part of our capital to these assets. We are continuing to build our business of credit-enhancing securitized commercial real estate loans. In the first quarter of 2006, we acted, for the first time, as the lead buyer of credit-enhancement securities for a new CMBS issuance. This event marked a significant milestone in the development of our commercial credit enhancement business. We continue to sponsor Acacia CDO transactions and invest in the CDO equity securities we create. The market for sponsoring CDO securitizations continues to be attractive, although it has become more competitive. We expect that CDO investments will generate attractive cash flows over time. We believe that the CDO business is an area for innovation, and we continue to explore new ways to take advantage of these structures. In late 2005, we completed our first predominately commercial real estate CDO. We may also incorporate synthetic assets in Acacia’s asset pools. Over the next few years, we expect our CDO sponsorship business to grow and evolve in interesting new ways and to continue to generate attractive new investments and asset management fees. We seek to maintain a structured balance sheet that we believe should allow us to weather potential general economic downturns and liquidity crises. We generally seek to put ourselves in a position where changes in interest rates would not be likely to materially harm our ability to meet our long-term goals or maintain our regular dividend rate. We use debt to finance loans and securities that we are accumulating as inventory for sale to securitization entities sponsored by us. In our view, the long-term outlook for our business is good. Housing price increases over the past several years have reduced our risk of credit loss in the future for our existing residential assets. For most of our residential credit risk assets, the underlying loans were originated in 2003 and 2004. Commercial property values and cash flows are increasing in many areas. Our portfolio of assets as a whole has the ability to generate attractive earnings, cash flows, and dividends in the future, assuming real estate credit losses do not increase materially. Over the long term, we believe it is reasonably likely that we will be able to continue to find attractive investment opportunities, as we are an efficient competitor and because our market segments are growing (as the amount of real estate loans outstanding increases and the percentage of these loans that are securitized increases). In general, we expect per share earnings and our special dividend in 2006 to be lower than 2005 as a result of higher levels of unutilized capital, a newer portfolio on average (our seasoned assets have largely been sold or called), few gains from sales (as we are not planning a significant amount of sales at this time), fewer calls (as we have fewer callable assets) continued high premium amortization expenses on the residential loans consolidated from Sequoia trusts as these loans continue to prepay rapidly, and for other reasons. There is a high degree of quarter-to-quarter variability of earnings in our business models, and short-term earnings trends should be interpreted with care. As management, we focus on building the net present value of future cash flows and on building our ability to sustain our regular dividend rate. We do not focus on quarterly earnings.
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RESULTS OF OPERATIONSFIRST QUARTER 2006 AS COMPARED TO FIRST QUARTER 2005Acquisitions, Securitizations, Sales, and Calls During the first quarter of 2006, we acquired $53 million residential loan CES ($28 million on behalf of Acacia and $25 million funded with equity). This was a decrease from the $68 million we acquired in the first quarter of 2005 as we limited our asset acquisitions to preserve cash balances as part of our capital utilization plan. The bulk of the loans underlying the CES we acquired during 2006 continue to be of above-average quality as compared to securitized residential loans as a whole. In the first quarter of 2006, none of our residential loan CES were called. In the first quarter of 2005, we had calls of $14 million principal value that generated GAAP gains of $8 million. We have fewer assets that will likely become callable during 2006 than in recent years. At the end of the first quarter of 2006, we had residential loan CES securities with principal value totaling $1 million that were callable. During the first quarter of 2006, we sold $10 million residential loan CES, generating GAAP gains of $1 million. During the first quarter of 2005, sales of residential loan CES totaled $27 million and generated GAAP gains of $8 million. We did not acquire commercial real estate loans during the first quarter of 2006, a decrease from the $7 million acquired during the first quarter of 2005. We did not sell any commercial real estate loans during the first quarters of 2006 or 2005. Our commercial real estate loan activity provides additional collateral to the Acacia CDO securitizations we sponsor. During the first quarter of 2006, we acquired $7 million commercial loan CES, a decrease from the $13 million acquired in the first quarter of 2005. Over the past year, we have continued to increase our ability to analyze, source, and manage commercial real estate loan CES. No commercial loan CES were sold during the first quarters of 2006 or 2005. In the first quarter of 2006, our residential real estate loan acquisitions totaled $53 million. During the first quarter of 2006, we did not sell any of these loans to Sequoia entities, leaving us with an inventory of residential loans of $87 million at March 31, 2006. Sequoia entities did not issue asset-backed securities (ABS) during the first quarter of 2006. This level of residential loan securitization activity was a significant decrease from the first quarter of 2005 when Sequoia entities acquired loans of $0.8 billion and issued a like amount of ABS. Historically, we typically acquired LIBOR ARMs residential loans for the Sequoia securitization program we sponsor. The flatter yield curve reduced the amount of LIBOR ARM residential loans originated in late 2005 and early 2006. However, we have been increasing our ability to acquire other types of loans, and most of the loans currently in inventory are hybrid loans. We acquired $104 million of other residential and commercial real estate securities during the first quarter of 2006 as inventory for sale to our Acacia CDO securitization program. This was a decrease from the $168 million of these acquisitions we made for Acacia during the first quarter of 2005. We sold securities to Acacia entities totaling $212 million during both the first quarter of 2006 and 2005. At March 31, 2006, we had securities of $88 million in inventory for sale to future Acacia entities. In the first quarters of both 2006 and 2005, Acacia entities issued $300 million CDO ABS.Net Income Our reported GAAP net income was $28 million ($1.09 per share) for the first quarter of 2006, a decrease from the $61 million ($2.42 per share) earned in the first quarter of 2005. Our GAAP return on equity was 12% for the first quarter of 2006, compared to 27% for the first quarter of 2005.
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The reduction in our net income of $33 million from the first quarter of 2005 to 2006 resulted from a decrease in net interest income of $17 million, a decrease in net gains on sales and calls net of recognized gains (losses) and valuation adjustments of $17 million, and an increase in operating expenses of $1 million, and a decrease in provisions for income taxes of $2 million.Net Interest Income Net interest income decreased to $45 million in the first quarter of 2006 compared to $61 million in the first quarter of 2005. The reduction in net interest income of $17 million resulted primarily from an increase in the amount of unutilized capital and increased ARM prepayments rates on residential loans consolidated from Sequoia securitization entities. We are constraining our asset acquisitions in order to preserve excess cash balances for attractive investment opportunities in the future. Our current capital utilization plan is to invest our remaining excess capital steadily during 2006 and 2007. The impact of this excess capital balance on our net interest income is likely to dampen our earnings relative to what it might have been if we were more fully invested. We do have attractive opportunities to invest this cash now, and we may decide to accelerate (or slow) our acquisitions (as compared to our current capital utilization plan) depending on market conditions. Prepayment rates (CPR) for residential ARM loans owned by Sequoia entities increased from an average of 25% in the first quarter of 2005 to 45% in the first quarter of 2006. Faster prepayments on ARMs have been caused primarily by the flatter yield curve and the increase in popularity of negative amortization loans. Borrowers are more inclined to refinance out of ARMs and into hybrid or fixed rate loans when the effective interest rates on ARMs are not significantly lower than the fixed rate alternatives. Additionally, new forms of adjustable-rate mortgages (negative amortization, “option ARMs”, and Moving Treasury Average ARMs) represent an increased share of the ARM market and have increased short reset ARMs to offer types of ARMs refinancing. These faster prepayment rates for consolidated ARM loans had a negative impact on our net interest income in the first quarter of 2006. However, in the long term we believe we will likely benefit from faster residential loan prepayments due to our significant investment in discount-priced residential loan CES that have ARM loans in their underlying pools.
