(Exact Name of Registrant as Specified in Its Charter)
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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
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Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
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Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
TABLE OF CONTENTS
Item 1.
Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Defaults Upon Senior Securities
Submission of Matters to a Vote of Security Holders
Item 5.
Other Information
Item 6.
Exhibits
i
The accompanying notes are an integral part of these consolidated financial statements.
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Redwood Trust, Inc., together with its subsidiaries (Redwood, we, or us), invests in, finances, and manages real estate assets. We invest in residential and commercial real estate loans and in asset-backed securities backed by real estate loans. We seek to invest in assets that have the potential to generate sufficient long-term cash flow returns to support our goal of distributing an attractive level of dividends per share to shareholders over time. For tax purposes, we are structured as a real estate investment trust (REIT).
Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. Our executive offices are located at One Belvedere Place, Suite 300, Mill Valley, California 94941.
The consolidated financial statements presented herein are at September 30, 2009 and December 31, 2008, and for the three and nine months ended September 30, 2009 and 2008. These consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) in the United States for interim financial information and with the Securities and Exchange Commission’s (SEC) instructions to Form 10-Q and Article 10 of Regulation S-X. Results for the three and nine months ended September 30, 2009, may not necessarily be indicative of the results for the year ending December 31, 2009. These unaudited interim consolidated financial statements should be read in conjunction with our audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2008. All amounts presented herein, except per share data, are shown in thousands.
In the third quarter of 2009, we adopted Statement of Financial Accounting Standards No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles — a replacement of FASB Statement No. 162 (FAS 168), which establishes the Accounting Standards Codification (ASC) as the single source of authoritative GAAP in the United States. As a result of this adoption, we generally do not reference specific accounting standards herein.
Our consolidated financial statements include the accounts of Redwood, its direct and indirect wholly-owned subsidiaries, and other entities in which we have a controlling financial interest. All significant intercompany balances and transactions have been eliminated. A number of Redwood’s consolidated subsidiaries are qualifying REIT subsidiaries and the remainder are taxable subsidiaries. References to the Redwood REIT include Redwood and its qualifying REIT subsidiaries, excluding taxable subsidiaries.
We are the asset manager and an investor in the Redwood Opportunity Fund LP (the Fund) that we sponsor. The Fund primarily invests in mortgage-backed securities. We also sponsor two securitization programs. Our Sequoia program is used for the securitization of residential mortgage loans. References to Sequoia refer collectively to all the consolidated Sequoia securitization entities. Our Acacia program is used for the securitization of mortgage-backed securities and other types of financial assets. References to Acacia refer collectively to all the consolidated Acacia securitization entities.
We apply the principles established by the Financial Accounting Standards Board (FASB) to determine whether we must consolidate any entities where we have continuing involvement. We do not service any assets, including assets owned at the Fund, Sequoia, or Acacia.
We consolidate the assets, liabilities, and noncontrolling interests of the Fund that we sponsor, as we are the primary beneficiary of this entity. The primary beneficiary is the party that absorbs the majority of a variable interest entity’s (VIEs) anticipated losses and/or the majority of the expected returns. Our significant limited partnership interest and ongoing asset management responsibilities constitute this majority.
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We consolidate most of the assets and liabilities of the Sequoia and Acacia securitization entities that we sponsor that were not accounted for as sales. These entities did not meet the criteria for sale accounting under GAAP at the time we transferred financial assets to them. Our continuing involvement includes our retention of junior interests and call rights and certain ongoing management responsibilities or other discretionary activities. For financial reporting purposes, the underlying loans and securities owned at Sequoia and Acacia entities are shown on our consolidated balance sheets under real estate loans and real estate securities and the asset-back securities (ABS) issued to third parties are shown under ABS issued. In our consolidated statements of income (loss), we record interest income on the loans and securities owned by Sequoia and Acacia and interest expense on the ABS issued by these consolidated securitization entities.
The preparation of financial statements requires us to make a number of significant estimates. These include estimates of fair value of certain assets and liabilities, amount and timing of credit losses, prepayment rates, and other estimates that affect the reported amounts of certain assets and liabilities as of the date of the consolidated financial statements and the reported amounts of certain revenues and expenses during the reported period. It is likely that changes in these estimates (e.g., valuation changes due to supply and demand, credit performance, prepayments, interest rates, or other reasons) will occur in the near term. Our estimates are inherently subjective in nature and actual results could differ from our estimates and the differences could be material.
We have the option to measure eligible financial assets, financial liabilities, and commitments at fair value on an instrument-by-instrument basis. This option is available when we first recognize a financial asset or financial liability or enter into a firm commitment. Subsequent changes in the fair value of assets, liabilities, and commitments where we have elected the fair value option are recorded in the consolidated statements of income (loss).
Our decision to apply the fair value option for new financial instruments is generally based upon our funding strategy for the specific financial asset acquired. For example, securities that we anticipate funding with equity will generally be accounted for as available-for-sale (AFS) securities. Securities that we anticipate funding with a combination of debt and equity or those financed through the issuance of asset-backed liabilities will generally be measured using the fair value option along with the corresponding liabilities. Additionally, we may elect the fair value option for nontraditional real estate investments or for a variety of other reasons.
See Note 4 for further discussion on the fair value option.
Our financial statements include assets and liabilities that are measured at their estimated fair values in accordance with GAAP. A fair value measurement represents the price at which an orderly transaction would occur between willing market participants at the measurement date. We develop fair values for financial assets or liabilities based on available inputs and pricing that is observed in the marketplace. Examples of market information that we attempt to obtain include the following:
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After considering all available indications of the appropriate rate of return that market participants would require, we consider the reasonableness of the range indicated by the results to determine an estimate that is most representative of fair value.
The markets for many of the real estate securities that we invest in and issue are generally illiquid. Establishing fair values for illiquid assets and liabilities is inherently subjective and is often dependent upon our estimates and modeling assumptions. If we determine that either the volume and/or level of trading activity for an asset or liability has significantly decreased from normal market conditions, or price quotations or observable inputs are not associated with orderly transactions, the market inputs that we obtain might not be relevant. For example, broker or pricing service quotes might not be relevant if an active market does not exist for the financial asset or liability. The nature of the quote (for example, whether the quote is an indicative price or a binding offer) is also evaluated.
In circumstances where relevant market inputs cannot be obtained, increased analysis and management judgment are required to estimate fair value. This generally requires us to establish the use of our internal assumptions about future cash flows and appropriate risk-adjusted discount rates. Regardless of the valuation inputs we apply, the objective of fair value measurement is unchanged from what it would be if markets were operating at normal activity levels and/or transactions were orderly; that is, to determine the current exit price.
See Note 5 for further discussion on fair value measurements.
Residential and commercial real estate loans at fair value are loans where we have elected the fair value option. The fair value option was elected on January 1, 2008, for all the loans owned by Acacia securitization entities as of that date. Coupon interest is recognized as revenue when earned and deemed collectible or until a loan becomes more than 90 days past due. Changes in fair value are recurring and are reported through our consolidated statements of income (loss) in market valuation adjustments, net.
Residential and commercial real estate loans held-for-sale are loans that we are marketing for sale to third parties. These loans are carried at the lower of their cost or fair value, as measured on an individual basis. If the fair value of a loan held-for-sale is lower than its amortized cost basis, this difference is reported as a negative market valuation adjustment through our consolidated statements of income (loss). Coupon interest for loans held-for-sale is recognized as revenue when earned and deemed collectible or until a loan becomes more than 90 days past due. Gains or losses on the sale of real estate loans are based on the specific identification method.
Real estate loans held-for-investment include residential real estate loans owned and securitized at Sequoia entities and commercial real estate loans owned at Redwood. These loans are carried at their unpaid principal balances adjusted for net unamortized premiums or discounts and net of any allowance for loan
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losses. Coupon interest is recognized as revenue when earned and deemed collectible or until a loan becomes more than 90 days past due. Interest previously accrued for loans that have become greater than 90 days past due is reserved for in the allowance for loan losses. Cash principal and interest that is advanced from servicers subsequent to a loan becoming greater than 90 days past due is used to reduce the outstanding loan principal balance.
We use the interest method to determine an effective yield to amortize the premium or discount on real estate loans held-for-investment. For residential loans acquired prior to July 1, 2004, we use coupon interest rates as they change over time and anticipated principal payments to determine periodic amortization. For residential 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 determine periodic amortization.
We reclassify loans held-for-investment to loans held-for-sale if we determine that these loans will be sold to third parties. This may occur, for example, if we exercise our right to call ABS issued by a Sequoia securitization trust and decide to subsequently sell the underlying loans to third parties.
For real estate loans classified as held-for-investment, we establish and maintain an allowance for loan losses based on our estimate of credit losses inherent in our loan portfolios at the reporting date. To calculate the allowance for loan losses, 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 or pool of loans.
We consider the following factors in making such determinations:
Once we determine the amount of defaults, the timing of the defaults, and severity of losses upon the defaults, we estimate expected losses for each individual loan or pool of loans over its expected life. We then estimate the timing of these losses and the losses probable to occur over an appropriate loss confirmation period. This period is defined as the range of time between the occurrence of a credit loss (such as the initial deterioration of the borrower’s financial condition) and the confirmation of that loss (the actual impairment or charge-off of the loan). The losses expected to occur within the estimated loss confirmation period are the basis of our allowance for loan losses, since we believe these losses exist as of the reported date of the financial statements. We re-evaluate the adequacy of our allowance for loan losses on at least a quarterly basis.
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As part of the loss mitigation efforts undertaken by servicers of residential loans owned by Sequoia securitization entities, a growing number of loan modifications have been completed to help make mortgage loans more affordable for certain borrowers. Loan modifications may include, but are not limited to: (i) conversion of a floating rate mortgage loan into a fixed rate mortgage loan; (ii) reduction in the contractual interest rate of a mortgage loan; (iii) forgiveness of a portion of the contractual interest and/or principal amounts owed on a mortgage loan; and, (iv) extension of the contractual maturity of a mortgage loan. We evaluate all loan modifications performed by servicers to determine if they constitute troubled debt restructurings according to GAAP. If a loan is determined to be a troubled debt restructuring, it is removed from the general loan pools used for calculating allowances for loan losses and assessed for impairment on an individual basis based upon any adverse change in the expected future cash flows resulting from the modification. This difference is recorded to the provision for loan losses in the consolidated statements of income (loss).
See Note 7 for further discussion on the allowance for loan losses.
We do not currently maintain a loan repurchase reserve, as we do not originate real estate loans and we believe that any risk of loss due to loan repurchases (i.e., due to breach of representations and warranties) would be a contingency to the companies from whom we acquired the loans and therefore would be covered by our recourse to those companies. Management is not aware of any outstanding repurchase claims against Redwood.
Trading securities include residential, commercial, and collateralized debt obligation (CDO) securities. Trading securities are carried at their estimated fair values. Coupon interest is recognized as interest income when earned and deemed collectible. All changes in fair value are reported through our consolidated statements of income (loss) in market valuation adjustments, net.
We primarily denote trading securities as those securities where we have adopted the fair value option. We currently account for certain securities at Redwood and all securities at Acacia entities as trading securities.
AFS securities include certain residential, commercial, and CDO securities. AFS securities are carried at their estimated fair values with cumulative unrealized gains and losses reported as a component of accumulated other comprehensive income (loss) in our consolidated statements of equity. Coupon interest is recognized as interest income when earned and deemed collectible, and the interest method is used to determine an effective yield to amortize purchase premiums, discounts, and fees associated with these securities into income over time. This requires us to project cash flows over the remaining life of each security and make assumptions with regards to interest rates, prepayment rates, the timing and amount of credit losses, 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, and our own judgment and experience.
For an AFS security where the security’s fair value has declined below its amortized cost basis, we evaluate the security for either temporary or other-than-temporary impairment (OTTI). This evaluation requires us to assess changes in our cash flow valuation assumptions for the security. We also consider whether there has been a significant adverse change in the regulatory and/or economic environment as part of this analysis. If we determine that there has been no significant adverse change in our cash flow assumptions for the security, then any impairment is deemed temporary in nature and the associated difference between the
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security’s fair value and amortized cost basis is recorded as an unrealized loss through accumulated other comprehensive income (loss), a component of stockholders’ equity. If we determine that there has been a significant adverse change in our cash flow assumptions for the security, then an OTTI exists.
We evaluate impairments in accordance with authoritative GAAP guidance that we adopted during the second quarter of 2009. According to this guidance, for a security where an impairment exists and we either intend to sell the impaired security, will more likely than not be required to the sell the impaired security before it recovers in value, or do not expect to recover the impaired security’s amortized cost basis even if we do not intend to sell the security, we record the difference between the security’s fair value and its amortized cost in our consolidated statements of income (loss) as the impairment is deemed as OTTI. For a security where an impairment exists, but for which we do not intend to sell the security and it is more likely than not that we will not be required to sell it prior to recovery, we analyze the expected cash flows, or cost recovery, of the security. If an OTTI exists, we discount the security’s cash flows to a present value using the prior period yield for the security to determine an “expected recoverable value.” The difference between this expected recoverable value and the amortized cost basis is deemed to be the “credit” component of OTTI that is recorded in our consolidated statements of income (loss). The amortized cost of the security is then adjusted to the expected recoverable value, and the difference between the expected recoverable value and fair value is deemed to be the “non-credit” component of OTTI that is recorded to accumulated other comprehensive income (loss). Future amortization and accretion for the security is computed based upon its new amortized cost basis.
In the second quarter of 2009, as part of our adoption of this new guidance, we evaluated $450 million of previously recorded OTTI on securities still held at April 1, 2009. We determined that $224 million of these OTTI related to securities where we either had the intent to sell or the OTTI did not include a non-credit component. The remaining $226 million of these OTTI related to securities that included a $165 million aggregate credit component and a $61 million aggregate non-credit component. In accordance with the guidance, we recorded a $61 million one-time cumulative-effect adjustment, net of any related tax effects, to reclassify the non-credit component of these OTTI previously recorded through our consolidated statements of income (loss), as was prescribed under previous GAAP. This reclassification increased retained earnings and decreased other comprehensive income (OCI), resulting in zero net impact to our reported stockholders’ equity.
See Note 8 for further discussion on real estate securities and cumulative effect adjustment.
Other investments include a guaranteed investment contract (GIC) entered into by an Acacia securitization entity that we consolidate for financial statement purposes. We elected the fair value option for this investment on January 1, 2008, and it is recorded on our consolidated balance sheets at its estimated fair value. Changes in fair value are reported through our consolidated statements of income (loss) through market valuation adjustments, net. Interest income is reported through our consolidated statements of income (loss) through interest income, other investments.
See Note 9 for further discussion on other investments.
Cash and cash equivalents include non-restricted cash and highly liquid investments with original maturities of three months or less. At September 30, 2009, we did not have any significant concentrations of credit risk arising from cash deposits as all of our cash and cash equivalents were invested in U.S. Government Treasury Bills or FDIC-insured bank products.
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Restricted cash primarily includes principal and interest payments that are collateral for, or payable to, owners of ABS issued consolidated securitization entities, and cash pledged as collateral on interest rate agreements. Restricted cash may also include cash retained in Acacia or Sequoia securitization entities or in the Fund prior to the purchase of loans or securities, payments on or redemption of outstanding ABS issued, or distributions to limited partners.
Accrued interest receivable represents interest that is due and payable to us. Cash interest is generally received within thirty days of recording the receivable. For financial assets where we have elected the fair value option, the associated accrued interest on these assets is measured at fair value. For financial assets where we have not elected the fair value option, the associated accrued interest carrying values approximate fair values.
Derivative financial instruments include contractual interest rate agreements and credit default swaps. All derivative financial instruments are reported at fair value on our consolidated balance sheets, in accordance with derivative accounting guidance. Derivatives with a positive value to us are reported as an asset and derivatives with a negative value to us are reported as a liability. The changes in fair value of derivatives accounted for as trading instruments are reported in the consolidated statements of income (loss) through market valuation adjustments, net.
