UNITED STATES OF AMERICA
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
x
o
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended: December 31, 2017
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Transition Period from _______________ to _______________.
Commission File Number 1-13759
REDWOOD TRUST, INC.
(Exact Name of Registrant as Specified in Its Charter)
Maryland
(State or Other Jurisdiction of
Incorporation or Organization)
One Belvedere Place, Suite 300
Mill Valley, California
(Address of Principal Executive Offices)
68-0329422
(I.R.S. Employer
Identification No.)
94941
(Zip Code)
(415) 389-7373
(Registrant’s Telephone Number, Including Area Code)
Securities Registered Pursuant to Section 12(b) of the Act:
Title of Each Class:
Common Stock, par value $0.01 per share
Name of Exchange on Which Registered:
New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x
No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o
No x
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
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted
and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes
x
No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s
knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth
company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer o
Non-accelerated filer o
Smaller reporting company o
Emerging growth company o
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised
financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o
No x
At June 30, 2017 , the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $1,292,062,376 based on the closing sale price as
reported on the New York Stock Exchange.
The number of shares of the registrant’s Common Stock outstanding on February 26, 2018 was 75,557,381 .
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s definitive Proxy Statement to be filed with the Securities and Exchange Commission under Regulation 14A within 120 days after the end of
registrant’s fiscal year covered by this Annual Report are incorporated by reference into Part III.
REDWOOD TRUST, INC.
2017 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Item 1.
Item 1A.
Item 1B.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.
Item 7.
Business
Risk Factors
Unresolved Staff Comments
Properties
Legal Proceedings
Mine Safety Disclosures (Not Applicable)
PART I
PART II
Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities
Selected Financial Data
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
Financial Statements and Supplementary Data
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Controls and Procedures
Other Information
Directors, Executive Officers and Corporate Governance
Executive Compensation
PART III
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Certain Relationships and Related Transactions, and Director Independence
Principal Accounting Fees and Services
Item 8.
Item 9.
Item 9A.
Item 9B.
Item 10.
Item 11.
Item 12.
Item 13.
Item 14.
Item 15.
Item 16.
Exhibits, Financial Statement Schedules
Form 10-K Summary
Consolidated Financial Statements
PART IV
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Page
1
6
42
42
43
44
45
48
49
95
100
100
100
100
101
101
103
103
103
104
109
F- 1
ITEM 1. BUSINESS
Introduction
PART I
Redwood Trust, Inc., together with its subsidiaries, focuses on investing in mortgages and other real estate-related assets and engaging in mortgage banking
activities. We seek to invest in real estate-related assets that have the potential to generate attractive cash flow returns over time and to generate income through
our mortgage banking activities. We operate our business in two segments: Investment Portfolio and Residential Mortgage Banking.
Our primary sources of income are net interest income from our investment portfolios and non-interest income from our mortgage banking activities. Net
interest income consists of the interest income we earn on investments less the interest expense we incur on borrowed funds and other liabilities. Income from
mortgage banking activities consists of the profit we seek to generate through the acquisition of loans and their subsequent sale or securitization.
Redwood Trust, Inc. has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Internal
Revenue Code”), beginning with its taxable year ended December 31, 1994. We generally refer, collectively, to Redwood Trust, Inc. and those of its subsidiaries
that are not subject to subsidiary-level corporate income tax as “the REIT” or “our REIT.” We generally refer to subsidiaries of Redwood Trust, Inc. that are
subject to subsidiary-level corporate income tax as “our operating subsidiaries” or “our taxable REIT subsidiaries” or “TRS.” Our mortgage banking activities and
investments in mortgage servicing rights ("MSRs") are generally carried out through our taxable REIT subsidiaries, while our portfolio of mortgage- and other real
estate-related investments is primarily held at our REIT. We generally intend to retain profits generated and taxed at our taxable REIT subsidiaries, and to
distribute as dividends at least 90% of the taxable income we generate at our REIT.
Redwood Trust, Inc. 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, both on a consolidated basis and with respect to each of our segments, is set forth in Financial
Statements
and
Supplementary
Data
as well as in Management’s
Discussion
and
Analysis
of
Financial
Condition
and
Results
of
Operations
which are included in Part II, Items 8
and 7, respectively, of this Annual Report on Form 10-K.
Our
Business
Segments
During the first quarter of 2017, we reorganized our segments to align with changes in how we view our segments for making operating decisions and
assessing performance. Specifically, we eliminated our Commercial segment and renamed our Residential Investments segment as the Investment Portfolio
segment. This Investment Portfolio segment now includes both residential investments and our commercial investments, which are primarily comprised of
investments in multifamily securities. Our Commercial segment previously included our commercial mortgage banking operations and our commercial loan
investments, which were wound-down and sold, respectively, during 2016. We conformed the presentation of prior periods, whereby commercial loan investments
are included in the Investment Portfolio segment and commercial mortgage banking activities are included in Corporate/Other. Following is a full description of
our current segments.