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Interest Income Total interest income consists of interest earned on consolidated earning assets, plus income from amortization of discount for assets acquired at prices below principal value, less expenses for amortization of premium for assets acquired at prices above principal value, less credit provision expenses on loans.Table 2 Interest Income and Yield
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Table 3 Interest Income and Yield by Portfolio
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A discussion of the changes in total income, average balances, and yields for each of our portfolios is provided below.Table 5 Consolidated Residential Real Estate Loans — Interest Income and Yield
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assets in early periods of ownership that are lower than what we might realize over the life of the assets if future performance turns out to be better than the low range of our expectations. Specifically, the initial yield we book on newly acquired residential loan CES may be lower than the market mid-range expectation of performance (and below our hurdle rate of 14% pre-tax and pre-overhead internal rate of return). We review the actual performance of each residential loan CES and the market’s and our renewed range of expectations every quarter. We adjust the yields of assets as a result of supportable changes in market conditions and anticipated performance. In addition, to the extent we credit-enhance loans with special credit risks (e.g., negative amortization loans), we may not recognize interest income that is not paid currently. We make ongoing determinations of the likelihood that any deferred interest payments will be collectible in recognizing current period yields. Table 7 Commercial Real Estate Loans — Interest Income and Yield
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income) based on the anticipated losses in the underlying pool of loans. Since these commercial loan CES are the first loss pieces, anticipated credit losses (the amount of designated credit protection) may exceed the amount of the net discount. In this case we write down our basis in this asset over time. In order to do so, we recognize on-going amortization expenses even though we acquired the asset at a discount to principal value. Over time, if the loans underlying these commercial loan CES perform better than we originally expected, we would re-designate a portion of the credit protection to accretable discount, thereby increasing the yield recognized on these assets by reducing any amortization expenses or increasing discount amortization income. The terms of our commercial CES differ from residential CES in that we generally do not receive principal on our investment until the end of the note term (typically seven to ten years). Our commercial portfolio is performing well; the fundamentals of the commercial business are doing well, and we expect over time that our returns on our commercial CES investments should meet our hurdle rate of 14%. However, for GAAP purposes, our recognized yields may not approach this rate until later in the life of the investment as the accretion of the discount into income is slower in the earlier years, given the uncertainty of future events. Since most of our existing commercial CES are newer investments, the overall yield on this portfolio is currently lower than we might expect if credit performance meets or exceeds our long-term estimates. Table 9 Consolidated Securities Portfolio — Interest Income and Yield
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Table 10 Total Interest Expense
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The decrease in the cost of funds of Redwood debt is the result of lower average balance of debt outstanding, offset by higher short-term interest rates.Table 14 Cost of Funds of Asset-Backed Securities Issued
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information technology staffs, and as we develop an increased capability to pursue new business and corporate transaction opportunities. Our operating efficiency ratio was higher in the first quarter of 2006 than in 2005 due to rising expenses at a time when net interest income has declined from the extraordinary levels achieved in recent years. Total operating expenses in 2006 are likely to be higher than in 2005. We exclude excise tax and variable option expense or income (VSOE/ VSOI) in determining the efficiency ratio. By excluding these items, management believes that we are providing a performance measure comparable to measures commonly used by other companies in our industry because these two types of excluded expenses do not reflect ongoing costs ofday-to-day operations of our company. Stock option grant expenses under FAS 123R, however, are an on-going expense and are included in operating expense before excise tax and VSOE/ VSOI. Excise tax is a function of the timing of dividend distributions. In years when we delay distributing dividends on a portion of our REIT taxable income, under the REIT tax rules, we may pay excise taxes on a portion of this delayed distribution. Excise tax is included in operating expenses on our Consolidated Statements of Income. With the adoption of Financial Accounting Statement No. 123R, Share-Based Payment (FAS 123R), effective January 1, 2006, we will no longer have VSOE/ VSOI in 2006 and beyond. In prior periods, VSOE/ VSOI was a non-cash expense or income item that varied as a function of Redwood’s stock price. If our stock price increased during a quarter and the stock price was above the exercise price of a small number of our options that were deemed “variable” due to their structural features, we recorded a GAAP expense in that period equal to the increase in the stock price times the number ofin-the-money “variable” options that remained outstanding. If our stock price decreased during a quarter, we recorded income in that period equal to the decrease in the stock price times the number of in-the-money “variable” options that remained outstanding. Fixed compensation expenses include employee salaries and related employee benefits. Other operating expenses include office costs, systems, legal and accounting fees, and other business expenses. We expect to continue to make significant investments in expanding our product lines and business units and developing our business processes and information technologies. As a result, we expect these fixed and other operating expenses will continue to increase over time. Equity compensation expense includes the amortized cost of equity awards. This amount increased beginning January 1, 2006, as a result of the adoption of FAS 123R and due to the fact that substantially all of our equity awards recently granted are restricted shares or DSUs. The value at grant of all these awards is expensed over the vesting period, which is typically four years or less. Variable compensation includes employee bonuses (which are based on the adjusted return on equity earned by Redwood and, to a lesser degree, on individual performance) and, in periods prior to 2006, DER expenses on options then outstanding and granted prior to December 31, 2002. The primary drivers of this expense are the profitability (return on equity) of Redwood, taxable income at the REIT (which determines total dividend distribution requirements), the number of employees, and the number of stock awards outstanding that receive DER payments that were expensed (options granted prior to January 1, 2003). Net Recognized Gains (Losses) and Valuation Adjustments For the first quarter of 2006, our net recognized losses and valuation adjustments totaled $1.9 million as compared to net recognized gains of $15.0 million for the first quarter of 2005. There were no realized gains due to calls during the first quarter of 2006, compared to $7.5 million call gains in the first quarter of 2005, as we had fewer securities that had reached their call factor. Gains on sales we initiated as part of our portfolio restructuring were lower in the first quarter of 2006 at $1.0 million, compared to $8.3 million in the first quarter of 2005.