We maintain an overall interest rate risk management strategy that incorporates the use of interest rate agreements. We enter into interest rate agreements for a variety of reasons, including minimizing significant fluctuations in earnings or market values on certain assets or liabilities that may be caused by interest rate volatility. Interest rate agreements that we use as part of our interest rate risk management strategy may include interest rate options, swaps, options on swaps, futures contracts, options on futures contracts, and options on forward purchases.
Prior to 2008, we accounted for derivatives used to hedge interest rate exposure in Acacia securitization entities as cash flow hedges. At January 1, 2008, all of our consolidated derivatives designated as cash flow hedges were de-designated and accounted for as trading instruments. To the extent the associated hedged items continue to exist, the fair value of cash flow hedges at the time of de-designation remains in accumulated other comprehensive income and is amortized using the straight-line method through interest expense over the remaining lives of the hedged Acacia ABS issued. Net purchases and proceeds from interest rate agreements are classified as financing activities within our consolidated statements of cash flows.
A credit default swap (CDS) is an agreement to provide (receive) credit event protection based on a financial index or specific security in exchange for receiving (paying) a fixed-rate fee or premium over the term of the contract. These instruments enable us to synthetically assume the credit risk of a reference security or index of securities. All of our existing CDS contracts were initiated during 2007 by one of the Acacia entities that we consolidate for financial reporting purposes. Net purchases and proceeds from CDS are classified as financing activities within our consolidated statements of cash flows.
See Note 10 for further discussion on derivative financial instruments.
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Income recognition for GAAP and tax differ in material respects. These differences often reflect differing accounting treatments for tax and GAAP, such as accounting for discount and premium amortization, credit losses, equity awards, asset impairments, and certain valuation estimates. As a result of these differences, we may recognize taxable income in periods prior to when we recognize income for GAAP. When this occurs, we pay the tax liability and establish a deferred tax asset and an associated deferred tax benefit for GAAP. As the income is subsequently realized in future periods under GAAP, the deferred tax asset is recognized as an expense. Our deferred tax assets are generated by differences in GAAP and taxable income at our taxable subsidiaries.
ABS issuance costs are costs associated with the issuance of ABS from the Sequoia securitization entities we sponsor. These costs typically include underwriting, rating agency, legal, accounting, and other fees. ABS issuance costs associated with liabilities accounted for under the fair value option are expensed as incurred. ABS issuance costs associated with liabilities reported at cost are deferred. Deferred ABS issuance costs are reported on our consolidated balance sheets as deferred charges and are amortized as an adjustment to interest expense using the interest method, based upon the actual and estimated repayment schedules of the related ABS issued under the principle guidance for interest on receivables and payables. Sequoia deferred ABS issuance costs are accounted for in accordance with this guidance.
As of January 1, 2008, deferred issuance costs associated with Acacia securitizations were included as part of our adoption of the fair value option for assets and liabilities at Acacia. As a result, these deferred costs were charged to retained earnings as a part of a one-time cumulative effect adjustment on January 1, 2008.
Other assets on our consolidated balance sheets include real estate owned (REO), fixed assets, principal receivable, and other prepaid expenses. REO is reported at the lower of cost or fair value. Subsequent declines in the value of an REO property are recorded in our consolidated statements of income (loss) as a component of market valuation adjustments, net. All other assets are reported at cost.
See Note 11 for further discussion on other assets.
Short-term debt can include master repurchase agreements, bank borrowings, and other forms of collateralized borrowings with various commercial banks and investment banks that expire within one year. These facilities may be unsecured or collateralized by loans or securities. Since November 2008 we have had no short-term debt outstanding.
Accrued interest payable represents interest that is due and payable to third parties. Interest is generally paid within thirty days to three months of recording the payable, based upon our remittance requirements. For borrowings where we have elected the fair value option, the associated accrued interest on these liabilities is measured at fair value. For financial liabilities where we have not elected the fair value option, the associated accrued interest carrying values approximate fair values.
The majority of the liabilities reported on our consolidated balance sheets represent ABS issued by bankruptcy-remote securitization entities sponsored by Redwood.
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Sequoia and Acacia assets are held in the custody of trustees. These trustees collect principal and interest payments (less servicing and related fees) from the assets and make corresponding principal and interest payments to the ABS investors. ABS obligations are payable solely from the assets of these entities and are not obligations of Redwood.
Sequoia ABS issued are carried at their unpaid principal balances net of any unamortized discount or premium.
Effective January 1, 2008, Acacia ABS issued are accounted for under the fair value option and carried at their estimated fair values on our consolidated balance sheets. Changes in fair value (gains or losses) are reported in our consolidated statements of income (loss) through market valuation adjustments, net. Prior to January 1, 2008, Acacia ABS issued were accounted for under the same method as Sequoia ABS issued.
See Note 12 for further discussion on ABS issued.
Long-term debt includes trust preferred securities and subordinated notes at Redwood and is carried at its unpaid principal balance. Both are unsecured debt, requiring quarterly interest payments at a floating rate equal to the three-month London Interbank Offered Rate (LIBOR) plus a margin until they are redeemed in whole or mature at a future date.
See Note 13 for further discussion on long-term debt.
Basic earnings (loss) per share (EPS) is computed by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income (loss) 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. In accordance with earnings per share guidance, if there is a loss from continuing operations, the common stock equivalents are deemed antidilutive and diluted income (loss) per share is calculated in the same manner as basic income (loss) per share.
On January 1, 2009, authoritative GAAP was updated to state that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are “participating securities” and therefore should be included in computing EPS using the two-class method. Our adoption of this guidance required us to recast previously reported EPS and did not have a significant impact on EPS.
Net unrealized gains and losses on real estate securities available-for-sale and interest rate agreements previously designated as cash flow hedges under derivative accounting literature are reported as components of other comprehensive income (loss) on our consolidated statements of equity and comprehensive income (loss). Net unrealized gains and losses on securities and interest rate agreements held by our taxable subsidiaries that are reported in other comprehensive income (loss) are adjusted for the effects of taxation and may create deferred tax assets or liabilities.
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Noncontrolling interest represents the aggregate limited partnership interests in the Fund held by third parties. In accordance with FASB noncontrolling interest guidance, the noncontrolling interest of the Fund is shown as a component of equity on our consolidated balance sheets, and the portion of income allocable to third parties is shown as net income attributable to noncontrolling interest in our consolidated statements of income (loss). A reconciliation of equity attributable to noncontrolling interest is disclosed in our consolidated statements of equity and comprehensive income (loss).
In March 2008, we amended our previously amended 2002 Redwood Trust, Inc. Incentive Plan (Incentive Plan) for executive officers, employees, and non-employee directors. This amendment was approved by our shareholders in May 2008. The Incentive Plan authorizes our Board of Directors (or a committee appointed by our Board of Directors) to grant incentive stock options (ISOs), non-qualifying stock options (NQSOs), deferred stock units (DSUs), restricted stock, performance shares, performance units (including cash), stock appreciation rights, limited stock appreciation rights (awards), and dividend equivalent rights (DERs) to eligible recipients other than non-employee directors. These awards generally vest over a four-year period. Non-employee directors are also provided annual awards under the Incentive Plan that generally vest immediately.
The cost of equity awards is determined in accordance with share-based payment accounting guidance and amortized over the vesting term using an accelerated method for equity awards granted prior to December 1, 2008. For equity awards granted after December 1, 2008, the cost of the awards is amortized over the vesting period on a straight-line basis. Timing differences between the accelerated and straight-line method of amortization were determined to not be material to our financial statements.
In May 2002, our stockholders approved our 2002 Redwood Trust, Inc. Employee Stock Purchase Plan (ESPP), effective July 1, 2002. The purpose of the ESPP is to give our employees an opportunity to acquire an equity interest in Redwood through the purchase of shares of common stock at a discount. The ESPP allows eligible employees to purchase common stock at 85% of its fair value, subject to certain limits. Fair value as defined under the ESPP is the lesser of the closing market price of the common stock on the first day of the calendar year or the first day of the calendar quarter. This plan was amended by our stockholders in May 2009 to increase the number of available shares.
In May 2002, our Board of Directors approved our 2002 Executive Deferred Compensation Plan (EDCP). The EDCP allows eligible employees and directors to defer portions of current salary and certain other forms of compensation. Redwood matches some deferrals. Compensation deferred under the EDCP is an asset of Redwood and subject to the claims of the general creditors of Redwood. The EDCP allows for the investment of deferrals in either an interest crediting account or DSUs.
See Note 16 for further discussion on equity compensation plans.
We have elected to be taxed as a REIT under the Internal Revenue Code and the corresponding provisions of state law. To qualify as a REIT we must distribute at least 90% of our annual REIT taxable income to shareholders (not including taxable income retained in our taxable subsidiaries) within the time
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frame set forth in the tax code and also meet certain other requirements. Beginning in 2003, we elected to retain up to 10% of our REIT ordinary taxable income and had provisioned for corporate income taxes on the retained income while maintaining our REIT status. In August 2008, our Board of Directors decided to distribute as dividends 100% of our REIT taxable income generated in 2007 and 2008 and our tax provisions changed accordingly.
We assess our tax positions for all open tax years and determine whether we have any material unrecognized liabilities in accordance with FASB guidance on accounting for uncertainty in income taxes. We record these liabilities to the extent we deem them incurred. We classify interest and penalties on material uncertain tax positions as interest expense and operating expense, respectively, in our consolidated statements of income (loss).
See Note 18 for further discussion on taxes.
In June 2009, the FASB issued Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets — an amendment of FASB Statement No. 140 (FAS 166). FAS 166 requires more information about transfers of financial assets, including securitization transactions, and where companies have continuing exposure to the risks related to transferred financial assets. It eliminates the concept of a “qualifying special-purpose entity,” changes the requirements for derecognizing financial assets, and requires additional disclosures. Specifically, FAS 166 (1) requires that all arrangements made in connection with a transfer of financial assets be considered in the derecognition analysis, (2) clarifies when a transferred asset is considered legally isolated from the transferor, (3) modifies the requirements related to a transferee’s ability to freely pledge or exchange transferred financial assets, and (4) provides guidance on when a portion of a financial asset can be derecognized. FAS 166 enhances information reported to users of financial statements by providing greater transparency about transfers of financial assets and a company’s continuing involvement in transferred financial assets. FAS 166 is effective for financial asset transfers occurring after the beginning of an entity’s first fiscal year that begins after November 15, 2009. Early adoption is prohibited. We are currently evaluating the impact of FAS 166 and have not yet determined the impact of adopting this principle. Considering our past transfers of financial assets to securitization entities (i.e., Sequoia and Acacia) through application of previously issued guidance, changes to the consolidation criteria prescribed by FAS 166 for similar transfers could have a significant impact on our reported results in the future.
In June 2009, the FASB issued Statement of Financial Accounting Standards No. 167, Amendments to FASB Interpretation No. 46(R), (FAS 167), which amends the consolidation guidance that applies to VIEs. The amendment changes how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. Accordingly, an enterprise will need to carefully reconsider its previous conclusions of VIE consolidation, including (1) whether an entity is a VIE, (2) whether the enterprise is the VIE’s primary beneficiary, and (3) what type of financial statement disclosures are required. FAS 167 will require a company to provide additional disclosures about its involvement with variable interest entities and any significant changes in risk exposure due to that involvement. A company will be required to disclose how its involvement with a variable interest entity affects the company’s financial statements. FAS 167 is effective as of the beginning of the first fiscal year that begins after November 15, 2009. Early adoption is prohibited. We are currently evaluating the impact of FAS 167 and have not yet determined the impact of adopting this principle. Given our previous reliance on qualifying special purpose entity (QSPE) designations for third party securitization trusts for which we have invested in, the required reconsideration of our variable interests in
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those trusts as of January 1, 2010, could have a significant impact on our financial statements. For example, we may determine that we are the primary beneficiary of securitization trusts that we had considered QSPEs in the past and would therefore be required to consolidate those VIEs for financial reporting purposes beginning in 2010.
In August 2009, the FASB issued Accounting Standards Update (ASU) 2009-05, Measuring Liabilities at Fair Value, to clarify how entities should estimate the fair value of liabilities under Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures. The ASU clarifies that the quoted price for the identical liability, when traded as an asset in an active market, is also a Level 1 measurement for that liability when no adjustment to the quoted price is required. In the absence of a Level 1 measurement, an entity must use one or more of the following valuation techniques to estimate fair value (in a manner consistent with the principles in ASC 820), which can be classified into two broad categories: (1) a valuation technique that uses a quoted price (a quoted price of an identical liability when traded as an asset, or a quoted price of a similar liability or of a similar liability when traded as an asset) or (2) another valuation technique consistent with the principles of ASC 820 (a market approach or an income approach). The new guidance is effective for the first interim or annual reporting period beginning after August 28, 2009. As this guidance is consistent with the methodology we use to price liabilities, adoption will not have an effect on our consolidated financial statements.
On January 1, 2008, we elected to apply the fair value option provided under GAAP for the assets (loans, securities, and unamortized deferred ABS issuance costs) and liabilities (ABS issued) of our consolidated Acacia securitization entities. We also elected the fair value option for certain securities at Redwood that we anticipated potentially selling or securitizing in the future. The election of the fair value option resulted in a $1.5 billion cumulative effect transition adjustment at January 1, 2008. There was no deferred tax impact associated with the adoption since the net unrealized losses in accumulated other comprehensive income (loss) that were reclassified to retained earnings were generated at the REIT, which distributes predominantly all of its taxable income.
As of September 30, 2009, the loans at Acacia had an aggregate fair value of $6 million and an unpaid principal balance of $26 million, the securities had an aggregate fair value of $270 million and an unpaid principal balance of $2.5 billion, and asset-backed securities issued at Acacia had an aggregate fair value of $288 million and an unpaid principal balance of $3.0 billion.
We elected the fair value option for certain ABS issued by Sequoia and acquired by Acacia as a result of the deconsolidation of certain Sequoia entities during the fourth quarter of 2008 and second quarter of 2009. These ABS issued had been previously eliminated as intercompany assets for financial reporting purposes. During the third quarter of 2009, we elected the fair value option for $2 million of residential senior securities.
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The following table presents the carrying values and estimated fair values of assets and liabilities that are required to be recorded or disclosed at fair value as of September 30, 2009 and December 31, 2008.
For financial reporting purposes, we follow a fair value hierarchy established under GAAP that is used to measure the fair value of the assets and liabilities in the table above. This hierarchy prioritizes relevant market inputs in order to determine an “exit price”, or the price at which an asset could be sold or a liability could be transferred in an orderly process that is not a forced liquidation or distressed sale at the date of measurement. Level 1 inputs are observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 inputs are observable inputs other than quoted prices for an asset or liability that are obtained through corroboration with observable market data. Level 3 inputs are unobservable inputs (e.g., our own data or assumptions) that are used when there is little, if any, relevant market activity for the asset or liability being measured at fair value.
In certain cases, inputs used to measure fair value fall into different levels of the fair value hierarchy. In such cases, the level in which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement. Our assessment of the significance of a particular input requires judgment and considers factors specific to the asset or liability being measured.
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The following table presents assets and liabilities recorded at fair value on our consolidated balance sheet on a recurring basis and indicates the fair value hierarchy of the valuation techniques used to measure fair value.
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The following table presents additional information about Level 3 assets and liabilities.
The following table presents the portion of gains or losses included in our consolidated statement of income (loss) that were attributable to Level 3 assets and liabilities recorded at fair value on a recurring basis and still held at September 30, 2009 and 2008. Gains or losses incurred on assets or liabilities sold or otherwise disposed of during the three and nine months ended September 30, 2009 and 2008 are not included in this presentation.
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The following table presents information on assets and liabilities recorded at fair value on a non-recurring basis.
The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of income (loss) for the three and nine months ended September 30, 2009 and 2008.