Our Investment Portfolio segment includes a portfolio of investments in residential mortgage-backed securities ("RMBS") retained from our Sequoia
securitizations, as well as RMBS issued by third parties and other credit risk-related investments. In addition, this segment includes a subsidiary of Redwood Trust
that is a member of the Federal Home Loan Bank of Chicago ("FHLBC") and that utilizes attractive long-term financing from the FHLBC to make long-term
investments directly in residential mortgage loans. Finally, this segment invests in MSRs associated with residential loans we have sold or securitized, as well as
MSRs that we purchased from third parties. The Investment Portfolio segment’s main sources of revenue are interest income from investment portfolio securities
and residential loans held-for-investment, as well as MSR income. Additionally, this segment may realize gains and losses upon the sale of securities. Funding
expenses, hedging expenses, direct operating expenses, and tax provisions associated with these activities are also included in this segment.
1
Our Residential Mortgage Banking segment primarily consists of operating a mortgage loan conduit that acquires residential loans from third-party originators
for subsequent sale, securitization, or transfer to our investment portfolio. We typically acquire prime, jumbo mortgages and the related mortgage servicing rights
on a flow basis from our network of loan sellers and distribute those loans through our Sequoia private-label securitization program or to institutions that acquire
pools of whole loans. We occasionally supplement our flow purchases with bulk loan acquisitions. This segment also includes various derivative financial
instruments that we utilize to manage certain risks associated with residential loans we acquire. Our Residential Mortgage Banking segment’s main source of
revenue is income from mortgage banking activities, which includes valuation increases (or gains) on the sale or securitization of loans, and from hedges used to
manage risks associated with these activities. Additionally, this segment may generate interest income on loans held pending securitization or sale. Funding
expenses, direct operating expenses, and tax expenses associated with these activities are also included in this segment.
Consolidated
Securitization
Entities
We sponsor our Sequoia securitization program, which we use for the securitization of residential mortgage loans. We are required under Generally Accepted
Accounting Principles in the United States (“GAAP”) to consolidate the assets and liabilities of certain Sequoia securitization entities we have sponsored for
financial reporting purposes. However, each of these entities is independent of Redwood and of each other, and the assets and liabilities of these entities are not
owned by us or legal obligations of ours, respectively, although we are exposed to certain financial risks associated with our role as the sponsor or depositor of
these entities and, to the extent we hold securities issued by, or other investments in, these entities, we are exposed to the performance of these entities and the
assets they hold. We refer to certain of these securitization entities issued prior to 2012 as “consolidated Legacy Sequoia entities,” and the securitization entities
formed in connection with the securitization of Redwood Choice expanded-prime loans as the "consolidated Sequoia Choice entities." Where applicable, in
analyzing our results of operations, we distinguish results from current operations “at Redwood” and from consolidated Legacy Sequoia or Sequoia Choice entities.
Information
Available
on
Our
Website
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 the charters for our Audit
Committee, Compensation Committee, and 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 website 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 website includes
information concerning purchases and sales of our equity securities by our executive officers and directors, as well as disclosure relating to certain non-GAAP
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 Annual Report on Form 10-K.
Our Investor Relations Department can be contacted at One Belvedere Place, Suite 300, Mill Valley, CA 94941, Attn: Investor Relations, telephone (866) 269-
4976 or email investorrelations@redwoodtrust.com.
2
Cautionary Statement
This Annual Report on Form 10-K 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 this Annual Report on Form 10-K 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.
Statements regarding the following subjects, among others, are forward-looking by their nature: (i) statements we make regarding Redwood’s business
strategy and strategic focus, including statements relating to our overall market position, strategy and long-term prospects; (ii) statements related to our financial
outlook and expectations for 2018, including with respect to our investment portfolio and residential mortgage banking activities; (iii) statements regarding the
upcoming maturity of convertible notes in 2018, including that we have sufficient capital to repay our maturing convertible debt due in April 2018, and that, going
forward, we will consider the most efficient sources of capital both from optimization within our portfolio and from the capital markets; (iv) statements regarding
the impact of the 2017 tax reform legislation on our business and on the broader housing market; (v) statements regarding mortgage banking activities, including
statements relating to pending securitization activity, as well as the expansion of our core mortgage credit strategies through the growth of our expanded-prime
Redwood Choice loan program and the pursuit of initiatives providing financing to single-family housing investors and providing new types of capital solutions to
our existing loan sellers; (vi) statements relating to acquiring residential mortgage loans in the future that we have identified for purchase or plan to purchase,
including the amount of such loans that we identified for purchase during the fourth quarter of 2017 and at December 31, 2017, and expected fallout and the
corresponding volume of residential mortgage loans expected to be available for purchase; (vii) statements relating to our estimate of our available capital
(including that we estimate our capital available for investments at December 31, 2017 was approximately $280 million); (viii) statements we make regarding our
dividend policy, including our intention to pay a regular dividend of $0.28 per share per quarter in 2018; and (ix) statements regarding our expectations and
estimates relating to the characterization for income tax purposes of our dividend distributions, our expectations and estimates relating to tax accounting, tax
liabilities and tax savings, and GAAP tax provisions, and our estimates of REIT taxable income and TRS taxable income.