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Accounting rules (FAS 115, EITF 99-20, and SAB 5(m)) require us to review the projected discounted cash flows on certain of our assets (based on credit, prepayment, and other assumptions), and tomark-to-market through our income statement those assets that have experienced any deterioration in discounted projected cash flows (as compared to the previous projection) that could indicate other-than-temporary impairment as defined by GAAP. Generally, assets with reduced projected cash flows are written down in value (through a non-cash income statement charge) if the current market value for that asset is below our current basis. If the market value is above our basis, our basis remains unchanged and there is no gain recognized in income. It is difficult to predict the timing or magnitude of these adjustments; the quarterly adjustment could be substantial. Under the accounting rules (FAS 115, EITF 99-20, and SAB 5(m)), we recognized other-than-temporary impairments of $3.2 million for the first quarter of 2006 and $0.4 million for the first quarter of 2005. In the first quarter of 2006, a portion of the other-than-temporary impairments were realized due in part to our decision to call Acacia CDO 2. We will likely complete this call in the second quarter of 2006 and we plan on selling many of the underlying assets and interest rate agreements at that time. For GAAP, we recorded a $2 million negative market valuation adjustment at this time for the assets that had market values less than our book values. Upon the call in the second quarter, we will likely realize net gains from the sale of assets with market values in excess of our book values. Some of our interest rate agreements are accounted for as trading instruments. As a result, we recognized gains of $0.3 million in 2006 and losses of $0.5 million in the first quarter of 2005 on these interest rate agreements. Provisions for Income Taxes As a REIT, we are required to distribute to our stockholders at least 90% of our REIT taxable income each year. Therefore, we generally pass through substantially all of our earnings to stockholders without paying federal income tax at the corporate level. We pay income tax on the REIT taxable income we retain and the income we earn at our taxable non-REIT subsidiaries. Taxable income calculations differ from GAAP income calculations. We provide for income taxes for GAAP purposes based on our estimates of our taxable income, the amount of taxable income we permanently retain, and the taxable income we estimate was earned at our taxable subsidiaries. Our income tax provision in the first quarter of 2006 was $2.8 million, a decrease from the $4.7 million income tax provision taken in the first quarter of 2005. In previous years, we generated taxablegains-on-sales from our securitization activities at the taxable subsidiaries. Since these securitizations were treated as financings under GAAP, deferred tax assets were created. The deferred tax assets are amortized through the deferred tax provision as the related GAAP income is recognized. In the first quarter of 2005, substantially more of the income was generated than at the first quarter of 2006, and, accordingly, more of the deferred tax asset was amortized during the earlier period.
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Taxable Income and Dividends Total taxable income is not a measure calculated in accordance with GAAP. It is the pre-tax income calculated for tax purposes. Estimated total taxable income is an important measure as it is the basis of our dividend distributions to shareholders. Taxable income calculations differ significantly from GAAP income calculations. REIT taxable income is that portion of our taxable income that we earn in our parent (REIT) company and its REIT subsidiaries. It does not include taxable income earned in taxable non-REIT subsidiaries. We must distribute at least 90% of our REIT taxable income as dividends to shareholders each year. As a REIT we are not subject to corporate income taxes on the REIT taxable income we distribute. We pay income tax on the REIT taxable income we retain (we can retain up to 10% of the total). The remainder of our taxable income is income we earn in taxable subsidiaries. We pay income tax on this income and retain the after-tax income at the subsidiary level. The table below reconciles GAAP net income to total taxable income and REIT taxable income for the first quarters of 2006 and 2005.Table 16 Differences Between GAAP Net Income and Total Taxable and REIT Taxable Income
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income recognition is faster for our CES, especially in the early years. At March 31, 2006, the cumulative difference in GAAP and tax bases on our CES was $57 million. Based on our estimates of 2005 and first quarter of 2006 REIT taxable income, at March 31, 2006 we had $65 million of undistributed REIT taxable income which we will pay as regular dividends to our stockholders during 2006 and through September 2007. Our quarterly estimates of taxable income and REIT taxable income are subject to change over the year as we refine our annual income calculations and due to changes in applicable income tax laws and regulations. As of March 31, 2006, we had met all of the dividend distribution requirements of a REIT. We generally attempt to avoid acquiring assets or structuring financings or sales at the REIT level that would be likely to generate distributions of Unrelated Business Taxable Income (UBTI) or excess inclusion income to our stockholders, or that would cause prohibited transaction taxes on us; however, there can be no assurance that we will be successful in doing so.FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCESImpact of Hurricanes in 2005 During the third quarter of 2005, hurricanes Katrina and Rita hit the Gulf Coast States, including parts of Louisiana, Mississippi, and Texas. We own both residential and commercial securities that have first loss risk on loans in the affected areas. Based on available information and our analysis, we believe our hurricane-related losses (as measured for tax) will be up to $6 million on the residential and commercial loans we credit-enhance. This is lower than our initial estimates that ranged between $6 million and $18 million. We update our estimates as we obtain additional information and adjust our credit reserves accordingly. There can be no assurance that actual losses will fall within this range as there are many factors yet to be determined including insurance claims, the ongoing state of the local economies, and the general strength or weakness of the real estate markets in the affected areas.Assets Each of our product lines and portfolios is a component of our single business of investing in, credit-enhancing, and securitizing residential and commercial real estate loans and securities. Our consolidated earning assets, as presented for GAAP purposes, consist of five portfolios: residential real estate loans, residential loan CES, commercial real estate loans, commercial loan CES, and securities portfolio. A discussion of the activities in each of these portfolios appears below.Residential Real Estate Loans Residential loans shown on our Consolidated Balance Sheets include loans owned by securitization entities we have sponsored plus loans we own (typically on a temporary basis prior to sale to a securitization entity). Loans underlying residential CES we have acquired from securitizations that were not sponsored by us do not appear on our Consolidated Balance Sheets. The consolidated balance of residential real estate loans at March 31, 2006 of $12.0 billion was lower than the $13.9 billion we reported at December 31, 2005. Prepayments on loans consolidated for GAAP purposes were greater than acquisitions of new loans. This was the result of both an increase in prepayment speeds and a decrease in the volume of acquisitions and sponsored securitizations. Prepayment speeds increased in ARMs as a result of a flattening of the yield curve (an increase in short-term interest rates relative to long-term interest rates). This change in the yield curve also served to reduce the new production of adjustable-rate loans indexed to LIBOR in the marketplace, reducing our acquisition opportunities. In addition, we face increased competition to purchase these loans.
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At March 31, 2006, Redwood owned $87 million residential real estate loans accumulated for future securitizations or whole loan sale. None of these loans were pledged to support Redwood debt. ABS securitization entities consolidated on Redwood’s balance sheet owned $11.9 billion of residential real estate loans on March 31, 2006. Charge-offs (credit losses) recorded in this portfolio totaled $0.4 million during the first quarter of 2006 and $0.2 million in the first quarter of 2005. Credit losses remained at an annualized rate of less than 1 basis point (0.01%) during these periods. Serious delinquencies increased from $37 million at December 31, 2005 to $50 million at March 31, 2006. Serious delinquencies include loans delinquent more than 90 days, in bankruptcy, in foreclosure, and real estate owned. As a percentage of this loan portfolio, serious delinquencies remained at low levels relative to the U.S. residential real estate loans as a whole, and were 0.42% of our current loan balances at March 31, 2006, an increase from 0.27% at December 31, 2005. The reserve for credit losses on residential real estate loans is included as a component of residential real estate loans on our Consolidated Balance Sheets. The residential real estate loan credit reserve balance of $22 million was 0.19% of the current balance of this portfolio at March 31, 2006, compared to $23 million, or 0.16% of the current balance, at December 31, 2005. The total amount of credit reserves did not decrease over the quarter even though the balance of loans decreased; the decline in loan balance was offset by increased delinquencies and a worsening credit outlook.Residential Loan Credit-Enhancement Securities For GAAP purposes, this portfolio includes residential real estate loan CES acquired from securitizations sponsored by others. It does not include CES we acquired from our Sequoia entities. We mark residential loan CES to their current estimated market value on our Consolidated Balance Sheets (but not generally through our consolidated statements of income unless we determine there is other-than-temporary impairment). At March 31, 2006, our reported ownership of these residential loan CES totaled $644 million. This was an increase from the $613 million market value we reported on December 31, 2005. Our acquisitions plus net positive market value adjustments exceeded calls, sales, and principal pay downs for the first quarter of 2006.