A description of the instruments measured at fair value as well as the general classification of such instruments pursuant to the Level 1, Level 2, and Level 3 valuation hierarchy is listed below.
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We invest in residential and commercial real estate loans that we acquire from third party originators. We finance these loans through the Sequoia and Acacia entities that we sponsor or with equity.
The following table summarizes the classifications and carrying value of the residential and commercial real estate loans recorded on our consolidated balance sheets at September 30, 2009 and December 31, 2008.
Residential real estate loans held-for-sale are owned with equity. At September 30, 2009, there were 14 residential loans held-for-sale with $4 million in outstanding principal value and a lower of cost or fair value of $2 million. At December 31, 2008, there were 15 residential loans held-for-sale with $5 million in outstanding principal value and a lower of cost or fair value of $3 million.
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Residential real estate loans held-for-investment are owned at Sequoia securitization entities that we consolidate for financial reporting purposes. The following table provides additional information on residential real estate loans held-for-investment at September 30, 2009 and December 31, 2008.
At September 30, 2009 and December 31, 2008, the carrying value of our held-for-investment loans was $3.8 billion and $4.6 billion, respectively. The difference is primarily due to the deconsolidation of $439 million of real estate loans in the second quarter of 2009, as result of a sale of variable interests in a Sequoia securitization, and principal paydowns on the loans.
Of the $3.8 billion of principal face and $53 million of unamortized premium on these loans at September 30, 2009, $1.9 billion of principal face and $35 million of unamortized premium relates to residential loans acquired prior to July 1, 2004. During the first nine months of 2009, 8% of these residential loans prepaid and we amortized 26% of the premium based upon the accounting elections we apply. For residential loans acquired after July 1, 2004, the principal face was $1.9 billion and the unamortized premium was $18 million at September 30, 2009. During the first nine months of 2009, 25% of these residential loans prepaid and we amortized 8% of the premium. Of the $4.6 billion of principal face and $68 million of unamortized premium on these loans at December 31, 2008, $2.0 billion of principal face and $48 million of unamortized premium relates to residential loans acquired prior to July 1, 2004, and $2.6 billion of principal face and $20 million of unamortized premium relates to residential loans acquired after July 1, 2004.
Commercial real estate loans at fair value are owned at Acacia entities that we consolidate for financial reporting purposes. On January 1, 2008, we elected the fair value option for loans at Acacia and record them at their estimated fair values. Prior to 2008, these loans were classified as held-for-investment. At September 30, 2009, there were five commercial loans at fair value with an outstanding principal value of $26 million and a fair value of $6 million, and one of which has been delinquent since May 2009. At December 31, 2008, there were five commercial loans at fair value, with an outstanding principal of $27 million and a fair value of $12 million, and none of which were delinquent.
Commercial real estate loans held-for-investment are owned with equity. The following table provides additional information on commercial real estate loans held-for-investment as of September 30, 2009 and December 31, 2008.
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At September 30, 2009, there were two commercial loans held-for-investment with $11 million in outstanding principal value and a carrying value of $0.2 million. During the first quarter of 2007, we fully reserved for an anticipated loss on a $10 million mezzanine commercial loan, which was originated to finance a condominium-conversion project. We do not expect to recover any outstanding principal upon completion and sale of the condominium units, and thus maintained the allowance as of September 30, 2009.
We establish an allowance for loan losses on our residential and commercial loans held-for-investment based on our estimate of losses incurred in these loan portfolios.
At September 30, 2009 and December 31, 2008, all residential loans classified as held-for-investment were owned by Sequoia entities. The following table summarizes the activity in the allowance for loan losses on residential loans held-for-investment for the three and nine months ended September 30, 2009 and 2008.
Serious delinquencies on consolidated Sequoia loans were $145 million and $143 million as of September 30, 2009 and 2008, respectively. Serious delinquencies include loans delinquent more than 90 days and in foreclosure. As a percentage of outstanding loan balances, serious delinquencies were 3.79% and 2.36% at September 30, 2009 and 2008, respectively.
When foreclosure is pursued in full satisfaction for a defaulted loan, we estimate the specific loan loss, if any, based on estimated net proceeds from the sale of the property (including accrued but unpaid interest and other costs), and charge this specific estimated loss against the allowance for loan losses. During the nine months ended September 30, 2009, there were $12 million of charge-offs that reduced our allowance for loan losses. These charge-offs arose from $41 million of defaulted loan principal. Foreclosed property is subsequently recorded as REO, a component of other assets.
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There was no activity in the allowance for loan losses for our commercial loans for the three and nine months ended September 30, 2009 and 2008.
We invest in third party residential, commercial, and CDO securities. The following table presents the fair values of our real estate securities by collateral type and entity as of September 30, 2009 and December 31, 2008.
The following table presents our securities by trading and AFS, collateral type, and entity as of September 30, 2009 and December 31, 2008.
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Senior securities are those interests in a securitization that have the first right to cash flows and are last in line to absorb losses. Re-REMIC securities that we currently own were created through the resecuritization of certain senior interests to provide additional credit support to those interests. These re-REMIC securities are therefore subordinate to the remaining senior interest, but senior to any subordinate tranches of the securitization from which they were created. Subordinate securities (generally rated AA and lower) are all interests below senior and re-REMIC interests. At September 30, 2009 all of our real estate securities had contractual maturities over ten years, except for less than $1 million of residential securities that had contractual maturities greater than 5 years but less than 10 years.
When we purchase a credit-sensitive AFS security at a significant discount to its face value, we often do not amortize into income a significant portion of this discount that we are entitled to earn but do not expect to collect due to the inherent credit risk of the security. We may also expense a portion of our investment in the security to the extent we believe that principal losses will exceed the purchase discount. We designate the amount of principal face that we do not amortize into income as a credit reserve on the security, with any remaining net unamortized discounts or premiums amortized into income over time using the interest method.
The following table presents the components of carrying value (which equals fair value) of AFS securities as of September 30, 2009 and December 31, 2008.
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The following table presents the changes for the three and nine months ended September 30, 2009, of the unamortized discount and designated credit reserves on AFS securities.
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The loans underlying our residential subordinate securities totaled $81 billion at September 30, 2009, consisting of $73 billion prime and $8 billion non-prime loans. These loans are located nationwide with a large concentration in California (47%). Serious delinquencies (90+ days, in foreclosure or REO) at September 30, 2009 were 6.73% of current principal balances. For loans in prime pools, serious delinquencies were 4.23% of current balances. For loans in non-prime pools, serious delinquencies were 30.11% of current balances. The loans underlying our commercial subordinate securities totaled $47 billion at September 30, 2009, and consist primarily of office (39%), retail (29%), and multifamily (15%) commercial loans. These loans are located nationwide. Serious delinquencies (60+ days and in foreclosure or REO) at September 30, 2009 were 3.63% of current principal balances.
The following table presents the components comprising the carrying value of AFS securities that were in an unrealized loss position as of September 30, 2009 and December 31, 2008.
At September 30, 2009, after giving effect to purchases, sales, and extinguishments due to credit losses, our consolidated balance sheet included 634 AFS securities, of which 264 were in an unrealized loss position, of which 32 were in an unrealized loss position for twelve consecutive months or longer. At December 31, 2008, our consolidated balance sheet included 594 AFS securities, of which 194 were in an unrealized loss position and none were in a continuous loss position for twelve months or longer.
Of the total unrealized losses at September 30, 2009 and December 31, 2008, $15 million and $16 million, respectively, relate to securities owned at the Fund. The remaining unrealized losses relate to securities owned at Redwood.
When the fair value of an AFS security is below our cost basis, we evaluate the security for OTTI. Part of this evaluation is based upon significant adverse changes in the assumptions used to value the security. The table below summarizes the significant valuation assumptions we used for our AFS securities as of September 30, 2009.
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During the three months ended September 30, 2009, we determined that $25 million of OTTI existed, of which $9 million was recognized in our consolidated statement of income (loss). We determined that $2 million of this $9 million related to securities that we either had the intent to sell or the OTTI did not include a non-credit component. The remaining $7 million was the aggregate credit component of OTTI on securities, which also had an aggregate non-credit component of $16 million.
The following table details the activity related to the credit component of OTTI (i.e., OTTI in either current earnings or retained earnings) for AFS securities still held at September 30, 2009.
Gains and losses from the sale of AFS securities are recorded as realized gains, net, in our consolidated statements of income (loss). The following table presents the gross realized gains on sales and calls of AFS securities for the three and nine months ended September 30, 2009 and 2008.
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Other investments include a GIC owned by an Acacia securitization entity and recorded on our consolidated balance sheets at its estimated fair value. This GIC represents a deposit certificate issued by a rated investment bank and serves as collateral to cover realized losses on CDS entered into by this same Acacia entity. The CDS references residential mortgage-backed securities issued in 2006 that were initially A and BBB-rated. The fair value of the GIC was $29 million as of September 30, 2009, which is equal to its carrying value. The GIC has been drawn down by $51 million since its acquisition to cover credit losses and principal reductions on the referenced securities.
We report our derivative financial instruments at fair value as determined using third-party models and confirmed by broker/dealers that make markets in these instruments. Our Redwood and Acacia entities hold derivative positions at September 30, 2009. Acacia’s derivative financial instruments are owned by Acacia securitization entities and are not the obligation of Redwood.
The following table shows the aggregate fair value and notional amount by entity of our derivative financial instruments as of September 30, 2009 and December 31, 2008.
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We currently account for our interest rate agreements as trading instruments. Changes in the fair value of the interest rate agreements and all associated income and expenses are reported in our consolidated statements of income (loss) as a component of market valuation adjustments, net. We had net valuation adjustments on interest rate agreements of negative $15 million and positive $13 million for the three and nine months ended September 30, 2009, respectively, and negative $11 million and negative $36 million for the three and nine months ended September 30, 2008, respectively.
We did not have any interest rate agreements designated as cash flow hedges during the three and nine months ended September 30, 2009. For interest rate agreements previously designated as cash flow hedges, our total unrealized loss reported in accumulated other comprehensive income (loss) was negative $24 million at September 30, 2009, and negative $27 million at December 31, 2008. For the three and nine months ended September 30, 2009, we reclassified $1 million and $3 million, respectively, of unrealized losses on derivatives previously designated as cash flow hedges to interest expense. For the three and nine months ended September 30, 2008, we reclassified $1 million and $4 million, respectively, of unrealized losses on derivatives to interest expense.
All of our existing CDS contracts were initiated during 2007 by an Acacia securitization entity that we have consolidated for financial reporting purposes. As the seller of these contracts we receive a fixed-rate premium and have assumed the credit risk of the reference securities.
These CDS are accounted for as trading instruments. The estimated fair values of these contracts fluctuate for a variety of reasons, such as the likelihood or occurrence of a specific credit event, the market perception of default risk and counterparty risk, and supply and demand changes. A qualifying credit event, defined as an interest shortfall, a failure to pay principal, or a distressed rating downgrade, may trigger Acacia as the seller of protection to compensate the counterparty (which it does so by drawing down on the GIC it owns). During the three and nine months ended September 30, 2009, the reference securities underlying our CDS experienced principal losses resulting in $17 million and $49 million in obligations, respectively. During the three and nine months ended September 30, 2009, the fair value of these CDS increased less than $1 million and $1 million, respectively. During the three and nine months ended September 30, 2008, the fair value of these CDS decreased less than $1 million and $20 million, respectively.
The following table presents the fair value of our CDS along with certain risk characteristics as of September 30, 2009 and December 31, 2008. All of these CDS have expiration dates of greater than 15 years.
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We incur credit risk to the extent that counterparties to our derivative financial instruments do not perform their obligations under specified contractual agreements. If a derivative counterparty does not perform, we may not receive the proceeds to which we may be entitled under these agreements. To mitigate this risk, we enter into agreements that are either a) transacted on a national exchange or b) transacted with counterparties that are either i) designated by the Federal Reserve Bank of New York as a primary government dealer, ii) affiliates of primary government dealers, or iii) rated A or higher. We also attempt to transact with several different counterparties in order to reduce our specific counterparty exposure. We consider counterparty risk as part of our fair value assessments of all derivative financial instruments.
As of September 30, 2009, Redwood and its affiliates had eighteen International Swaps and Derivatives Association (ISDA) agreements with ten different bank counterparties. We were in compliance with all open positions as of September 30, 2009.
Other assets as of September 30, 2009, and December 31, 2008, are summarized in the following table.
REO consists of foreclosed properties received in full satisfaction of defaulted real estate loans. The carrying value of REO at September 30, 2009, was $16 million, of which $21 million related to transfers into REO in the first nine months of 2009, offset by $18 million of REO liquidations, $2 million of negative market valuation adjustments during this same period, and $4 million of REO derecognized as a result of our deconsolidation of a Sequoia entity. The carrying value of REO as of December 31, 2008, was $19 million, of which $38 million related to transfers into REO during 2008, offset by $21 million of REO liquidations, $8 million of negative valuation changes, and $5 million of REO derecognized as a result of our deconsolidations of certain Sequoia entities.
At September 30, 2009, there were 82 REO properties recorded on our balance sheet, of which, 81 were owned at Sequoia and 1 was owned at Redwood. At December 31, 2008, there were 93 REO properties recorded on our balance sheet, of which, 90 were owned at Sequoia and 3 were owned at Redwood. Properties located in California, Ohio, Georgia, and Michigan accounted for 57% of our REO outstanding at September 30, 2009.
The Sequoia and Acacia securitization entities that we sponsor issue ABS to acquire assets from us and from third parties. Each series of ABS issued consists of various classes that pay interest on a monthly or quarterly basis. Substantially all ABS issued pay variable rates of interest, which are indexed to one, three, or six-month LIBOR. Some ABS issued pay fixed rates of interest or pay hybrid rates, which are fixed rates that
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subsequently adjust to variable rates. ABS issued also include some interest-only classes with coupons set at a fixed-rate or a fixed spread, or set at a spread to the interest rates earned on the assets, less the interest rates paid on the liabilities of a securitization entity.
The components of ABS issued by consolidated securitization entities we sponsor as of September 30, 2009 and December 31, 2008, along with other selected information, are summarized in the following table.
The maturity of each class of ABS issued is primarily determined 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 ABS issued will often occur earlier than its stated maturity. As of September 30, 2009, all of the $4.0 billion reported value of ABS issued ($6.8 billion principal value) had contractual maturities of over five years.
Amortization of Sequoia deferred ABS issuance costs was less than $1 million and $2 million for the three and nine months ended September 30, 2009, respectively, and $1 million and $5 million for the three and nine months ended September 30, 2008, respectively.
The following table summarizes the accrued interest payable on ABS issued as of September 30, 2009 and December 31, 2008. Interest due on Sequoia ABS issued is settled monthly and interest due on Acacia ABS issued is settled quarterly.
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The following table summarizes the carrying value components of the collateral for ABS issued and outstanding as of September 30, 2009 and December 31, 2008.
In 2006, we issued $100 million of trust preferred securities through Redwood Capital Trust I, a wholly-owned Delaware statutory trust, in a private placement transaction. These trust preferred securities require quarterly distributions at a floating coupon rate equal to three-month LIBOR plus 2.25% until the notes are redeemed in whole, which will be no later than January 30, 2037. The weighted average interest rate on our trust preferred securities was 3.76% and 4.26%, for the three and nine months ended September 30, 2009, and 4.13% and 4.43%, for the three and nine months ended September 30 2008, respectively. The earliest optional redemption date without penalty is January 30, 2012.
In 2007, we issued an additional $50 million of subordinated notes, which require quarterly distributions at a floating interest rate equal to three-month LIBOR plus 2.25% until the notes are redeemed in whole, which will be no later than July 30, 2037. The weighted average interest rate on our subordinated notes was 3.76% and 4.26%, for the three and nine months ended September 30, 2009, and 4.13% and 4.43%, for the three and nine months ended September 30, 2008, respectively. The earliest optional redemption date without a penalty is July 30, 2012. In July 2009, we repurchased $10 million principal amount of this subordinated debt for $3.4 million. The $6.6 million gain on extinguishment of debt was recorded in realized gains, net, on our consolidated statements of income (loss).
At both September 30, 2009 and December 31, 2008, the accrued interest payable balance on long-term Redwood debt was $1 million. There are no financial covenants associated with our long-term debt.
As of September 30, 2009, we were obligated under non-cancelable operating leases with expiration dates through 2018 for $13 million. The majority of the future lease obligations relates to a ten-year operating lease for our executive office that expires in 2013 and a lease for additional space that expires in 2018. The total payments required under these leases are recognized as office rent expense on a straight-line basis over the lease terms. Operating lease expense was less than $1 million for both the three months ended September 30, 2009 and 2008, and $1 million for both the nine months ended September 30, 2009 and 2008.
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The following table presents our future lease commitments as of September 30, 2009.
Leasehold improvements for our offices are amortized into expense over the ten-year lease term, expiring in 2013. The unamortized leasehold improvement balance was $3 million at September 30, 2009 and $4 million at December 31, 2008.
At September 30, 2009, there are no material pending legal proceedings to which we or any of our subsidiaries is a party or of which our property is the subject.
The following table provides the basic and diluted earnings (loss) per share computations for the three and nine months ended September 30, 2009 and 2008.
For the three months ended September 30, 2009, there were 612,245 dilutive equity awards for the period. For the nine months ended September 30, 2009, and the three and nine months ended September 30, 2008, there were no dilutive equity awards based on our reported net loss for these periods. For the nine months ended September 30, 2009, the number of outstanding equity awards that were antidilutive totaled 1,107,192. For the three and nine months ended September 30, 2008, the number of outstanding equity awards that were antidilutive totaled 1,061,751 and 1,198,412 respectively. There were no other participating securities during these periods.
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We announced a stock repurchase authorization in November 2007 for the repurchase of up to 5,000,000 common shares. This plan replaced all previous share repurchase plans and has no expiration date. During the three and nine months ended September 30, 2009, there were 273 shares acquired under the plan as part of an effort to repurchase fractional shares held by participants in our dividend reinvestment plan who held less than one share. During the three and nine months ended September 30, 2008, there were 341,656 shares acquired under the plan. As of September 30, 2009, there remained 4,658,071 shares available for repurchase under this plan.
Of the total equity on our balance sheet at September 30, 2009, $19 million is noncontrolling interest. Noncontrolling interest represents the aggregate limited partnership (LP) interests in the Fund held by third parties. As of September 30, 2009, the noncontrolling interest represents a 48% third-party interest in the Fund. Income allocated to the noncontrolling interest is based on the third party LP ownership percentage. The ownership percentage is determined by dividing the number of units held by third party LP investors by the total units outstanding. Subsequent changes, if any, in our ownership percentage would be treated as equity transactions and result in a reallocation between shareholders’ equity and noncontrolling interest in our consolidated balance sheets.
The following table provides a summary of the components of accumulated other comprehensive income (loss) as of September 30, 2009 and December 31, 2008.
At September 30, 2009, the net unrealized gains on AFS securities was $39 million, a $77 million change from the net unrealized loss of $38 million at December 31, 2008. During the first nine months of 2009, $60 million of unrealized losses were recognized in accumulated other comprehensive income (loss) as a result of adopting recent accounting guidance on OTTI, $37 million of net unrealized loss was reclassified to earnings upon recognition of OTTI, and $97 million of fair value increases in securities were recognized in unrealized losses. A portion of these unrealized losses, $5 million at September 30, 2009 and $8 million at December 31, 2008, were on AFS securities owned by the Fund.
At September 30, 2009, interest rate agreements had an unrealized loss of $24 million, which will be expensed through our consolidated statements of income (loss) over the remaining lives of previously designated hedged items (See Note 10), which will generally be equal to $1 million per quarter.
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As of September 30, 2009, and December 31, 2008, 1,206,204 and 1,005,937 shares of common stock, respectively, were available for grant under Redwood’s Incentive Plan. The increase in number of shares available reflects forfeitures of previously awarded equity awards. The unamortized compensation cost under the Incentive Plan and the Employee Stock Purchase Plan totaled $11 million at September 30, 2009, as shown in the following table:
The weighted average amortization period remaining for all of our equity awards was one year at September 30, 2009.
As of September 30, 2009 and December 31, 2008, there were 600,723 and 647,873, respectively, of stock options outstanding. All of the outstanding stock options were fully vested as of September 30, 2009. The aggregate intrinsic value of the options outstanding and options currently exercisable was less than $1 million at both September 30, 2009 and December 31, 2008.
There were 36,750 and 47,150 stock options exercised for the three and nine months ended September 30, 2009, respectively. None of these stock option exercises were by executive officers. There were no stock options exercised for the three months ended September 30, 2008, and 43,812 stock options exercised for the nine months ended September 30, 2008. In the first nine months of 2008, officers exercised 7,750 options and surrendered 6,050 shares to pay exercise costs and taxes totaling less than $1 million, within the guidelines of the Incentive Plan. The total intrinsic value or gain (fair market value less exercise price) for options exercised was less than $1 million in each of the three and nine months ended September 30, 2009 and 2008.
As of September 30, 2009 and December 31, 2008, there were 43,184 and 53,242 shares, respectively, of restricted stock outstanding. Restrictions on these shares lapse through January 2013. There were no restricted stock awards granted during the three and nine months ended September 30, 2009.
As of September 30, 2009 and December 31, 2008, there were 1,234,718 and 1,730,531, respectively, of DSUs outstanding, of which 256,366 and 522,826, respectively, had vested. There were 32,968 and 76,990 DSUs granted during the three and nine months ended September 30, 2009. During the three and nine months ended September 30, 2009, DSU distributions to participants in the Executive Deferred Compensation Plan (EDCP) totaled 242,930 and 522,147, respectively. There were less than $1 million and $7 million of cash distributions to EDCP participants during the three and nine months ended September 30, 2009, respectively.
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The ESPP allows a maximum of 200,000 shares of common stock to be purchased in aggregate for all employees. As of September 30, 2009 and December 31, 2008, 85,700 and 67,306 shares have been purchased, respectively, and there remained a negligible amount of uninvested employee contributions in the ESPP.
Components of our operating expenses for the three and nine months ended September 30, 2009 and 2008 are presented in the following table.
For both the three and nine months ended September 30, 2009, we recognized a benefit from income taxes of less than $1 million, relating to our anticipation of applying this year’s net operating losses at certain taxable subsidiaries to offset taxable income generated in prior years. For the three and nine months ended September 30, 2008, our benefit from income taxes was $10 million and $7 million, respectively. The following is a reconciliation of the statutory federal and state tax rates to our projected annual effective rate at September 30, 2009 and 2008.
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In November 2008, our Board of Directors announced its intention to pay a regular quarterly dividend to shareholders during 2009 of $0.25 per share, which has since been declared and paid for the first three quarters of 2009. We currently anticipate recognizing a REIT taxable loss for 2009, and thus, these dividend distributions will likely be characterized as a return of capital for tax purposes.
We assessed our tax positions in accordance for all open tax years (Federal — years 2006 to 2008, State — years 2005 to 2008) and concluded as of September 30, 2009 and December 31, 2008, that we have no material unrecognized liabilities.
We evaluated subsequent events through November 4, 2009 the date the financial statements were available to be issued. In our evaluation, we determined there were no material recognized or unrecognized subsequent events.
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Redwood Trust, Inc., together with its subsidiaries, is a financial institution that seeks to invest in real estate related assets that have the potential to provide attractive cash flows over a long period of time and support our goal of distributing attractive levels of dividends to our stockholders. For tax purposes, we are structured as a real estate investment trust, or REIT. We are able to pass through substantially all of our earnings generated at our REIT to our stockholders without paying income tax at the corporate level. We pay income tax on the REIT taxable income we retain and on the income we earn at our taxable subsidiaries. Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. Our executive offices are located at One Belvedere Place, Suite 300, Mill Valley, California 94941.
References herein to “Redwood,” the “company,” “we,” “us,” and “our” include Redwood Trust, Inc. and its consolidated subsidiaries, unless the context otherwise requires. Financial information concerning our business is set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the consolidated financial statements and the notes thereto, and the supplemental financial information, which is included in Part I, Items 1 and 2 of this Quarterly Report on Form 10-Q.
Our website can be found at www.redwoodtrust.com. We make available, free of charge through the investor information section of our website, access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the U.S. Securities Exchange Act of 1934, as well as proxy statements, as soon as reasonably practicable after we electronically file such material with, or furnish it to, the U.S. Securities and Exchange Commission (SEC). We also make available, free of charge, access to our Corporate Governance Standards, charters for our Audit Committee, Compensation Committee, and Corporate Governance and Nominating Committee, our Corporate Governance Standards, and our Code of Ethics governing our directors, officers, and employees. Within the time period required by the SEC and the New York Stock Exchange, we will post on our web site any amendment to the Code of Ethics and any waiver applicable to any executive officer, director, or senior officer (as defined in the Code). In addition, our web site includes information concerning purchases and sales of our equity securities by our executive officers and directors, as well as disclosure relating to certain non generally accepted accounting principles (GAAP) and financial measures (as defined in the SEC’s Regulation G) that we may make public orally, telephonically, by webcast, by broadcast, or by similar means from time to time. The information on our website is not part of this Quarterly Report on Form 10-Q.
Our Investor Relations Department can be contacted at One Belvedere Place, Suite 300, Mill Valley, CA 94941, Attn: Investor Relations, telephone (866) 269-4976.
This Quarterly Report on Form 10-Q and the documents incorporated by reference herein contain forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve numerous risks and uncertainties. Our actual results may differ from our beliefs, expectations, estimates, and projections and, consequently, you should not rely on these forward-looking statements as predictions of future events. Forward-looking statements are not historical in nature and can be identified by words such as “anticipate,” “estimate,” “will,” “should,” “expect,” “believe,” “intend,” “seek,” “plan” and similar expressions or their negative forms, or by references to strategy, plans, or intentions. These forward-looking statements are subject to risks and uncertainties, including, among other things, those described in our 2008 Annual Report on Form 10-K and in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2009, in each case set forth under the caption “Risk Factors.” Other risks, uncertainties, and factors that could cause actual results to differ materially from those projected are described below and may be described from time to time in reports we file with the SEC, including reports on Forms 10-Q and 8-K. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
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Statements regarding the following subjects, among others, are forward-looking by their nature: (i) the future cash flows and investment returns we expect to receive from our investments and the timing of the receipt of such cash flows, including, without limitation, whether we will realize investment returns consistent with our base case, stress case, or upside case for any particular assets or group of assets; (ii) our beliefs about the future direction of housing market fundamentals, including, without limitation, home prices, mortgage delinquencies, inventory of homes for sale, percentage of voluntary and involuntary home sales, and mortgage interest rates; (iii) our views on the sustainability of government interventions into various financial markets and the possible future effects of the government’s withdrawal from such interventions; (iv) statements regarding our future investment strategy and our strategy for managing various risks, including, without limitation, interest rate risk and our statements regarding our ability to find and create attractive investments in the future, including, without limitations, statements about our ability to participate in future securitization transactions and credit risk transfers; (v) our characterizations of the performance of investments that remain outstanding, which performance, therefore, remains subject to change in the future; (vi) statements about the possible future direction of any economic recovery, the future direction of market prices for assets we invest in, and future trends relating to our pace of acquiring or selling assets; (vii) our views about the future direction of the commercial real estate sector and our potential future investment activity in this sector, and the attractiveness of any future investment in this sector; (viii) our statements regarding future capital raising activity and our belief that we have sufficient resources to meet our capital needs for the foreseeable future; (ix) our expectations regarding future credit losses and impairments on our investments; (x) our statements regarding future operating expenses; (xi) our views regarding the drivers of interest income in future periods; (xii) our statement that we do not anticipate calling any Sequoia securitizations in 2009 or 2010; (xiii) our expectations relating to tax accounting that we will report a taxable loss in 2009 and that all 2009 dividends will characterized as a return of capital, our anticipation of additional losses for tax accounting purpose (and our statements regarding likely future trends in this regard), and our statement that our quarterly taxable income will remain volatile; and (xiv) statements relating to our board of directors’ intention to pay a regular dividend of $0.25 per share per quarter in 2009 and that we do not expect to pay a special dividend in 2009.
Important factors, among others, that may affect our actual results include: changes in interest rates; changes in mortgage prepayment rates; the timing of credit losses within our portfolio; our exposure to adjustable-rate and negative amortization mortgage loans; the state of the credit markets and other general economic conditions, particularly as they affect the price of earning assets and the credit status of borrowers; the concentration of the credit risks we are exposed to; the ability of counterparties to satisfy their obligations to us; legislative and regulatory actions, including those affecting the mortgage industry or our business; the availability of high quality assets for purchase at attractive prices; declines in home prices and commercial real estate prices; increases in mortgage payment delinquencies; changes in the level of liquidity in the capital markets which may adversely affect our ability to finance our real estate asset portfolio; changes in liquidity in the market for real estate securities, the re-pricing of credit risk in the capital markets, inaccurate ratings of securities by rating agencies, rating agency downgrades of securities, and increases in the supply of real estate securities available-for-sale, each of which may adversely affect the values of securities we own; the extent of changes in the values of securities we own and the impact of adjustments reflecting those changes on our income statement and balance sheet, including our stockholders’ equity; our ability to maintain our status as a real estate investment trust for tax purposes; our ability to generate the amount of cash flow we expect from our investment portfolio; changes in our investment, financing, and hedging strategies and the new risks that those changes may expose us to; changes in the competitive landscape within our industry, including changes that may affect our ability to retain or attract personnel; our failure to manage various operational risks associated with our business; our failure to maintain appropriate internal controls over financial reporting; our failure to properly administer and manage our securitization entities; risks we may be exposed to if we expand our business activities, such as risks relating to significantly increasing our direct holdings of loans; limitations imposed on our business due to our REIT status and our status as exempt from registration under the Investment Company Act of 1940; our ability to successfully deploy excess capital into attractive investment opportunities, and raise additional capital to fund our investing activity; and other factors not presently identified. Fair values for our securities and asset-backed securities (ABS) issued are dependent upon a number of market-based assumptions including future interest rates, prepayment rates, discount rates, credit
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loss rates, and the timing of credit losses. We use these assumptions to generate cash flow estimates and internal values for each individual security.
This Quarterly Report on Form 10-Q may contain statistics and other data that in some cases have been obtained from or compiled from information made available by servicers and other third-party service providers.
Redwood is a financial institution focused on investing in, financing, and managing residential and commercial real estate loans and securities. Our primary source of income is net interest income, which consists of the interest income we earn from our investments less the interest expenses we incur on our borrowed funds and other liabilities. We assume a range of risks in our investments and the level of risk is influenced by the manner in which we finance our purchases of, and derive income from, our investments. Our primary real estate investments include investments in real estate loans and securities, an investment in a private fund that we sponsor — Redwood Opportunity Fund, LP (the Fund) — and investments in securitization entities that we sponsor — Sequoia and Acacia.
Our direct investments in residential, commercial, and collateralized debt obligations (CDO) securities are currently financed with equity and long-term debt, although we may use short-term debt financing to acquire securities and loans from time to time. These investments are primarily senior and subordinate mortgage-backed securities backed by high-quality residential and commercial real estate loans. “High-quality” real estate loans are loans that typically have low loan-to-value ratios, borrowers with strong credit histories, and other indications of quality relative to the range of loans within U.S. real estate markets as a whole. The long term focus of our operations is to invest in subordinate securities (often below investment grade) that have concentrated structural credit risk. More recently, we have been investing in senior securities (often investment-grade) at distressed prices, which have the first right to cash flows in a securitization and therefore less concentrated credit risk than subordinate securities.