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As a result of the concentrated credit risk associated with residential loan CES, we are generally able to acquire these securities at a discount to their face (principal) value. The difference between the principal value ($1.09 billion) and adjusted cost basis ($594 million) of these residential loan CES at March 31, 2006 was $493 million. Of this difference, $374 million was designated as internal credit protection (reflecting our estimate of likely credit losses on the underlying loans over the life of these securities), while the remaining $119 million represented a purchase discount we are accruing into income over time. The table below presents the principal value, amortized cost, and carrying values of our consolidated residential loan CES by first-, second-, or third loss position. The first- and second-loss position residential loan CES are generally funded with equity. The third-loss position residential loan CES are generally owned by the Acacia entities and consolidated on our balance sheets.Table 17 Residential Loan Credit-Enhancement Securities
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In the first quarter of 2006, we did not recognize losses due to other-than-temporary impairment on our residential loan CES. We recognized under $0.1 million of other-than-temporary impairments on our residential loan CES for the first quarter of 2005. These losses are included in net recognized gains (losses) and valuation adjustments in our Consolidated Statements of Income.Commercial Real Estate Loans We have been investing in commercial real estate loans since 1998. Our commercial real estate loan portfolio decreased to $55 million at March 31, 2006 from $60 million at December 31, 2005 due to principal pay-downs of $5 million, resulting from the pay-off of one loan. We plan to continue to make additional investments in commercial real estate loans, including mezzanine loans, subordinated (junior or second lien) loans, andB-Notes(B-Notes represent a structured commercial real estate loan that retains a higher portion of the credit risk and generates a higher yield than the initial loan). Factors particular to each commercial loan (e.g., lease activity, market rents, and local economic conditions) could cause credit concerns, and may require us to provide for future losses by establishing a credit reserve. We continually monitor and determine the level of appropriate reserves for our commercial loans. At March 31, 2006, we had an $8.1 million reserve on a loan, which is the same reserve we had established at acquisition of this loan. We acquired this loan at a discount to par and designated a credit reserve based on our expected cash flows at that time. We have no credit reserves for other commercial real estate loans.Commercial Loan Credit-Enhancement Securities We acquire unrated first-loss interests in commercial mortgage-based securities (CMBS) and fund them with equity. We define these non-rated CMBS as commercial loan CES. At March 31, 2006, we owned $199 million of principal value of these securities with a market value of $67 million. As a result of acquisitions, this was an increase from the $175 million principal value and $58 million market value we owned at December 31, 2005. Some of the commercial loan CES we own represent interests in a commercial CMBS re-REMIC consisting primarily of first-and-second-loss interests in several other CMBS. At March 31, 2006, we credit-enhanced $28 billion commercial real estate loans through ownership of first-loss CMBS (excluding the re-REMIC interests), an increase from the $26 billion commercial real estate loans we credit-enhanced at December 31, 2005. Serious delinquencies (i.e., 90 plus days, in bankruptcy, in foreclosure, or REO) were $23 million, or 0.08%, of the loan balances, at March 31, 2006. This was an increase from the $17 million, or 0.07%, at December 31, 2005. We incurred no credit losses on these underlying loans in the first quarter of 2006 or 2005. At both March 31, 2006 and December 31, 2005, we credit-enhanced $17 billion commercial real estate loans through our interests in a CMBS re-REMIC. Delinquencies on these loans were $220 million, or 1.33% of the loan balances at March 31, 2006. Delinquencies on these loans were $228 million, or 1.34% of the loan balances at December 31, 2005. External credit protection on these loans was $1.6 billion at both March 31, 2006 and December 31, 2005. Our internally designated credit reserves were $14 million at both March 31, 2006 and December 31, 2005. For the first quarter of 2006, total credit losses on these underlying loans were $5 million, all of which were borne by CES not owned by us. Credit losses realized during the first quarter of 2005 were $45 million and were all borne against CES not owned by us.Securities Portfolio We continue to acquire diverse residential real estate loan securities, commercial real estate loan securities, debt interests in real estate-oriented CDOs, in each case primarily rated AA, A, and BBB. Also included in this portfolio are non-investment grade interests in commercial real estate securities (excluding commercial loan CES), corporate bonds issued by REITs, and equity in CDOs sponsored by others. We have sold most of our securities in this consolidated
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portfolio (as it is reported for GAAP purposes) to Acacia bankruptcy-remote securitization entities. Acacia issues CDO ABS to fund its acquisition of these assets. We consolidate Acacia’s asset’s within our securities portfolio or residential loan CES. We reflect Acacia’s issuance of CDO ABS as ABS issued obligations on our Consolidated Balance Sheets. The increase in the securities portfolio during the first quarter of 2006 was the result of additional acquisitions of securities for sale to Acacia. Our consolidated securities portfolio totaled $1.8 billion carrying value on March 31, 2006, of which $1.8 billion had been sold to Acacia ABS securitization entities as of that date. At December 31, 2005, we had $1.7 billion carrying value of these securities, of which $1.6 billion had been sold to Acacia entities as of that date. We are continuing to acquire non-investment grade CMBS that are rated BB and B. We generally sell these assets to Acacia entities. The balance of these CMBS assets was $160 million at both March 31, 2006 and December 31, 2005. The table below presents the types of securities we own as reported in this securities portfolio by their credit ratings as of March 31, 2006 and December 31, 2005.Table 18 Consolidated Securities Portfolio — Underlying Collateral Characteristics
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to secure the associated debt. Additional collateral or cash may be required to meet changes in market values from time to time under these agreements. These borrowings have maturities of less than one year and interest rates that generally change monthly based upon a margin over the one-month LIBOR interest rate. Our debt levels vary based on the timing of our asset accumulation and securitization activities and on our levels of investment capital. During the first quarter of 2006, as measured daily, our maximum debt level was $229 million, our minimum debt level was zero, and our average debt level was $137 million. Redwood’s debt is typically secured debt, secured by a pledge of securities accumulated as inventory for sale to Acacia securitization entities or by residential real estate loans accumulated for sale to Sequoia. We also have an unsecured line of credit available that was not drawn upon as of March 31, 2006. Covenants associated with a portion of our short-term debt generally relate to our tangible net worth, liquidity reserves, and leverage requirements. We have not had, nor do we currently anticipate having, any problems in meeting these covenants. However, many factors, including ones external to us, may affect our ability to meet these covenants and may affect our liquidity in the future. In 2005, we formed Madrona Residential Funding, LLC (“Madrona”), a special purpose entity and wholly owned subsidiary of RWT Holdings. Madrona gives us the flexibility to access the capital markets and issue short-term debt instruments to finance the accumulation of loans prior to sale to sponsored securitization entities. Madrona is designed to fund residential loans accumulated for eventual sale to our Sequoia securitization program by issuing A1+/P1 rated commercial paper. Madrona was established to accumulate up to $1.5 billion of loans (with a current authorization for $300 million) and can warehouse each loan up to 270 days. There are specific eligibility requirements for financing loans in this facility that are similar to our existing financing facilities with several banks and large investment banking firms. There is a credit reserve account for approximately 70 basis points that will serve as credit-enhancement to the commercial paper investors. In addition, we issued $5.4 million of a BBB-rated Madrona ABS to provide further credit support to the holders of commercial paper. This facility has a three-year term. As of March 31, 2006, there was no commercial paper issuance outstanding.Asset-Backed Securities Issued Redwood consolidates on its balance sheets the ABS that are obligations of those securitization entities that are sponsored by Redwood. These ABS issued are not obligations of Redwood. Sequoia had $11.5 billion ABS outstanding on March 31, 2006 compared to $13.4 billion on December 31, 2005. Pay downs of existing ABS issued by Sequoia exceeded new issuance. Acacia entities issued ABS of a type known as CDOs to fund their acquisitions of real estate securities from Redwood. Acacia CDO issuance outstanding was $2.4 billion on March 31, 2006 and $2.2 billion on December 31, 2005. We issued $0.3 billion of Acacia ABS in both the first quarter of 2006 and 2005. For the first quarter of 2006, there were $26 million of Acacia ABS pay downs.Stockholders’ Equity Our reported stockholders’ equity increased by 3% during the first quarter of 2006, from $935 million at December 31, 2005 to $967 million at March 31, 2006 as a result of $28 million earnings, $18 million dividends declared, $8 million stock issuance, $1 million proceeds from stock option exercises, $5 million non-cash equity adjustments related to grant and amortization of equity awards, and a $8 million net increase in unrealized gains of assets and interest rate agreements that aremarked-to-market through our Consolidated Balance Sheets. We may seek to issue additional shares even during a period when we are maintaining uninvested cash balances. This would allow us to accommodate additional portfolio growth while also using cash balances to reduce overall risk (and insure funding for future opportunities). We issue equity only when we believe such issuance would enhance long-term earnings and dividends per share, compared to what they would have been otherwise.