The entities that we sponsor — the Fund, Sequoia, and Acacia — invest in real estate assets. Assets held at the Fund include senior securities backed by non-prime residential and CDO collateral, which were funded through the sale of limited partnership interests to us and to third party investors. The offer and sale of these interests were privately placed and were not registered under the federal securities laws in reliance on an exemption from registration. Assets held at the Sequoia entities include residential real estate loans, which are funded through the issuance of ABS to us and to third party investors. Assets held at the Acacia entities include real estate securities, and some loans and other mortgage related investments, which are funded through the issuance of ABS and equity to us and to third party investors.
Our investments in each of these entities are currently financed with equity and long-term debt. Our capital at risk is limited to these investments as each entity is independent of Redwood and of each other and the assets and liabilities are not owned by and are not obligations of Redwood. For financial reporting purposes, we are generally required to consolidate these entities’ assets, liabilities, and noncontrolling interests.
Earlier this year, when there was substantial fear in the financial markets and prices for MBS had fallen to historic lows without a commensurate decrease in projected cash flows, we saw a buying opportunity. We raised capital in the first and second quarters of 2009 to capitalize on what we expected to be an extraordinary investment opportunity to acquire senior non-agency residential mortgage-backed securities (RMBS) at distressed prices. At that time we were extremely bearish on the underlying fundamentals for housing and employment. Yet even after factoring in that outlook, our target investments were projected to generate attractive base case returns, well-protected stress case returns, and exceptional upside returns if prepayments and credit outperformed our expectations. The securities that best fit our investment criteria were seasoned RMBS (issued in 2005 or earlier), backed by prime or near-prime borrowers.
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In hindsight, we were right — it was an extraordinary opportunity — and during the third quarter there was an increase in RMBS prices that has been good news for the overall value of our existing portfolio. Our earnings and book value are moving in the right direction, and our cash flows are strong, as shown in the Summary of Results of Operations, Financial Condition, Capital Resources and Liquidity.
The increase in RMBS prices, however, has also had the effect of diminishing our ability to invest additional capital to acquire senior non-agency RMBS at distressed prices. Predictably, this unprecedented investment opportunity for senior mortgage securities attracted lots of investors, and numerous competitors followed after us, raising a substantial amount of capital to invest in the sector. This new pool of capital and other technical factors contributed to the upward movement of residential and commercial mortgage-backed security prices in the second and third quarters, as shown in the following chart.
Senior RMBS Prices
Source: JPMorgan Chase
We believe the primary drivers of the upward movement in RMBS prices have been the deluge of new liquidity into the secondary mortgage markets and the positive effects of government initiatives. Liquidity has come from renewed buying by traditional banks as well as new entrants into the RMBS space such as hedge funds and newly formed REITs. Liquidity has also come from a market shift away from lower-risk, lower-yielding instruments and into higher-risk, higher-yielding instruments. The Federal Reserve and Treasury Department have undertaken extraordinary steps to introduce liquidity and leverage into the capital markets as a strategy to increase the value of financial assets; these programs have included the zero interest rate policy, direct government purchases of RMBS, TALF (Term Asset-Backed Securities Loan Facility), and PPIF (Public-Private Investment Fund).
Although price appreciation on securities has increased the value of our existing portfolio of securities, it has generally reduced the potential returns we believed we could generate from new investments. As a result, during the third quarter we began reducing our acquisition activity of RMBS, and increased our focus on
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other investment opportunities. The increase in prices has also given us an exceptional opportunity to cull our portfolio. We have been selling our weakest performing assets from a credit standpoint to investors that are either willing to accept lower returns, have a more bullish view on housing and prepayment fundamentals, or are enhancing yields by employing leverage. To that end, we sold $57 million of RMBS during the second quarter of 2009, $74 million in the third quarter, and another $34 million in October.
Our decision to acquire senior RMBS at steep discounts was an investment opportunity for Redwood, not a long-term business plan. We quickly took advantage of that opportunity and began stepping aside when the potential rewards were no longer apparent to us based upon our analysis of current market prices and expected returns. Our success at Redwood has been driven in part by our history of being patient and disciplined investors. This includes pulling back from investment strategies when appropriate. And so while we have slowed our RMBS investment pace for now, we remain hard at work developing other ways to invest our capital to the benefit of our shareholders. For instance, we continue to work with our business partners to fashion customized credit solutions for large institutional investors such as banks and insurance companies.
With respect to the fundamentals underlying our investments, from a credit standpoint, serious delinquencies on prime mortgages have risen significantly since the beginning of the year, consistent with the scenarios we modeled and well within our range of expectations. On the prepayment side, prime and higher quality non-prime loans have generally paid down at a rate on the higher end of our expectations, due to seasonal factors and the low mortgage rates available to borrowers who conform to the underwriting guidelines of Fannie Mae, Freddie Mac, and the Federal Housing Administration (collectively referred to as government sponsored enterprises, or GSEs). Overall, this is good news — credit performance has been tracking in line with our expectations and prepayments have been somewhat faster than we expected.
There are varying opinions on the outlook for residential and commercial real estate investments. If prices continue to remain elevated, it will be more challenging to find senior RMBS investments that both meet our investment criteria and exceed our risk-adjusted return requirements. This is consistent with our long-standing view that the senior RMBS opportunity was just that — a limited opportunity created by unprecedented market conditions. We do not intend to react to these market conditions by accepting lower yields, changing our investment risk criteria, or trying to enhance yields with repo or other callable financing. Accordingly, our recent investment pace has slowed, from $341 million in the second quarter, to $246 million in third quarter, and to $6 million in October. It is possible that the trend towards higher prices could reverse if investors’ perception of credit risk heightens or if government programs do not work as the market expects. If this happens, senior RMBS may once again be an attractive investment opportunity.
Looking forward, our goal is to create our own investments and to minimize our dependence on market liquidity cycles, which at the end of the day are out of anyone’s control. To this end, we are engaged with originators, triple-A investors, rating agencies, industry trade groups, and government representatives to restart the private securitization markets for mortgage loans. In the long run, we believe that it is important and necessary for the residential mortgage market to have a non-government, non-GSE securitization alternative, especially because it is inefficient to return to the day when mortgages were only financed through bank portfolio lending. Ultimately, when the private securitization markets begin to function again, we believe we will have an opportunity to resume our leading role in credit enhancing jumbo mortgages while generating long-term cash flows from credit investments we either created or acquired.
Unlike some forecasters, we are not calling a bottom to the decline in home prices — in fact, we are modeling a further overall decline in home prices nationwide. We expect downward price pressure on housing to be caused by a mounting oversupply of homes for sale, stubbornly high unemployment, and a higher percentage of foreclosures and other involuntary transactions in the fall and winter. We believe these negative factors will trump the often-touted positive impact from increased borrower affordability.
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We believe that the unprecedented level of government intervention in the mortgage markets is most likely unsustainable and are watching and preparing for the eventual withdrawal of government support. The government is currently supporting essentially the entire mortgage market, as Fannie Mae, Freddie Mac, and the Federal Housing Administration (FHA) collectively guaranteed over 90% of the $995 billion of industry-wide loan originations in the first half of 2009, up from an average of 50% over the last 20 years. Through late October 2009, the Federal Reserve has also purchased nearly $1 trillion out of a planned $1.25 trillion of agency MBS in an attempt to lower mortgage rates and enable borrowers to refinance and lower their mortgage payments. Once the government withdraws this support (assuming all other things remain unchanged), we will likely see mortgage rates move higher. Unfortunately, this will require a highly complex and lengthy unwinding process that we believe will likely take much longer than most people expect and may have long term lingering effects on large parts of the economy.
As the government pulls back from supporting the mortgage market, triple-A investors of private capital such as pension funds, insurance companies, and banks, along with other credit investors such as Redwood, will be watching for many needed improvements in the mortgage securitization process. To rebuild investor trust, we believe that (among other things) originators must demonstrate that the loan underwriting process has improved, rating agencies must reform their methodologies, and the sanctity of contract law must be preserved, despite recent challenges pertaining to the agreements governing securitizations.
The commercial mortgage sector has historically represented a strategic area of growth for Redwood. We began making commercial investments in 1998, but it has been nearly three years since we last made a new commercial investment, as we have patiently waited for the risk/return balance to tip back in our favor. As we discuss below, we feel that the time to re-enter this sector is nearing. To that end, in September we hired Scott Chisholm to oversee our commercial mortgage activities. Mr. Chisholm was most recently a Managing Director and Head of the New York office for Prudential Mortgage Capital Company.
As we look at the commercial sector we see the significant and growing imbalance in the supply and demand for commercial loan financing. Most traditional lenders, with the exception of the GSEs, are largely inactive and internally focused on their own credit and capital issues. The volume of new lending has slowed dramatically, commercial mortgage financing is becoming increasingly scarce, and there is approximately $1.4 trillion of commercial mortgage debt maturing over the next three years. Given these factors, we are confident that there will be opportunities to deploy capital in the not too distant future on high quality commercial assets at attractive risk-adjusted yields.
With respect to any plans for raising capital, our philosophy since Redwood was founded has been to ask for capital only if we have a use for it. It seems unlikely that we would seek additional equity capital in the near term. Our management team is compensated based on the results we generate for shareholders, not the amount of equity we manage. We believe our current cash position, projections of future cash flows, and our ability to free up capital internally is sufficient to meet our capital needs for the foreseeable future. We would reevaluate our capital needs if there was a significant unforeseen change in the level of attractive investment opportunities.
Looking forward, our future GAAP earnings will largely be driven by our recently acquired residential senior and re-REMIC securities, which currently comprise 68% of our total earning assets. The predominance of senior cash flows in our portfolio makes our future returns less sensitive to credit risk than in the past, although we are still exposed to significant credit risk. Future earnings will also be impacted by how we deploy our remaining cash balances, which currently comprise 20% of our total earning assets, and future cash flows. As we noted above, our earnings are moving in the right direction, but our goal is to increase them above the current level. In order to accomplish that goal we will need to invest more of our cash balances in order to reduce the earnings drag from carrying high levels of cash. However, we will remain patient investors, as we believe that it is more important to make the right investment, than make investments quickly.
To the extent our loss expectations do not significantly change and we continue to hold fewer subordinate securities, we expect impairments to remain at or below current period levels. We continue to observe our GAAP results and the economics of our business moving more in-line with each other. Having said that, we may engage in complex transactions where GAAP accounting and our business economics once again diverge.
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We anticipate a taxable loss at the REIT for the 2009 tax year and therefore expect all of this year’s dividends to be characterized as a return of capital. Our quarterly taxable income is likely to remain volatile as it is difficult to accurately project the quarter in which anticipated credit losses on our legacy investments will be realized for tax accounting purposes.
Our reported GAAP net income was $27 million ($0.35 per share) for the third quarter of 2009, as compared to a GAAP net loss of $111 million ($3.34 per share) for the third quarter of 2008. Our GAAP book value per common share was $11.68 at September 30, 2009, an increase from $9.02 at December 31, 2008. We declared a regular dividend of $0.25 per share for the third quarter of 2009 and $0.75 per share for the third quarter of 2008.
The following table presents the components of our GAAP net income (loss) for the three and nine months ended September 30, 2009 and 2008.
Net interest income was $46 million for the third quarter of 2009 as compared to $39 million for the third quarter of 2008, an increase of $7 million. The increase was primarily due to higher average balances of residential senior securities held at Redwood that are funded with equity. Net interest income after provision and market valuation adjustments was $24 million for the third quarter of 2009 as compared to a loss of $106 million for the third quarter of 2008, an increase of $130 million. This increase was primarily due to lower negative market valuation adjustments (MVA) at Redwood due to fewer impairment charges on securities and an $8 million decrease in the provision for loan losses at Sequoia due to lower balances of residential loans.
Operating expenses were $15 million for the third quarter of 2009 as compared to $17 million for the third quarter of 2008, a decrease of $2 million. This decrease was primarily due to a reduction in headcount and fewer legal and consulting expenses, partially offset by an increase in variable compensation expense. We currently anticipate that operating expenses will be lower in the fourth quarter of 2009, as compared to the third quarter of 2009. However, operating expenses could increase in subsequent periods as we focus on our new business development activities.
Realized gains, net, were $18 million for the third quarter of 2009 as compared to less than a $1 million loss for the third quarter of 2008, an increase of $18 million. This increase was due to gains on sales of securities and the repurchase of long-term debt during the third quarter of 2009.
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The Results of Operations section of this Management’s Discussion and Analysis contains a detailed analysis of the components of net income.
Our estimated total taxable loss was $23 million ($0.30 per share) for the third quarter of 2009 as compared to taxable income of $2 million ($0.07 per share) for the third quarter of 2008, a decrease of $25 million. Our estimated REIT taxable loss was $25 million ($0.32 per share) for the third quarter of 2009 as compared to REIT taxable income of $2 million ($0.07 per share) for the third quarter of 2008, a decrease of $27 million. The increase in the REIT taxable loss was primarily due to an increase in realized credit losses on subordinate securities. Realized credit losses at the REIT for the third quarters of 2009 and 2008 were $67 million and $33 million, or $0.86 and $0.99 per share, respectively.
Our REIT taxable income is that portion of our total taxable income that we earn at Redwood and its qualifying REIT subsidiaries and determines the minimum amount of dividends we must distribute to shareholders in order to maintain our tax status as a REIT.
The Financial Condition, Liquidity, and Capital Resources section of this Management’s Discussion and Analysis contains a detailed discussion and analysis of the components of GAAP book value at September 30, 2009 and December 31, 2008. The following supplemental non-GAAP components of book value addresses our assets and liabilities at September 30, 2009, as reported under GAAP and as estimated by us using fair values for our investments. We show our investments in the Fund, and the Sequoia and Acacia entities as separate line items to highlight our specific ownership interests, as the underlying assets and liabilities of these entities are legally not ours. Our non-GAAP estimated economic value is calculated using bid-side asset marks (or estimated bid-side values) and offer-side marks for our financial liabilities (or estimated offered-side values), as required to determine fair value under GAAP. This method of calculating economic value more closely represents liquidation value and does not represent the higher amount we would have to pay at the offered-side to replace our existing assets or the higher amount we would have to pay to redeem our liabilities. For additional information to consider when reviewing the following table, please see “Factors Affecting Management’s Estimate of Economic Value” below.
During the third quarter, our GAAP book value increased by $1.33 per share to $11.68. The increase resulted from $1.09 per share of positive market valuation adjustments and $0.49 per share from earnings before market valuation adjustments, less $0.25 per share of dividends. Our estimate of economic book value increased by $0.98 per share to $12.28. Economic value is determined by calculating the fair value of our investments in consolidated entities directly as opposed to deriving their reported GAAP values by netting
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their consolidated assets and liabilities. In calculating our estimate of economic value, we also value our long-term debt at its estimated fair value rather than its amortized cost basis as reported for GAAP.
In reviewing our non-GAAP estimate of economic value, there are a number of important factors and limitations to consider. The estimated economic value of our stockholders’ equity is calculated as of a particular point in time based on our existing assets and liabilities or, in certain cases, our estimate of economic value of our existing assets and liabilities, and does not incorporate other factors that may have a significant impact on that value, most notably the impact of future business activities and cash flows. As a result, the estimated economic value of our stockholders’ equity does not necessarily represent an estimate of our net realizable value, liquidation value, or our market value as a whole. Amounts we ultimately realize from the disposition of assets or settlement of liabilities may vary significantly from the estimated economic values of those assets and liabilities. Because temporary changes in market conditions can substantially affect our estimate of the economic value of our stockholders’ equity, we do not believe that short-term fluctuations in the economic value of our assets and liabilities are necessarily representative of the effectiveness of our investment strategy or the long-term underlying value of our business. When quoted market prices or observable market data are not available to estimate fair value, we rely on Level 3 inputs. Because assets and liabilities classified as Level 3 are generally based on unobservable inputs, the process of calculating economic value is generally subjective and involves a high degree of management judgment and assumptions. These assumptions may have a significant effect on our estimates of economic value, and the use of different assumptions as well as changes in market conditions could have a material effect on our results of operations or financial condition.
The following chart summarizes the economic value of our cash, securities, and investments at September 30, 2009
Cash, Securities, and Investments at RedwoodSeptember 30, 2009($ in millions)
We have segmented our securities portfolio by acquisition date in the above chart to highlight that 91% of the economic value of our cash, securities, and investments are currently held in cash or in recently acquired securities. Our future earnings will be primarily driven by the performance of these recent investments along with how we deploy our existing cash and future cash flows.
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The following table presents the components of fair value (which equals GAAP carrying value) for real estate securities at Redwood at September 30, 2009. We segment our securities portfolio by priority of cash flows — senior, re-REMIC, and subordinate — and, for residential, by quality of underlying loans — prime and non-prime.
The following table details the net increase in the fair value of securities at Redwood during the three months ended September 30, 2009 and June 30, 2009.
During the third quarter, we acquired $246 million of residential securities. We also sold residential securities with a basis of $63 million and realized a gain of $11 million. We continue to prudently manage our portfolio and may sell additional assets as conditions merit. The table below details our acquisitions in the current quarter.
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Principal payments reduced the fair value of our securities by $25 million during the third quarter compared to $13 million in the second quarter. The increase in principal payments primarily reflects the increase in size of our portfolio. Unscheduled prepayments on our securities were generally unchanged from the prior quarter.
We estimate that the change in fair value of our securities due to market price adjustments was an increase of $76 million during the third quarter. This increase was primarily due to increased demand for residential senior and re-REMIC securities.
In October 2009, we acquired $4 million in prime residential senior securities and $2 million in residential re-REMIC securities and sold $28 million of prime residential, $6 million of residential re-REMIC securities and $8 million of commercial subordinate securities.
Our investments in the Fund, Sequoia, and Acacia totaled $102 million, or 12% of our securities and investments at September 30, 2009. The fair value (which equals GAAP carrying value) of our investment in the Fund was $24 million. The Fund is primarily invested in non-prime residential securities and is managed by a subsidiary of Redwood. Our investment represents a 52% interest in the Fund.
The fair value of our investments at Sequoia was $47 million and the GAAP carrying value was $76 million. The $47 million of economic value consists of $45 million of interest-only securities (IOs) and $2 million of senior and subordinate securities, and is calculated using the same valuation process that we follow to fair value our other real estate securities. These IOs earn the “spread” between the coupon rate on the $2.5 billion notional amount of underlying adjustable rate mortgage (ARM) loans and the cost of funds (indexed to one-month LIBOR) on the ABS issued within each respective securitization entity. Returns on these investments increase when prepayments slow and decrease when prepayments speed up.
The fair value of our investments in Acacia was $2 million and the GAAP carrying value was $2 million. These investments consist of equity interests and securities in the Acacia CDO entities we sponsor, which have minimal value, as well as management fees. We valued the management fees at $2 million, which equals our projected management fees discounted at a 45% rate.
We continue to maintain our strong balance sheet and liquidity. At September 30, 2009, we had $217 million in cash and cash equivalents, or $2.79 per share, and we had $240 million in cash and cash equivalents at October 31, 2009. As of September 30, 2009, $19 million of our cash was either committed to future investments or unavailable for investment under our internal risk-adjusted capital and risk management policies. All of our cash is currently invested in U.S. Treasury Bills or bank deposits insured by the Federal Deposit Insurance Corporation.
We had no short-term debt at September 30, 2009. We currently fund our investments with permanent capital (equity and long-term debt) that is not subject to margin calls and financial covenants. At September 30, 2009, our total capital was $1.05 billion, which consisted of $907 million of common equity and $140 million of 30-year long-term debt due in 2037. The estimated fair value of this debt was $64 million
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at September 30, 2009, based upon a market price equal to 46% of face value. In July 2009, we repurchased $10 million of this debt at a market price equal to 34% of face value.
Our quarterly sources and uses of our cash is one of the financial metrics on which we focus. Therefore, as a supplement to the Consolidated Statement of Cash Flows included in this Quarterly Report on Form 10-Q, we show in the table below (i) the cash balance at the beginning and ending of the third and second quarters of 2009, which are GAAP amounts, and (ii) the components of sources and uses of cash organized in a manner consistent with the way management analyzes them. The presentation of our sources and uses of cash for the table below is derived by aggregating and netting all items within our GAAP Consolidated Statement of Cash Flows for the appropriate periods.
Third quarter business cash flow totaled $68 million, up $13 million from the second quarter, as cash flow from our investment portfolio increased by $14 million, cash operating expenses increased by $2 million, and interest on our long-term debt declined by $1 million. Third quarter acquisitions were $246 million.
Third quarter cash flow from securities and investments included $32 million of coupon interest and $46 million of principal. Given the nature of our investments (e.g., deep discount subordinated securities, senior securities acquired at discounts, IOs, equity investments in Acacia, and other types) it is difficult to draw conclusions in any one period about what portion of our cash flow represents “income” and what represents a “return of capital.” It is only at the end of an asset’s life that we can accurately determine what portion of the cumulative cash received (whether principal or interest) was income and what was a return of capital.
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The table below presents the components of our cash flow from securities and investments for the three months ended September 30, 2009 and June 30, 2009.
Since we are acquiring more senior securities, the variability of the cash flows we receive every quarter will be primarily dependent on prepayment speeds, and since prepayments will vary, there will be some volatility in the cash flows generated by our senior securities portfolio. We generated $3 million in cash (all interest) from our investments in re-REMICs in the third quarter. The large majority of this cash was from our second quarter investments.
Cash flow generated from our residential subordinated securities totaled $14 million in the third quarter, compared to $18 million in the second quarter, and totaled $52 million in the first nine months of 2009. In the third quarter, we received $8 million from principal payments and $6 million from interest. We earn cash interest payments on the face value ($521 million at September 30, 2009), which is reduced by principal paydowns and credit losses. Credit losses can vary significantly from period to period and totaled $97 million in the third quarter, compared to $127 million in the second quarter. We expect credit losses will remain at elevated levels and thus, cash flows will trend down, and, if the expected credit losses occur quickly, the decline in cash flows from this portfolio could be rapid.
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The following discussion is based upon management’s consolidating results for Redwood, the Fund and Securitization Entities (Sequoia and Acacia) and acts as a supplement to our GAAP results for the three and nine months ended September 30, 2009 and 2008.
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The following table presents the net interest income (loss) after MVA at Redwood for the three and nine months ended September 30, 2009 and 2008.
Net interest income at Redwood was $29 million for the third quarter of 2009 as compared to $23 million for the third quarter of 2008, an increase of $6 million. The increase was primarily due to higher
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average balances of investment securities that were funded with equity. Net interest income at Redwood was $70 million for the first nine months of 2009 as compared to $79 million for the first nine months of 2008, a decline of $9 million. The decline was primarily due to lower interest yields on our subordinate securities as a result of our adoption of new accounting guidance for measuring OTTI, partially offset by higher overall balances of senior securities.
Interest income at Redwood was $30 million for the third quarter of 2009, as compared to $23 million for the third quarter of 2008, an increase of $7 million. Interest income was $73 million for the first nine months of 2009, as compared to $82 million for the first nine months of 2008, a decline of $9 million.
The following table details how interest income changed as a result of changes in average investment balances (“volume”) and changes in interest yields (“rate”). In both periods, the balance of securities increased and the rate of interest decreased.
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The following table presents the components of the interest income we earned on available-for-sale (AFS) securities in the three and nine months ended September 30, 2009 and 2008.
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Interest expense at Redwood was $1 million for the third quarter of 2009, as compared to $2 million for the third quarter of 2008, a decline of $1 million. Interest expense was $5 million for the first nine months of 2009, as compared to $7 million for the first nine months of 2008, a decline of $2 million.
The following table details how interest expense at Redwood changed as a result of changes in average debt balances (“volume”) and interest yields (“rate”). Interest expense declined due to the corresponding decline in debt balances as well as lower benchmark LIBOR interest rates over the past twelve months.
At Redwood, most of our assets are funded with equity capital. At September 30, 2009, we had no short-term debt and $140 million long-term debt outstanding. At September 30, 2008, we had $7 million of short-term debt and $150 million of long-term debt outstanding.
The GAAP accounting principles that determine the timing and amount of market valuation adjustments recorded to our financial statements are complex and may not clearly reflect the timing, nature, and extent of economic changes impacting the fair values of our investments during any specific reporting period.
The following table shows the impact of market valuation adjustments on our consolidated statements of income (loss) and our consolidated balance sheets for the three and nine months ended September 30, 2009 and 2008.
In the second quarter of 2009, we adopted new accounting guidance for other-than-temporary (OTTI) impairments. As part of this adoption, we were required to evaluate $431 million of OTTI at Redwood that
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was previously expensed through our consolidated statements of income (loss). Upon evaluation, we determined that $58 million of this OTTI, net of tax, related to non-credit factors and reclassified this portion of total OTTI to accumulated other comprehensive income (loss) (OCI). This adjustment effectively increased retained earnings and decreased accumulated comprehensive income (loss), resulting in zero net impact to our reported stockholders’ equity.
In the third quarter of 2009, we recognized $23 million of impairments at Redwood. Of this amount, $8 million was recognized in our consolidated statement of income and $15 million was recognized as a reduction in stockholders’ equity.
The following table presents the components of operating expenses for the three and nine months ended September 30, 2009 and 2008.
Operating expenses were $15 million for the third quarter of 2009, as compared to $17 million for the third quarter of 2008, a decline of $2 million. The decline was primarily due to a $3 million decrease in non-recurring legal expenses. This decline was partially offset by a $2 million increase in total compensation expense.
The following table details the components of realized gains on sales of investments, net, for the three and nine months ended September 30, 2009 and 2008.
Realized gains of $18 million for the third quarter of 2009 reflect increased gains on the sales of securities as part of our ongoing portfolio management activities and the repurchase of long-term debt at a
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significant discount to the principal amount. Realized gains of $44 million for the first nine months of 2009 also include a $19 million gain from the deconsolidation of a Sequoia securitization entity during the second quarter of 2009.
We consolidate the Fund as we have determined that we are the primary beneficiary of this entity.
The following table presents the components of the interest income we earned on AFS securities at the Fund in the three and nine months ended September 30, 2009 and 2008.
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Net interest income at the Fund was $2 million and $7 million, respectively, for the three and nine months ended September 30, 2009, and compared to net interest income of $3 million and $8 million, respectively, for the three and nine months ended September 30, 2008. The declines in net interest income were primarily due to lower expected yields on AFS securities. This reduced discount amortization income over these periods.
The following table shows the impact of market valuation adjustments on our consolidated statements of income (loss) and our consolidated balance sheets and for the three and nine months ended September 30, 2009 and 2008.
At the Fund, there were $1 million and $6 million, respectively, of negative market valuation adjustments on AFS securities recognized through our consolidated statements of income (loss) for the three and nine months ended September 30, 2009, all of which were deemed to be OTTI.
We consolidate all Sequoia and Acacia entities that do not qualify as sales for financial reporting purposes. The following table presents the net interest (loss) income at Sequoia, and Acacia for the three months ended September 30, 2009 and 2008.
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Net interest income at Sequoia and Acacia was $15 million for the third quarter of 2009 as compared to $13 million in the third quarter of 2008, an increase of $2 million. Net interest income at Sequoia and Acacia was $39 million in the first nine months of 2009 as compared to $41 million in the first nine months of 2008, a decline of $2 million. These differences were primarily due to the amount and timing of spread changes between the income and expense yields on loans and ABS issued at Sequoia. These changes were largely due to changes in benchmark LIBOR interest rates. Overall net interest income declined during these periods due to lower average balances of loans and securities at Acacia and Sequoia.
Interest income at Sequoia and Acacia was $39 million for the third quarter of 2009, as compared to $105 million in the third quarter of 2008, a decline of $66 million. Interest income was $148 million for the first nine months of 2009, as compared to $360 million for the first nine months of 2008, a decline of $212 million.
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The following table details how interest income changed as a result of changes in average investment balances (“volume”) and changes in interest yields (“rate”) at Sequoia and Acacia. Interest income declined primarily due to lower average balances of loans at Sequoia and securities at Acacia, along with lower benchmark LIBOR interest rates on loans at Sequoia.
Average balances of loans at Sequoia decreased due to principal repayments on loans and securities with no offsetting acquisition activity. The average prepayment rate for Sequoia loans was 11% during the third quarter of 2009 as compared to 15% in the third quarter of 2008. At September 30, 2009, 95% of loan principal outstanding consisted of one-month or six-month LIBOR ARMs and 5% of loan principal outstanding consisted of hybrid ARMs. Sequoia loans also decreased due to the deconsolidation of certain Sequoia entities during the past nine months.
Interest income declined primarily because of lower volume due to declining market values on securities which reduced average balances. Partially offsetting lower volume is that the yields we accrete on many securities have increased as a result of lower market values, despite generally lower short-term LIBOR index rates during the third quarter and first nine months of 2009 as compared to the third quarter and first nine months of 2008.
Interest expense at Sequoia and Acacia was $25 million for the third quarter of 2009, as compared to $92 million in the third quarter of 2008, a decline of $67 million. Interest expense was $110 million for the first nine months of 2009, as compared to $319 million for the first nine months of 2008, a decline of $209 million.
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The following table details how interest expense at Sequoia and Acacia changed as a result of changes in average debt balances (“volume”) and interest yields (“rate”).
Interest expense declined primarily due to lower average balances of ABS issued at Sequoia and Acacia, along with lower benchmark LIBOR interest rates at Sequoia. The interest rates for ABS issued at Acacia have increased despite declining benchmark LIBOR rates due to higher market yields as these ABS issued are recorded at fair value for financial reporting purposes.
The provision for loan losses was $10 million and $41 million for the three and nine months ended September 30, 2009, respectively, as compared to $18 million and $36 million for the three and nine months ended September 30, 2008, respectively. The allowance for loan losses increased to $50 million, or 1.30% of the residential loan balance, at September 30, 2009, from $47 million, or 0.77% of the residential loan balance at September 30, 2008. Serious delinquencies on Sequoia loans (90+ days delinquent) increased to $145 million, or 3.79% of residential loan balances at September 30, 2009, from $143 million, or 2.36%, at September 30, 2008. As of September 30, 2009, there were no Sequoia trusts in which we had an allowance for loan losses in excess of our investment.
At Sequoia, there were $1 million of negative mark-to-market adjustments on real estate owned properties recognized through the consolidated statements of income (loss) for the third quarter of 2009. At Acacia, there were net negative market valuation adjustments of $1 million for all assets and liabilities at Acacia recognized through our consolidated statements of income (loss) for the third quarter of 2009. There were net negative market valuation adjustments of $9 million for all assets and liabilities at Acacia recognized through our consolidated statements of income (loss) for the first nine months of 2009.
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We expect quarter-to-quarter GAAP earnings volatility from our business activities at Redwood and our consolidated entities. This volatility can occur for a variety of reasons, including the timing and amount of purchases, sales, calls, and repayment of consolidated assets, changes in the fair values of consolidated assets and liabilities, and certain non-recurring events. In addition, volatility may occur because of technical accounting issues, some of which are described below.
The unamortized premium for loans owned by Sequoia was $53 million at September 30, 2009. The amount of periodic premium amortization expense we recognize is volatile and dependent on a number of factors, including credit performance of the underlying loans, changes in prepayment speeds, and changes in short-term interest rates. Loan premium amortization was $15 million in the first nine months of 2009, compared to $21 million for the first nine months of 2008. We expect loan premium amortization in the fourth quarter of 2009 to be slightly lower than the third quarter’s level.
The yields we project on real estate securities can have a significant and potentially volatile effect on the periodic interest income we recognize for financial reporting purposes. Yields can vary as a function of credit results, prepayment rates, and interest rates. If estimated future credit losses are less than our prior estimate, credit losses occur later than expected, or prepayment rates are faster than expected (meaning the present value of projected cash flows is greater than previously expected for assets acquired at a discount to face value), the yield over the remaining life of the security may be adjusted upwards. If estimated future credit losses exceed our prior expectations, credit losses occur more quickly than expected, or prepayments occur more slowly than expected (meaning the present value of projected cash flows is less than previously expected for assets acquired at a discount to face value), the yield over the remaining life of the security may be adjusted downward.