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Certain assets aremarked-to-market through accumulated other comprehensive income; these adjustments affect our book value but not our net income. As of March 31, 2006, we reported a net accumulated other comprehensive income of $82 million and at December 31, 2005 we reported net accumulated other comprehensive income of $74 million. Changes in this account reflect changes in the fair value of our earning assets (a decrease of $8 million) and interest rate agreements (an increase of $14 million), and also reflect changes due to calls, sales, and other-than-temporary impairments of a portion of our securities (an increase of $2 million). Our reported book value at March 31, 2006 was approximately $38 per share.Cash Requirements, Sources of Cash, and Liquidity We use cash to fund our operating and securitization activities, invest in earning assets, service and repay Redwood debt, fund working capital, and fund our dividend distributions. One primary source of cash is principal and interest payments received on a monthly basis from real estate loans and securities. This includes payments received from ABS that we acquired as investment assets from ABS securitizations we sponsor. Other sources of cash include proceeds from sales of assets to securitizations entities, proceeds from sales of other assets, borrowings, and issuance of common stock. We currently use borrowings solely to finance the accumulation of assets for future sale to securitization entities. Sources of borrowings include repurchase agreements, bank borrowings, collateralized short-term borrowings, and non-secured lines of credit. We may also issue commercial paper. Our borrowings are typically repaid using proceeds received from the sale of assets to securitization entities. For residential loans, our typical inventory holding period is one to twelve weeks. For securities held for sale to Acacia CDO securitization entities, our typical holding period is one to six months. Our Consolidated Statement of Cash Flows include cash flows generated and used by the ABS securitization entities that are consolidated on our Consolidated Balance Sheets. Cash flows generated within these entities are not available to Redwood, except to the degree that a portion of these cash flows may be due to Redwood as an owner of one or more of the ABS issued by the entity. Cash flow obligations of and uses of cash by these ABS entities are not part of Redwood’s operations and are not obligations of Redwood, although a decrease in net cash flow (or an increase in credit losses) generated by an ABS entity could defer or reduce (or potentially eliminate) interest and/or principal payments otherwise due to Redwood as an owner of certain more risky ABS issued by the entities. At March 31, 2006, we had $1.0 billion of capital and no Redwood debt. This capital is available to invest in assets and to support our business. At March 31, 2006, $163 million of this capital was cash and working capital necessary to support our residential conduit and credit-enhancement operations, $47 million was invested in interest rate agreements, $174 million was cash available to acquire new assets (excess capital) and $583 million was invested in assets we believe will generate long-term cash flows at attractive rates of return. We believe that a weakening of the housing market, if it continues, will likely bring excellent asset acquisition opportunities over the next few years. In order to take advantage of future opportunities, our goal is to maintain cash balances that are available to make new investments. Our current plan, which is subject to change, is to invest our excess cash steadily during 2006 and 2007.Off-Balance Sheet Commitments At March 31, 2006, in the ordinary course of business, we had commitments to purchase $6 million of real estate loans that settled in the second quarter of 2006. These purchase commitments represent derivative instruments under FAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. The value of these
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commitments was negligible as of March 31, 2006. We also had commitments to purchase $5 million of securities as of March 31, 2006.Contractual Obligations and Commitments The table below presents our contractual obligations and commitments as of March 31, 2006, as well as the consolidated obligations of the securitization entities that we sponsored and are consolidated on our balance sheets. The operating leases are commitments that are expensed based on the terms of the related contracts.Table 19 Contractual Obligations and Commitments as of March 31, 2006
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take “first-loss” risk is high relative to our equity capital base. However, we do not use debt to fund these assets and our maximum credit loss from these assets (excluding loans and securities held temporarily as inventory for securitization) is limited and is less than our equity capital base. The majority of our credit risk comes from high-quality residential real estate loans. This includes residential real estate loans consolidated from ABS securitizations from which we have acquired a credit-sensitive ABS security, and loans we effectively “guarantee” or “insure” through the acquisitions of residential loan CES from securitizations sponsored by others. We are also exposed to credit risks in our commercial real estate loan portfolio, the “first-loss” commercial real estate securities we own, and in our other residential and commercial real estate securities, and in counter-parties with whom we do business. Credit losses on residential real estate loans can occur for many reasons, including: poor origination practices; fraud; faulty appraisals; documentation errors; poor underwriting; legal errors; poor servicing practices; weak economic conditions; decline in the value of homes; special hazards; earthquakes and other natural events; over-leveraging of the borrower; changes in legal protections for lenders; reduction in personal incomes; job loss; and personal events such as divorce or health problems. In addition, if the U.S. economy or the housing market weakens, our credit losses could be increased beyond levels that we have anticipated. The interest rate is adjustable for most of the loans securitized by securitization trusts sponsored by us and for a portion of the loans underlying residential loan CES we have acquired from securitizations sponsored by others. Accordingly, when short-term interest rates rise, required monthly payments from homeowners will rise under the terms of these ARMs, and this may increase borrowers’ delinquencies and defaults. In addition, a portion of the loans we credit-enhance are IO and negative amortization loans, which may have special credit risks. We occasionally acquire residential loan CES backed by negative amortization adjustable-rate loans made to high-quality residential borrowers. Even though most of these loans are made to high-quality borrowers who make substantial down payments and do not need a negative amortization feature in order to afford their home, we still expect significantly higher delinquencies and losses from these loans compared to regular amortization loans. We believe we have a good chance of generating attractive risk-adjusted returns on these investments as a result of the way the securitizations of these riskier loan types are structured and because of attractive acquisition pricing of these residential loan CES. Although seemingly attractive, there is substantial uncertainty about the future performance of these assets. Nonetheless, we will limit our overall investment in residential loan CES with these underlying loans. Credit losses on commercial real estate loans can occur for many reasons, including: poor origination practices; fraud; faulty appraisals; documentation errors; poor underwriting; legal errors; poor servicing practices; weak economic conditions; decline in the value of the property; special hazards; earthquakes and other natural events; over-leveraging of the property; changes in legal protections for lenders; reduction in market rents and occupancies and poor property management practices. In addition, if the U.S. economy weakens, our credit losses could be increased beyond levels that we have anticipated. The large majority of the commercial loans we credit-enhance are fixed-rate loans with required amortization. A small number of loans are IO loans for the entire term or a portion thereof, which may have special credit risks. In addition to residential and commercial loan CES, the Acacia entities we sponsor own investment-grade and other securities (typically rated AAA through B, and in a second-loss position or better, or otherwise effectively more senior in the credit structure as compared to a residential loan CES or commercial loan CES or equivalent held by us) issued by residential securitization entities that are sponsored by others. Generally, we do not control or influence the underwriting, servicing, management, or loss mitigation efforts with respect to these assets. Some of the securities Acacia owns are backed by sub-prime residential loans that have substantially higher risk characteristics than prime-quality loans. These lower-quality residential loans can be expected to have higher rates of delinquency and loss, and losses to Acacia (and thus to Redwood’s interest in these loans) could occur. Most of Acacia’s securities are reported as part of our consolidated securities portfolio on our Consolidated Balance Sheets. Acacia has also acquired investment-grade BB-rated, and B-rated residential loan securities from the Sequoia securitization entities we have sponsored. The probability of incurring a credit loss on
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these securities is less than the probability of loss from first-loss residential loan CES and commercial loan CES, as cumulative credit losses within a pool of securitized loans would have to exceed the principal value of the subordinated CES (and exhaust any other credit protections) before losses would be allocated to the Acacia securities. If the pools of residential and commercial loans underlying these securities were to experience poor credit results, however, these Acacia securities could have their credit ratings down-graded, could suffer losses in market value, or could experience principal losses. If any of these events occur, it would likely reduce our returns from the Acacia CDO equity securities we have acquired and may reduce our ability to sponsor Acacia transactions in the future. Interest Rate Risk Our strategy is to maintain an asset/liability posture on a consolidated basis that is effectively match-funded so that the achievement of our long-term goals is unlikely to be affected by changes in interest rates. This includes assets owned and the ABS issued by consolidated securitization entities, to the extent that any mismatches within the entities could affect our cash flows. We use interest rate agreements so that the interest rate characteristics of the ABS issued by consolidated securitization entities, as adjusted for outstanding interest rate agreements, closely matches the interest rate characteristics of the assets owned by those entities. Overall, we believe we maintain a close match between the interest rate characteristics of Redwood debt and the pledged assets. For most of our debt-funded assets (assets acquired for future sale to sponsored securitization entities or to other financial institutions as whole loans), the floating rate nature of our debt closely matches the adjustable-rate interest income earning characteristics of the accumulated assets. Not all of the accumulated assets we acquire are adjustable-rate. We also acquire fixed rate and hybrid rate securities for re-securitization through our Acacia CDO program, and we may acquire hybrid rate residential real estate loans in the future for our Sequoia securitization program. We typically use interest rate agreements to hedge associated interest rate mismatches when the assets we accumulate for future securitizations do not match the interest rate characteristics of our debt. At March 31, 2006, we consolidated $13.1 billion adjustable-rate ABS collateralized by adjustable-rate assets and $0.8 billion fixed/hybrid rate ABS collateralized by consolidated fixed/hybrid rate assets. We own the IO security, CDO equity, or similar security that economically benefits from the spread between the assets and the liabilities of the issuing securitization entity on a portion ($10.5 billion) of these consolidated entities. These assets and liabilities are closely matched economically and to the degree there is a mismatch we attempt to reduce this mismatch through the use of interest rate agreements. For the remainder of the consolidated ABS entities ($3.4 billion), we do not own the security that benefits from the asset/liability spread. Thus, spread changes between the yield of these assets and the cost of these liabilities do not affect our economic profits or cash flow. We do not utilize interest rate agreements with respect to interest rate mismatches that may exist between these assets and liabilities on these other consolidated ABS entities. The remainder of our consolidated assets at March 31, 2006 ($290 million six-month adjustable-rate assets, $5 million short-term fixed rate assets, $434 million hybrid and fixed-rate assets, and $237 million non-earning assets) were funded, for interest rate matching purposes, effectively with equity. Prepayment Risk We seek to maintain an asset/liability posture that benefits from investments in prepayment-sensitive assets while limiting the risk of adverse prepayment fluctuations to an amount that, in most circumstances, can be absorbed by our capital base while still allowing us to make regular dividend payments. Prepayments affect GAAP earnings in the near term primarily through the timing of the amortization of purchase premium and discount. Amortization income from discount assets may not necessarily offset amortization expense from premium assets, and vice-versa. Variations in
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current and projected prepayment rates for individual assets and changes in short-term interest rates (as they affect projected coupons on ARMs and thus change effective yield calculations on certain loans) may cause net premium amortization expense or net discount amortization income to vary substantially from quarter to quarter. In addition, the timing of premium amortization on assets may not always match the timing of the premium amortization taken to income on liabilities even when the underlying assets are the same (i.e., the prepayments are identical). We believe there is a relatively low likelihood of prepayment risk events occurring within our securitization inventory assets, as we typically sell these loans within a few months of acquiring them. However, changes in prepayment forecasts by market participants could affect the market prices for ABS (especially IO securities) sold by these securitization entities, and thus could affect the gain on sale for economic and tax purposes (not for GAAP purposes since these are accounted for as financings) that we seek to earn from sponsoring these securitizations. There are prepayment risks in the assets and associated liabilities consolidated on our balance sheets. In general, discount securities (such as CES) benefit from faster prepayment rates on the underlying real estate loans and premium securities (such as IO securities) benefit from slower prepayments on the underlying loans. Our largest current potential exposure to increases in prepayment rates is from short-term residential ARM loans. However, our premium balances on IO securities backed by ARM loans are currently significantly less than our discount balances on residential loan CES backed by ARM loans. As a result, we believe that we are currently biased in favor of faster prepayment speeds with respect to the long term economic effect of ARM prepayments. However, in the short term, changes in ARM prepayment rates could cause GAAP earnings volatility. ARM prepayment rates are driven by many factors, one of which is the steepness of the yield curve. As the yield curve flattens (short-term interest rates rise relative to longer-term interest rates), ARM prepayments typically increase. Prepayment rates on the ARMs underlying the Redwood-sponsored Sequoia securitizations increased from near 25% to nearly 50% over the last year as the yield curve flattened. Through our ownership of discount residential loan CES backed by fixed rate and hybrid residential loans, we generally benefit from faster prepayments on fixed and hybrid loans. Prepayment rates for these loans typically accelerate as medium-and long-term interest rates decline. Prepayments can also affect our credit results and risks. Credit risks for the CES we own are reduced each time a loan prepays. All other factors being equal, faster prepayment rates should reduce our credit risks on our existing portfolio. Market Value Risk At March 31, 2006, we reported on a consolidated basis $2.5 billion of assets that weremarked-to-market through our balance sheet (i.e., available for sale securities) but not through our income statement. Of these assets, 58% have adjustable-rate coupons, 19% have hybrid coupon rates, and the remaining 23% have fixed coupon rates. Many of these assets are credit-sensitive. Market value fluctuations of these assets can affect the balance of our stockholders’ equity base. Market value fluctuations for our securities can affect not only our earnings and book value, but also our liquidity, especially to the extent these assets may be funded with short-term debt prior to securitization. Most of our consolidated real estate assets are loans accounted for as held-for-investment and reported at cost. Although these loans have generally been sold to Sequoia entities at securitization and, thus, changes in the market value of the loans do not have an impact on our liquidity in the long term and changes in market value during the accumulation period (while these loans are funded with debt) may have a short-term effect on our liquidity.