Changes in the actual maturities of real estate securities may also affect their yields-to-maturity. Actual maturities are affected by the contractual lives of the associated mortgage collateral, periodic payments of principal, and prepayments of principal. Therefore, actual maturities of AFS securities are generally shorter than stated contractual maturities. Stated contractual maturities are generally greater than ten years. There can be no assurance that our assumptions used to estimate future cash flows or the current period’s yield for each asset will not change in the near term, and the change could be material.
All of the securities owned at Redwood and consolidated entities are classified as either trading or available-for-sale (AFS) securities, and in both cases are carried on our consolidated balance sheets at their estimated fair values. For trading securities, changes in fair values are recorded in the consolidated statements of income (loss). Periodic fluctuations in the values of these investments are inherently volatile and thus can lead to significant GAAP earnings volatility each quarter.
For AFS securities, cumulative unrealized gains and losses are recorded as a component of accumulated other comprehensive income (loss) in our consolidated statements of equity. Unrealized gains and losses are not charged against current earnings to the extent they are temporary in nature. Certain factors may require us however, to recognize these amounts as other-than-temporary impairments and record them through our current earnings. Factors that determine other-than-temporary-impairment include a change in our ability or intent to hold assets, adverse changes to projected cash flows of assets, or the likelihood that declines in the fair values of assets would not return to their previous levels within a reasonable time. Impairments can lead to significant GAAP earnings volatility each quarter.
As of January 1, 2008, we elected to adopt a new accounting standard, the fair value option, to record the assets and liabilities in Acacia and certain other assets at Redwood at fair value with changes in fair value recorded as a component of market valuation adjustments, net, in our consolidated statements of income (loss). We may also elect the fair value option for certain new acquisitions in the future. Our elections significantly reduced the disparity that existed between the GAAP carrying value of our Acacia equity
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investments and our estimate of their economic value. However, valuation changes in these financial instruments are inherently volatile and can lead to significant GAAP earnings volatility each quarter.
We can experience significant earnings volatility from our use of derivatives. We generally use derivatives to hedge cash flows on assets and liabilities that have different coupon rates (fixed rates versus floating rates, or floating rates based on different indices). The nature of the instruments we use and the accounting treatment for the specific assets, liabilities, and derivatives may lead to volatile periodic earnings, even when we are meeting our hedging objectives.
All derivatives are currently accounted for as trading instruments and their changes in market values flow through our consolidated statements of income (loss). The assets and liabilities we hedge may not be similarly accounted for as our hedging derivatives (e.g., they may be reported at cost, or only impairments may be reported through our consolidated statements of income (loss)). This could lead to reported income and book values in specific periods that do not necessarily reflect the economics of our hedging strategy. Even when the assets and liabilities are similarly accounted for as trading instruments, periodic changes in their value may not coincide as other market factors (e.g., supply and demand) may affect certain instruments and not others at any given time.
Changes in accounting principles can have a significant impact on the amount or timing of our reported GAAP earnings.
The following table summarizes our estimated taxable (loss) income and distribution to shareholders for the three and nine months ended September 30, 2009 and 2008.
For the three months ended September 30, 2009, we paid a regular quarterly dividend of $0.25. Since we currently expect a tax loss in 2009, the dividends we pay to shareholders in 2009 will likely be characterized as return of capital. Dividends characterized as return of capital are not taxable and reduce the basis of shares held at each quarterly distribution date. For the nine months ended September 30, 2009, we paid $0.75 per share in dividends.
Our estimated total taxable income for the third quarter of 2009 was negative $23 million ($0.30 per share) and included $67 million in credit losses. This compared to estimated total taxable income for the third quarter of 2008 of positive $2 million ($0.07 per share), which included $33 million of credit losses. We continue to expect credit losses to be the primary factor in our taxable income (loss) results for 2009.
There are differences in accounting for GAAP and tax that can lead to significant timing differences in the recognition of income and losses. For example, we are not allowed to anticipate credit losses for tax in a similar manner as for GAAP. As a result of these differences, our taxable income can differ significantly from our GAAP income during certain reporting periods.
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The tables below reconcile our tax and GAAP income for the three and nine months ended September 30, 2009 and 2008.
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Differences between taxable income and GAAP income are largely due to the following: (i) net interest income for tax is higher during the initial life of an asset due to the fact we cannot anticipate future credit losses in determining the current period yield for most assets; therefore, we generally amortize more of an asset’s purchase discount into income for tax than for GAAP prior to anticipated credit losses occurring; (ii) we cannot establish loss reserves for future anticipated events for tax, but can for GAAP; (iii) realized credit losses are expensed when incurred for tax; for GAAP, these losses are anticipated through lower yields on assets or through the loan loss provisions; (iv) the timing and possibly the amount of some expenses (e.g., compensation expenses) is different for tax than for GAAP; (v) since amortization and impairments differ for tax and GAAP, the tax and GAAP gains and losses on sales may differ, resulting in differences in realized gains on sale and, for tax purposes, we net capital losses against any available capital gains; and, (vi) for tax purposes, we do not consolidate noncontrolling interests or securitization entities as we do under GAAP.
We expect quarter-to-quarter estimated taxable income volatility for a variety of reasons, including the timing of credit losses and prepayments on our investments and the tax accounting for equity awards, as described below.
To determine estimated taxable income we are generally not permitted to anticipate, or reserve for, credit losses on investments which are generally purchased at a discount. For tax purposes, we accrete the entire purchase discount on a security into taxable income over the expected life of the security. Estimated taxable income is reduced when actual credit losses occur. For GAAP purposes, we establish a credit reserve and only accrete a portion of the purchase discount, if any, into income and write-down securities that become impaired. Our income recognition is therefore faster for tax as compared to GAAP, especially in the early years of owning a security (when there are generally few credit losses). At September 30, 2009, the cumulative difference between the GAAP and tax amortized costs basis of our residential, commercial, and CDO subordinate securities (excluding our investments in the Fund, Sequoia, and Acacia) was $395 million.
The timing of losses and which loans default will result in volatility in our tax results. During the third quarter, we realized $67 million of credit losses on securities for tax that we had previously provisioned for under GAAP. Realized credit losses were based on our tax basis, which averaged 43%, on securities that incurred principal face losses. After giving effect to sales of some of our commercial mortgage-backed securities (CMBS) in October, we anticipate an additional $319 million of tax losses on securities, based on our projection of face losses and assuming a similar tax basis as we have recently experienced. As of September 30, 2009, we had an allowance for loan losses (under GAAP) of $52 million for our consolidated residential and commercial loans. As we have no credit reserves or allowances for tax, any future credit losses on securities or loans will have a more significant impact on tax earnings than on GAAP earnings and may
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create significant taxable income volatility to the extent the level of credit losses fluctuates during reporting periods. We anticipate that tax losses will continue to be significant in the fourth quarter of 2009, and thus we continue to expect this year’s taxable income to be negative.
Since amortization and impairments on assets differ for GAAP and tax, the GAAP and tax basis on sold assets may differ, resulting in differences in gains on sale. In addition, for tax purposes, we are able to net capital losses against gains. Thus, although we sold assets in the third quarter and generated a GAAP gain of $11 million, for tax purposes these sales generated gains of less than $1 million. This reflects the differences in amortization and credit impairment between GAAP and tax. Also, in October 2009 we sold CMBS that generated additional capital losses. As of October 31, 2009, the REIT had $135 million in capital loss carry-forwards ($1.73 per share) that can be used to offset future capital gains.
As part of our investment in Sequoia securitization entities, we may retain interest-only (IOs) securities at the time they are issued. Our current tax basis in these securities is $26 million. The return on IO securities is sensitive to prepayments. Typically, fast prepayments reduce yields and slow prepayments increase yields. We are not permitted to recognize a negative yield under tax accounting rules, so during periods of fast prepayments our periodic premium expense for tax purposes can be relatively low and the tax cost basis for these securities may not be significantly reduced. In periods prior to 2008, we did experience fast prepayments on these loans. More recently, prepayments have been slowing, and our tax basis is now below the fair values for these IOs. Many of our Sequoia securitizations are callable or will become callable over the next two years, although we do not currently anticipate calling any Sequoia securitizations in 2009 or 2010. If we do call a Sequoia, the remaining tax basis in the IOs is written off creating an ordinary loss at the call date.
The total tax expense for equity award compensation is dependent upon varying factors such as the timing of payments of dividend equivalent rights, the exercise of stock options, the distribution of deferred stock units, and the deferrals to and withdrawals from our Executive Deferred Compensation Plan. For GAAP, the total expense associated with an equity award is determined at the award date and is recognized over the vesting period. For tax, the total expense is recognized at the date of distribution or exercise, not the award date. In addition, some compensation may not be deductible for tax if it exceeds certain levels and is not performance-based. Thus, the total amount of compensation expense, as well as the timing, could be significantly different for tax than for GAAP.
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The following table shows the components of our balance sheet at September 30, 2009.
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The following table provides real estate securities activity at Redwood for the three and nine months ended September 30, 2009.
We denote our residential securities based upon their position within a typical mortgage securitization capital structure. Senior securities are those interests in a securitization that have the first right to cash flows and are last in line to absorb losses. Re-REMIC securities, as presented herein, were created through the resecuritization of certain senior interests to provide additional credit support to those interests. Re-REMIC securities are therefore subordinate to the remaining senior interest, but senior to any subordinate tranches of the securitization from which they were created. Subordinate securities (generally originally rated AA and lower) are all interests below senior and re-REMIC interests.
The commercial securities and CDO securities that we own are generally subordinate securities.
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The following table presents the carrying value (which equals fair value) as a percent of face value for securities owned at Redwood at September 30, 2009 and December 31, 2008.
Prime securities are residential mortgage-backed securities backed by high credit quality loans. Many of these loans are jumbo loans, with loan balances greater than existing conforming loan limits. Prime securities typically have relatively high weighted average FICO scores (700 or higher), low weighted average loan-to-value ratios (75% LTV or less), and limited concentrations of investor properties. Regardless of whether or not the loans backing a mortgage-backed security are of high credit quality, there is credit risk that the borrower may not be able to repay the loan.
Non-prime securities are residential mortgage-backed securities that are not backed by high credit quality loans. Most of the borrowers backing non-prime loans have lower FICO scores or impaired credit histories, but exhibit the ability to repay the loan. To compensate for the greater risks and higher costs to service non-prime loans, borrowers often pay higher interest rates, and possibly higher origination fees. We use loss assumptions that are significantly higher when acquiring securities backed by non-prime loans than we use when acquiring securities backed by prime loans.
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The following table details the carrying value of our residential securities portfolio by the product type and collateral vintage at September 30, 2009 and December 31, 2008.
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The following table breaks out the underlying loans of our prime residential securities at Redwood by product type, loan rate, and vintage.
The majority (58%) of the loans underlying our securities are within the Agency conforming loan limit (the current conforming loan limits for the Federal Housing Administration, Fannie Mae, and Freddie Mac). These limits vary by county and are as high as $729,750 in high cost areas. The table above also provides the weighted average coupon rates for the respective vintage buckets. As of the end of October 2009, the current fixed mortgage rate for a conforming Agency loan was approximately 5.19%. As mortgage rates decline, the ability of borrowers to refinance and the attractiveness of financing increases, although mortgage rates are only one of the factors affecting refinancing.
The following table presents information on our residential AFS subordinate securities at Redwood at September 30, 2009, by their priority to absorb losses within their respective securitization.
The loans underlying all of our residential subordinate securities totaled $81 billion at September 30, 2009, consisting of $73 billion prime and $8 billion non-prime. These loans are located nationwide with a large concentration in California (47%). During the third quarter of 2009, realized residential credit losses were $97 million of principal value, a rate that equals 48 basis points (0.48%) of current loan balances on an annualized basis. Serious delinquencies (90+ days, in foreclosure or REO) at September 30, 2009 were 6.73% of current balances. These delinquencies were 4.23% of current balances for loans in prime pools and 30.11% of current balances for loans in non-prime pools.
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Our commercial subordinate securities totaled $17 million at September 30, 2009, as compared to $42 million at December 31, 2008, a decline of $25 million. This decline was primarily due to declines in the fair values of securities, as there were no acquisitions or sales of commercial subordinate securities during the first nine months of 2009. We may acquire commercial securities in the future if pricing for these securities becomes attractive to us relative to the risks taken.
At September 30, 2009, commercial subordinate securities provided credit enhancement on $47 billion of underlying loans on office, retail, multifamily, industrial, and other income-producing properties nationwide. Seriously delinquent loans underlying commercial subordinate securities were $1.7 billion at September 30, 2009, an increase of $1.1 billion from December 31, 2008. Our credit reserve of $472 million as of September 30, 2009, reflects the anticipation that we will only receive a small amount of principal over the life of these securities. Since commercial securities do not prepay like residential securities, our returns will be based on our receiving interest on the outstanding face value until the anticipated credit losses occur or our cash flow is shut off due to appraisal reductions or special servicing requirements. Realized credit losses on our commercial securities of $21 million were charged against our designated credit reserve during the third quarter.
During October 2009, we sold $8 million of our commercial subordinate securities, which provided credit enhancement on $18 billion of underlying loans. Our remaining investments in commercial securities consist of predominantly 2004 and 2005 subordinate bonds with a market value of $9 million. These securities have a face value of $176 million and credit reserves of $162 million.
In 2006, we issued $100 million of long-term debt in the form trust preferred securities through Redwood Capital Trust I, a wholly-owned Delaware statutory trust, in a private placement transaction. These trust preferred securities require quarterly distributions at a floating rate equal to three-month LIBOR plus 2.25% until the notes are redeemed in whole, which will be no later than January 30, 2037. The earliest optional redemption date without a penalty is January 30, 2012. In 2007, we issued $50 million of long-term debt in the form of subordinated notes, which require quarterly distributions at a floating rate equal to three-month LIBOR plus 2.25% until the notes are redeemed, no later than July 30, 2037. The earliest optional redemption date without penalty is July 30, 2012. In July 2009 we repurchased $10 million principal amount of subordinated debt in the open market at a cost of $3.4 million. We may from time to time seek to purchase outstanding long-term debt in open market purchases, privately negotiated transactions, or otherwise. Any future repurchases would depend on numerous factors including, without limitation, pricing, market conditions, and our capital requirements.
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The following table provides information on the activity at the Fund for the three and nine months ended September 30, 2009.
The fair value of securities held at the Fund was $41 million at September 30, 2009, which includes $15 million of unrealized losses. We recognized $1 million of other-than-temporary impairments on these securities in the third quarter of 2009.
We did not acquire any residential real estate loans during the third quarter of 2009. We may resume acquiring residential real estate loans on a bulk or flow basis from originators once the economics for securitization improve. Prior to 2006, our loan purchases were predominately comprised of short reset LIBOR-indexed ARMs. Beginning in 2006, we expanded our acquisitions to include hybrid loans (loans with a fixed-rate coupon for a period of two to ten years before becoming adjustable).
The following table provides details of our Sequoia residential real estate loans activity during the three and nine months ended September 30, 2009.
Our residential real estate loan balance declined to $3.8 billion at September 30, 2009, from $4.6 billion at December 31, 2008. At September 30, 2009, 95% of residential loans (by unpaid principal balance) were one-month or six-month LIBOR ARMs and the remaining 5% were hybrid loans. Prepayment speeds remain low as the ARM loans at Sequoia are largely indexed to one and six-month LIBOR. For September 2009,
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these loans had a weighted average coupon of 2.69%. Given the current very low coupon rate, we expect prepayment speeds on these loans to remain low, which is positive for the future cash flow generation from our IO investments. The prepayment speed on the hybrids has increased this year as these loans are nearing their reset dates and borrowers are likely facing higher future payments and are refinancing into other options. The following tables details the prepayment speeds at Sequoia.