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We use interest rate agreements to manage certain interest rate risks. Our interest rate agreements are reported at market value, with any periodic changes reported through either our income statement or in our balance sheet. Adverse changes in the market values of our interest rate agreements (which would generally be caused by falling interest rates) may require us to devote additional amounts of cash to margin calls. Inflation Risk Virtually all of our consolidated assets and liabilities are financial in nature. As a result, changes in interest rates and other factors drive our performance far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with GAAP and, as a REIT, our dividends must equal at least 90% of our REIT taxable 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. CRITICAL ACCOUNTING POLICIES The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of certain assets and liabilities at the date of the consolidated financial statements and the reported amounts of certain revenues and expenses during the reported period. Actual results could differ from those estimates. The critical accounting policies and the possible effect of changes in estimates on our financial results and statements are discussed below. Management discusses the ongoing development and selection of these critical accounting policies with the Audit Committee of the Board of Directors. We have recently become aware of a potential technical interpretation of GAAP that differs from our current accounting presentations. We have not changed our accounting treatment for this potential issue. However, if we were to change our current accounting presentations based on this interpretation, we do not believe there would be a material impact on our net income or balance sheets. This issue relates to the accounting for transactions where assets are purchased from a counterparty and simultaneously financed through a repurchase agreement with that same counterparty and whether these transactions create derivatives instead of the acquisition of assets with related financing (which is how we currently present these transactions). This potential technical interpretation of GAAP does not affect the economics of the transactions but may affect how the transactions would be reported in our financial statements. Our cash flows, our liquidity, and our ability to pay a dividend would be unchanged, and we do not believe our taxable income would be affected. Revenue Recognition When recognizing revenue on consolidated earning assets, we employ the interest method and determine an effective yield to account for purchase premiums, discounts, and other net capitalized fees or costs associated with purchasing and financing real estate loans and securities. For consolidated real estate loans, the interest method is applied as prescribed under FAS 91. For loans acquired prior to July 1, 2004, the interest method or effective yield is determined using interest rates as they change over time and future anticipated principal prepayments. For loans acquired subsequent to that date, the initial interest rate of the loans and future anticipated principal prepayments are used in determining the effective yield. For our consolidated securities, the interest method to determine an effective yield is applied as prescribed under FAS 91 or EITF 99-20 using anticipated principal prepayments. The use of these methods requires us to project cash flows over the remaining life of each asset. These projections include assumptions about interest rates, prepayment rates, timing and amount of credit losses, when certain tests will be met that may allow for changes in payments made under the structure of securities, estimates regarding the likelihood and timing of calls of securities at par, and other factors. We review our cash flow projections on an ongoing basis and monitor these projections based on input and analyses received from external sources, internal models,
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and our own judgment and experience. We constantly review our assumptions and make adjustments to the cash flows as deemed necessary. There can be no assurance that our assumptions used to generate future cash flows, or the current period’s yield for each asset, will prove to be accurate. Under the interest method, decreases in our credit loss assumptions embedded in our cash flow forecasts could result in increasing yields being recognized from residential loan CES. In addition, faster-than-anticipated prepayment rates would also tend to increase realized yields over the remaining life of an asset. In contrast, increases in our credit loss assumptions and/or slower than anticipated prepayment rates could result in lower yields being recognized under the interest method and may represent an other-than-temporary impairment under GAAP, in which case the asset may be written down to its fair value through our Consolidated Statements of Income. Redwood applies APB 21 and APB 12 in determining its periodic amortization for the premium on its debt, including the issuance of IO securities and deferred bond issuance cost (DBIC). We arrive at a periodic interest cost that represents a level effective rate on the sum of the face amount of the ABS issued and (plus or minus) the unamortized premium or discount at the beginning of each period. The difference between the periodic interest cost so calculated and the nominal interest on the outstanding amount of the ABS issued is the amount of periodic amortization. Prepayment assumptions used in modeling the underlying assets to determine accretion or amortization of discount or premium are used in developing the liability cash flows that are used to determine ABS issued premium amortization and DBIC expenses. Establishing Valuations and Accounting for Changes in Valuations Valuation adjustments to real estate loans held-for-sale are reported as net recognized losses and valuation adjustments on our Consolidated Statements of Income in the applicable period of the adjustment. Adjustments to the fair value of securities available-for-sale are reported through our Consolidated Balance Sheets as a component of accumulated other comprehensive income in stockholders’ equity within the cumulative unrealized gains and losses classified as accumulated other comprehensive income. The exception to this treatment of securities available-for-sale is when a specific impairment is identified or a decrease in fair value results from a decline in estimated cash flows that is considered other-than-temporary. In such cases, the resulting decrease in fair value is recorded in net recognized gains (losses) and valuation adjustments on our Consolidated Statements of Income in the applicable period of the adjustment. We estimate fair value of assets and interest rate agreements using available market information and other appropriate valuation methodologies. We believe estimates we use reflect market values we may be able to receive should we choose to sell assets. Our estimates are inherently subjective in nature and involve matters of uncertainty and judgment in interpreting relevant market and other data. Many factors are necessary to estimate market values, including, but not limited to, interest rates, prepayment rates, amount and timing of credit losses, supply and demand, liquidity, and other market factors. We apply these factors to each of our assets, as appropriate, in order to determine market values. Residential real estate loans held-for-sale are generally valued on a pool basis while commercial real estate loans held-for-sale and securities available-for-sale are valued on an asset-specific basis. We review our fair value calculations on an ongoing basis. We monitor the critical performance factors for each loan and security. Our expectations of future performance are shaped by input and analyses received from external sources, internal models, and our own judgment and experience. We review our existing assumptions relative to our and the market’s expectations of future events and make adjustments to the assumptions that may change our market values. Changes in perceptions regarding future events can have a material impact on the value of our assets. Should such changes or other factors result in significant changes in the market values, our net income and book value could be adversely affected.
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In addition to our valuation processes, we are active acquirers and occasional sellers of assets. Thus, we believe that we have the ability to understand and determine changes in assumptions that are taking place in the marketplace and make appropriate changes in our assumptions for valuing assets. In addition, we use third party sources to validate our valuation estimates. There are certain other valuation estimates we make that have an impact on current period income and expense. One such area is the valuation of certain equity grants. Under FAS 123R, we estimate the value of options, which is based on a number of assumptions. Currently, most of our equity awards are restricted stock and deferred stock units and the fair values at grant equal the market value of Redwood stock so there are no assumptions required to determine fair value. However, FAS 123R does require us to estimate for forfeitures and other factors that may affect the actual expense recognized in any one period. Credit Reserves For consolidated residential and commercial real estate loans held-for-investment, we establish and maintain credit reserves that we believe represent probable credit losses that will result from inherent losses existing in our consolidated residential and commercial real estate loans held-for-investment as of the date of the financial statements. The reserves for credit losses are adjusted by taking provisions for credit losses recorded as a reduction in interest income on residential and commercial real estate loans on our Consolidated Statements of Income. The reserves consist of estimates of specific loan impairment and estimates of collective losses on pools of loans with similar characteristics. To calculate the credit reserve for credit losses for residential real estate loans and home equity lines of credit (HELOCs), we determine inherent losses by applying loss factors (default, the timing of defaults, and the loss severity upon default) that can be specifically applied to each pool of loans. The following factors are considered and applied in such determination: •On-going analysis of the pool of loans, including, but not limited to, the age of the loans, underwriting standards, business climate, economic conditions, geographic considerations, and other observable data; •Historical loss rates and past performance of similar loans; •Relevant environmental factors; •Relevant market research and publicly available third-party reference loss rates; •Trends in delinquencies and charge-offs; •Effects and changes in credit concentrations; and, •Prepayment assumptions. Once we determine the applicable default rate, the timing of defaults, and the severity of loss upon the default, we estimate the expected losses of each pool of loans over their expected lives. We then estimate the timing of these losses and the losses probable to occur over an effective loss confirmation period. This period is defined as the range of time between the probable occurrence of a credit loss (such as the initial deterioration of the borrower’s financial condition) and the confirmation of that loss (the actual charge-off of the loan). The losses expected to occur within the effective loss confirmation period are the basis of our credit reserves because we believe those losses exist as of the reported date of the financial statements. We re-evaluate the level of our credit reserves on at least a quarterly basis and record provision, charge-offs, and recoveries monthly. The credit reserve for credit losses for the commercial real estate loans includes a detailed analysis of each loan and underlying property. The following factors are considered and applied in such determination. •On-going analysis of each individual loan, including, but not limited to, the age of the loans, underwriting standards, business climate, economic conditions, geographic considerations, and other observable data; •On-going evaluation of fair values of collateral using current appraisals and other valuations; •Discounted cash flow analysis; and, •Borrower’s ability to meet obligations.
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If a residential loan becomes REO or a commercial loan becomes impaired, or loans are reclassified as held-for-sale, specific valuations are primarily based on analyses of the underlying collateral. Residential and commercial loan CES are the securities issued by an ABS securitization entity that bear most of the initial credit risk of the underlying pool of loans that was securitized. As a result of the relatively high credit risks of these investments, we are able to purchase residential and commercial loan CES at a discount to principal (par) value. A portion of the purchase discount is subsequently accreted as interest income under the interest method while the remaining portion of the purchase discount is considered as a form of credit protection. The amount of credit protection is based upon our assessment of various factors affecting our assets, including economic conditions, characteristics of the underlying loans, delinquency status, past performance of similar loans, and external credit protection. We use a variety of internal and external credit risk analyses, cash flow modeling, and portfolio analytical tools to assist us in our assessments. If cumulative credit losses in the underlying pool of loans exceed the principal value of the first-loss piece, we may never receive a principal payment from that security. The maximum loss for the owner of these securities, however, is limited to the investment made in purchasing the CES. In addition to the amount of losses, the timing of future credit losses is also important. In general, the longer credit losses are delayed, the better our economic returns, as we continue to earn coupon interest on the face value of our security. Accounting for Derivative Instruments (Interest Rate Agreements) We use derivative instruments to manage certain risks such as market value risk and interest rate risk. Currently, the majority of our interest rate agreements are used to match the duration of liabilities to assets. The derivative instruments we employ include, but are not limited to, interest rate swaps, interest rate options, options on swaps, futures contracts, options on futures contracts, options on forward purchases, and other similar derivatives. We collectively refer to these derivative instruments as “interest rate agreements”. On the date an interest rate agreement is entered into, we designate each interest rate agreement under GAAP 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 instrument). We currently elect to account for most of our interest rate agreements as cash flow hedges; the remainder are accounted for as trading instruments. We record these derivatives at their estimated fair market values, and record changes in their fair values in accumulated other comprehensive income on our Consolidated Balance Sheets. These amounts are reclassified to our Consolidated Statements of Income over the effective hedge period as the hedged item affects earnings. Any ineffective portions of these cash flow hedges are included in our Consolidated Statements of Income, and any changes in the market value on our hedges designated as trading instruments. We may discontinue GAAP hedge accounting prospectively when we determine that (1) the derivative is no longer effective in offsetting changes in the fair value or cash flows of a hedged item; (2) it is no longer probable that the forecasted transaction will occur; (3) a hedged firm commitment no longer meets the definition of a firm commitment; or (4) designating the derivative as a hedging instrument is no longer appropriate. A discontinued hedge may result in recognition of certain gains or losses immediately through our Consolidated Statements of Income, or such gains or losses may be accreted from accumulated other comprehensive income into earnings over the original hedging period.Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Discussions about our quantitative and qualitative disclosures about market risk are included in our Management’s Discussion and Analysis included herein.
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Item 4. CONTROLS AND PROCEDURES We have carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as that term is defined in Rule 13a-15(e)under the Securities Exchange Act of 1934, as amended. Based on that evaluation, our principal executive officer and principal financial officer concluded that as of March 31, 2006, which is the end of the period covered by this10-Q, our disclosure controls and procedures are effective. There has been no change in Redwood’s internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rule 13a-15 that occurred during the quarter ended March 31, 2006 that has materially affected, or is reasonably likely to materially affect, Redwood’s internal control over financial reporting.
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PART II. OTHER INFORMATIONItem 2.UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
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SIGNATURESPursuant 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.
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