Residential Loans at SequoiaPrepayment Speeds
The following table provides information on the activity at Acacia for the three and nine months ended September 30, 2009.
In addition to the $270 million of real estate securities included in the table above, Acacia owned $44 million of ABS issued by Sequoia, $29 million in non-real estate securities, and $6 million in commercial loans at September 30, 2009.
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We enter into interest rate agreements to manage some of our interest rate risks. We hold these agreements with highly rated counterparties and maintain certain risk management policies limiting our exposure concentrations to any counterparty. At September 30, 2009 the Acacia entities were party to interest rate agreements with an aggregate notional value of $1.6 billion and a fair value of negative $63 million. Derivative obligations of Acacia are payable solely from the assets of the Acacia trusts and are not obligations of Redwood. These are all accounted for as trading instruments and all changes in value and any net payments and receipts are recognized through our consolidated statements of income (loss) through market valuation adjustments, net.
One Acacia entity entered into credit default swaps (CDS) in the first quarter of 2007. At September 30, 2009, these CDS had a $29 million notional balance and a fair value of negative $29 million. At December 31, 2008, these CDS had a notional balance of $78 million and a fair value of negative $78 million. During the three and nine months ended September 30, 2009, the reference securities underlying our CDS experienced principal losses resulting in a $17 million and $49 million in obligations, respectively. The increase in fair value, net of principal losses, on CDS is included in market valuation adjustments, net, in our consolidated statements of income (loss).
The majority of the assets shown on our consolidated balance sheets are owned by Sequoia and Acacia securitization entities. These entities acquire assets and issue asset-backed securities (ABS) in order to fund these acquisitions. These securitization entities are bankruptcy-remote from us — meaning that they are structured so that our liabilities are not liabilities of the securitization entities and the ABS issued by the securitization entities are not obligations of ours. Nevertheless, GAAP requires us to consolidate the assets and liabilities from Sequoia and Acacia entities for financial statement reporting purposes.
At September 30, 2009, there was $3.8 billion of loans owned by Sequoia securitization entities and reported at cost, which were funded with $3.7 billion of Sequoia ABS issued that were also reported at cost. At September 30, 2009, there was $270 million of securities owned by Acacia securitization entities and reported at fair value, which were funded with $288 million of Acacia ABS issued that were also reported at fair value. In total, the assets of these two programs represent 98% of our consolidated earning assets and the liabilities (ABS issued) of these programs represent 96% of our consolidated liabilities.
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The following table provides detail on the activity for asset-backed securities for the three and nine months ended September 30, 2009.
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The following table presents our contractual obligations and commitments as of September 30, 2009, as well as the obligations of the securitization entities that we sponsor and consolidate for financial reporting purposes.
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The following table provides cumulative balances of unrealized gains and losses by the type of investment at September 30, 2009 and December 31, 2008.
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See the “Critical Accounting Policies” section in Management’s Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2008, for a detailed discussion of the Company’s critical accounting policies. Since the issuance of our Annual Report on Form 10-K for the year ended December 31, 2008, there have been changes to our critical accounting policies or the methodologies or assumptions we apply under them as noted in Note 3 to the consolidated financial statements presented in this Quarterly Report on Form 10-Q. We also describe in Note3 certain recent accounting pronouncements that will amend the critical accounting policies we apply in future periods.
We seek to manage the risks inherent in our business — including but not limited to credit risk, interest rate risk, prepayment risk, liquidity risk, and fair value risk — in a prudent manner designed to enhance our earnings and dividends and preserve our capital. In general, we seek to assume risks that can be quantified from historical experience, to actively manage such risks, and to maintain capital levels consistent with these risks.
Integral to our core business is assuming the credit risk of real estate loans primarily through the ownership of residential and commercial real estate loans and securities. Some of our capital base is employed in owning credit enhancement securities that have below investment-grade credit ratings due to their concentrated credit risks with respect to underlying real estate loans and investment-grade securities. We believe that many of the loans underlying these securities are above-average in credit quality as compared to U.S. real estate loans in general (although there may nevertheless be significant credit losses in respect to these loans), but the balance and percentage of loans with special risk factors (higher risk commercial loans, interest-only and negative amortization residential loan types, and Alt-A and subprime residential loans) has increased and continues to increase. We may also own residential real estate loans that are not securitized.
Credit losses from the loans in securitized loan pools, in general, first reduce the principal value of and economic returns on the lower-rated securities in these pools. Credit losses on real estate loans can occur for many reasons, including: poor origination practices; fraud; faulty appraisals; documentation errors; poor underwriting; legal errors; poor servicing practices; weak economic conditions; decline in the value of homes, businesses, or commercial properties; special hazards; earthquakes and other natural events; over-leveraging of the borrower or on the property; reduction in market rents and occupancies and poor property management practices; changes in legal protections for lenders; reduction in personal incomes; job loss; and personal events such as divorce or health problems. In addition, if the U.S. economy or the housing market weakens further than we have anticipated, our credit losses could increase beyond levels that we have anticipated. Credit losses on real estate loans can vary for reasons not related to the general economy.
With respect to most of the loans securitized by securitization entities sponsored by us and for a portion of the loans underlying residential loan securities we have acquired from securitizations sponsored by others, the interest rate is adjustable. Accordingly, when short-term interest rates rise, required monthly payments from homeowners may rise under the terms of these loans, and this may increase borrowers’ delinquencies and defaults.
We also acquire securities backed by negative amortization adjustable-rate loans made to residential borrowers, some of which are prime-quality loans while many are Alt-A quality loans (and a few are subprime loans). We invest in these riskier loan types with the expectation of significantly higher delinquencies and losses as compared to regular amortization loans, but believe these securities offer us the opportunity to generate attractive risk-adjusted returns as a result of attractive pricing and the manner in which these securitizations are structured. Nevertheless, there remains substantial uncertainty about the future performance of these assets.
The large majority of the commercial loans we credit-enhance are fixed-rate loans, some of which are interest-only loans. In general, these loans are not fully amortizing and therefore require balloon payments at
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maturity. Consequently, we could be exposed to credit losses at the maturity of these loans if the borrower is unable to repay or refinance the borrowing with another third party lender.
We will experience credit losses on residential and commercial loans and securities, and to the extent the losses are consistent with the amount and timing of our assumptions, we expect to earn attractive returns on our investments. We manage our credit risks by understanding the extent of the risk we are taking and insuring the appropriate underwriting criteria are met, and we utilize systems and staff to continually monitor the ongoing credit performance of each loan and security. To the extent we find the credit risks on specific assets are changing adversely, we may be able to take actions (which may include selling the assets) to mitigate potential losses. However, we may not always be successful in foreseeing adverse changes in credit performance or in effectively mitigating future credit losses and the ability to sell an asset may be limited due to the structure of the asset or the absence of a liquid market for the asset.
In addition to residential and commercial subordinate securities, Redwood, the Fund, and Acacia own senior and other securities issued by securitization entities that are sponsored by others. A risk we face with respect to these securities is that we do not generally control or influence the underwriting, servicing, management, or loss mitigation with respect to these underlying loans.
The Acacia entities, the Fund, and Redwood also own securities backed by subprime and Alt-A residential loans that have substantially higher credit risk characteristics than prime-quality loans. Consequently, we can expect these lower-quality loans to have higher rates of delinquency and loss, and if such losses differ from our assumptions, Acacia, the Fund, and Redwood could suffer losses.
The Acacia entities also own certain senior securities and subordinate securities purchased from the Sequoia securitization entities we sponsor. If the pools of residential and commercial loans underlying these securities were to experience poor credit results, these securities could suffer decreases in fair value, or could experience principal losses. If any of these events occurs, it would likely reduce our returns from these investments.
Interest rates and the shape of the yield curve can affect the cash flows and fair values of our assets, liabilities, and interest rate agreements, and consequently, affect our earnings and reported equity. Our general strategy with respect to interest rates is to maintain an asset/liability posture (including hedges) on a consolidated basis that assumes some interest rate risks but not to such a degree that the achievement of our long-term goals would likely be affected by changes in interest rates. Accordingly, we are willing to accept short-term volatility of earnings and changes in our reported equity in order to accomplish our goal of achieving attractive long-term returns.
To implement our interest rate risk strategy, we may use interest rate agreements in an effort to maintain a close match between pledged assets and debt, as well as between the interest rate characteristics of the assets in the securitization entities and the corresponding ABS issued. However, we generally do not attempt to completely hedge changes in interest rates, and at times, we may be subject to more interest rate risk than we generally desire in the long term. Changes in interest rates will have an impact on the values and cash flows of our assets and corresponding liabilities.
We seek to maintain an asset/liability posture that benefits from investments in prepayment-sensitive assets while limiting the risk of adverse prepayment fluctuations to an amount that, in most circumstances, can be absorbed by our capital base while still allowing us to make regular dividend payments.
Prepayments affect GAAP earnings in the near-term primarily through the timing of the amortization of purchase premium and discount and through triggering market valuation adjustments. For example, amortization income from discount assets may not necessarily offset amortization expense from premium assets, and vice-versa. In addition, variations in current and projected prepayment rates for individual assets and changes in interest rates (as they affect projected coupons on ARMs and other assets and thus change effective yield calculations) may cause net premium amortization expense or net discount amortization income to vary substantially from quarter to quarter. Moreover, the timing of premium amortization on assets may not
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always match the timing of the premium amortization on liabilities even when the underlying assets and liabilities are in the same securitization and pay down at the same rate.
Prepayment risks exist in the assets and associated liabilities consolidated on our balance sheets. In general, discount securities benefit from faster prepayment rates on the underlying real estate loans while premium securities (such as IOs) benefit from slower prepayments on the underlying loans. We are currently biased in favor of faster prepayment speeds with respect to the long-term economic effect of residential loan prepayments. However, in the short-term, increases in residential loan prepayment rates could result in GAAP earnings volatility.
With respect to securities backed by residential mortgage loans (and in particular, IOs), changes in prepayment forecasts by market participants could affect the market values of those securities sold by securitization entities, and thus could affect the profits we earn from securitizing assets.
Our credit results and risks can also be affected by prepayments. For example, credit risks for the securities we own are reduced each time a loan prepays. All other factors being equal, faster prepayment rates should reduce our credit risks on our existing portfolio.
We caution that prepayment rates are difficult to predict or anticipate, and variations in prepayment rates can materially affect our earnings and dividend distribution requirements. ARM prepayment rates, for example, are driven by many factors, one of which is the steepness of the yield curve. As the yield curve flattens (short-term interest rates rise relative to longer-term interest rates), ARM prepayments typically increase. However, for borrowers who have impaired credit or who otherwise do not meet loan underwriting criteria, the ability to refinance (i.e., prepay) a loan even when interest rates decline may be limited.
The securities that we sponsor are generally funded with equity with no associated recourse debt that might affect our liquidity position. On January 1, 2008 we elected the fair value option for assets and liabilities at Acacia, with all changes in market values now being recorded through our income statement. Though this adds to our potential earnings volatility, the securities and ABS issued by Acacia entities have no recourse to us that would otherwise affect our liquidity position. Changes in the fair values (or ratings downgrades) of assets owned by an Acacia entity may also create differences between our reported GAAP and taxable income. However, we do not currently believe this will create liquidity issues for us.
Most of the real estate loans that we consolidate are accounted for as held-for-investment and reported at amortized cost. Most of these loans have been sold to Sequoia entities and, thus, changes in the fair value of the loans do not have an impact on our liquidity. However, changes in fair values during the accumulation period (while these loans are funded with short-term debt before they are sold to a Sequoia entity) may have a short-term effect on our liquidity. We may also own some real estate loans accounted for as held-for-sale and adverse changes in their value would be recognized through our income statement and may have an impact on our ability to obtain financing for them.
Our consolidated obligations consist primarily of ABS issued. Changes in fair value of ABS issued generally have no impact on our liquidity. ABS issued by Sequoia are reported at amortized cost as are the residential loans collateralizing these ABS. Beginning January 1, 2008, we report at fair value the ABS issued by Acacia and also report the underlying securities collateralizing the ABS issued at fair value. In either case, the resulting net equity (assets less liabilities) may not necessarily be reflective of the fair value of our interests in these securitization entities. However, since the ABS issued can only look to the cash flows generated by the assets within that securitization for payments of interest and repayments of the face value of the ABS, the changes in fair value do not have an effect on Redwood. Only to the extent that changes in fair values affect the timing of the cash flows we might receive on our investments in the Acacia entities, is there an effect to Redwood from changes in fair values of these securities. There are no such considerations in the Sequoia securitization entities.
We may fund some assets with a combination of short-term debt and equity (generally prior to securitization) that is recourse to Redwood. This generally increases our fair value and liquidity risks. We
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manage these risks by maintaining what we believe to be conservative capital levels under our internal risk-adjusted capital and risk management policies and by ensuring we have a variety of financing facilities available to fund each of our assets.
Virtually all of our consolidated assets and liabilities are financial in nature. As a result, changes in interest rates and other factors drive our performance far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates.
Our financial statements are prepared in accordance with GAAP. Our activities and balance sheets are measured with reference to historical cost or fair value without considering inflation.
Recent market and economic conditions have been unprecedented and challenging. There are continuing concerns about the overall economy, the systemic impact of inflation or deflation, energy costs, geopolitical issues, the availability and cost of credit, the U.S. mortgage market, unemployment, and the declining real estate market in the U.S.
These market and economic conditions have spurred government initiatives and interventions designed to address them. Given the size and scope of the government actions, they will affect many of the market risks described above, although the total impact is not yet fully known. As these initiatives are further developed and their effects become more apparent we will continue to seek to take them into account in managing the risks inherent in our business.
Information concerning market risk is incorporated herein by reference to Item 7A of our Annual Report on Form 10-K for the year ended December 31, 2008, as supplemented by the information under “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Market Risks” above. Other than developments described under Management’s Discussion and Analysis of Financial Condition and Results of Operations above, including changes in the fair values of our assets, there have been no other material changes in our quantitative or qualitative exposure to market risk since December 31, 2008.
We have adopted and maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed on our reports under the Securities Exchange Act of 1934, as amended (the Exchange Act) is recorded, processed, summarized, and reported within the time periods specified in the U.S. Securities and Exchange Commission’s rules and forms and that the information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluation the cost-benefit relationship of possible controls and procedures.
As required by Rule 13a-15(b) of the Exchange Act, we have carried out an evaluation, under the supervision and with the participation of management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective at a reasonable assurance level.
There have been no changes in our internal control over financial reporting during the second quarter of 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
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There are no material pending legal proceedings to which we or any of our subsidiaries is a party or of which our property is the subject.
Our risk factors are discussed under Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2008, and under Item 1A of our Quarterly Report on Form 10-Q for the quarter ended June 30, 2009.
During the three months ended September 30, 2009, we did not sell any equity securities that were not registered under the Securities Act of 1933, as amended. We announced a stock repurchase plan on November 5, 2007 for the repurchase of up to a total of 5,000,000 shares. This plan replaced all previous share repurchase plans and has no expiration date. During the three months ended September 30, 2009, there were 273 shares repurchased under the plan as part of an effort to repurchase fractional shares held by participants in our dividend reinvestment plan who held less than one share. As of September 30, 2009, 4,658,071 shares remained available for repurchase under our stock repurchase plan.
The following table contains information on the shares of our common stock that we purchased during the three months ended September 30, 2009.
None.
None
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Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
By:
/s/ George E. Bull, IIIGeorge E. Bull, III Chairman of the Board and Chief Executive Officer (Principal Executive Officer)
/s/ Martin S. Hughes Martin S. Hughes President, Chief Financial Officer,and Co-Chief Operating Officer (Principal Financial Officer)
/s/ Christopher J. AbateChristopher J. Abate Managing Director and Controller (Principal Accounting Officer)
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