3
Important factors, among others, that may affect our actual results include:
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the pace at which we redeploy our available capital into new investments;
interest rate volatility, changes in credit spreads, and changes in liquidity in the market for real estate securities and loans;
◦
"Credit spreads" is used generally to refer to the market value yield on a loan or security less the relevant risk-free benchmark interest rate;
changes in the demand from investors for residential mortgages and investments, and our ability to distribute residential mortgages through our whole-
loan distribution channel;
our ability to finance our investments in securities and our acquisition of residential mortgages with short-term debt;
changes in the values of assets we own;
general economic trends, the performance of the housing, real estate, mortgage, credit, and broader financial markets, and their effects on the prices of
earning assets and the credit status of borrowers;
the impact of changes to U.S. federal income tax laws on the U.S. housing market, mortgage finance markets, and our business;
changes to fiscal, tax, and other federal policies by Congress or President Trump’s administration;
developments related to the fixed income and mortgage finance markets and the Federal Reserve’s statements regarding its future open market activity
and monetary policy;
federal and state legislative and regulatory developments, and the actions of governmental authorities, including the new U.S. presidential administration,
and in particular those affecting the mortgage industry or our business (including, but not limited to, the Federal Housing Finance Agency’s rules relating
to FHLB membership requirements and the implications for our captive insurance subsidiary’s membership in the FHLB);
strategic business and capital deployment decisions we make;
our exposure to credit risk and the timing of credit losses within our portfolio;
the concentration of the credit risks we are exposed to, including due to the structure of assets we hold and the geographical concentration of real estate
underlying assets we own;
our exposure to adjustable-rate mortgage loans;
the efficacy and expense of our efforts to manage or hedge credit risk, interest rate risk, and other financial and operational risks;
changes in credit ratings on assets we own and changes in the rating agencies’ credit rating methodologies;
changes in interest rates;
changes in mortgage prepayment rates;
changes in liquidity in the market for real estate securities and loans;
our ability to finance the acquisition of real estate-related assets with short-term debt;
the ability of counterparties to satisfy their obligations to us;
our involvement in securitization transactions, the profitability of those transactions, and the risks we are exposed to in engaging in securitization
transactions;
exposure to claims and litigation, including litigation arising from our involvement in securitization transactions;
ongoing litigation against various trustees of RMBS transactions;
whether we have sufficient liquid assets to meet short-term needs;
our ability to successfully compete and retain or attract key personnel;
our ability to adapt our business model and strategies to changing circumstances;
changes in our investment, financing, and hedging strategies and new risks we may be exposed to if we expand our business activities;
our exposure to a disruption or breach of the security of our technology infrastructure and systems;
exposure to environmental liabilities;
our failure to comply with applicable laws and regulations;
our failure to maintain appropriate internal controls over financial reporting and disclosure controls and procedures;
the impact on our reputation that could result from our actions or omissions or from those of others; changes in accounting principles and tax rules;
our ability to maintain our status as a REIT for tax purposes;
limitations imposed on our business due to our REIT status and our status as exempt from registration under the Investment Company Act of 1940;
decisions about raising, managing, and distributing capital; and
other factors not presently identified.
This Annual Report on Form 10-K 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.
4
Certifications
Our Chief Executive Officer and Chief Financial Officer have executed certifications dated February 28, 2018 , as required by Sections 302 and 906 of the
Sarbanes-Oxley Act of 2002, and we have included those certifications as exhibits to this Annual Report on Form 10-K. In addition, our Chief Executive Officer
certified to the New York Stock Exchange (NYSE) on May 30, 2017 that he was unaware of any violations by Redwood Trust, Inc. of the NYSE’s corporate
governance listing standards in effect as of that date.
Employees
As of December 31, 2017 , Redwood employed 120 people.
5
Item 1A. Risk Factors
Risks Related to Recent or Potential Economic, Strategic, and Legislative/Regulatory Developments Affecting our Industry
General economic developments and trends and the performance of the housing, real estate, mortgage finance, and broader financial markets may adversely
affect our business and the value of, and returns on, real estate-related and other assets we own or may acquire and could also negatively impact our business
and financial results.
Our level of business activity and the profitability of our business, as well as the values of, and the cash flows from, the assets we own, are affected by
developments in the U.S. economy and the broader global economy. As a result, negative economic developments are likely to negatively impact our business and
financial results. There are a number of factors that could contribute to negative economic developments, including, but not limited to, high unemployment, rising
government debt levels, U.S. fiscal and monetary policy changes, including Federal Reserve policy shifts and changes in benchmark interest rates, changing U.S.
consumer spending patterns, negative developments in the housing, multifamily, and real estate markets, and changing expectations for inflation and deflation.
Additionally, changes and uncertainty resulting from the 2016 U.S. presidential election, the Trump administration, the U.K. vote to exit from the European Union
and the potential for other countries to leave the E.U. could adversely impact financial markets, as well as domestic and global economic growth. Personal income
and unemployment levels affect borrowers’ ability to repay residential mortgage loans underlying residential real estate-related assets we own (and renters’ ability
to meet rental obligations underlying multifamily securities and loans secured by non-owner occupied rental properties we own), and there is risk that economic
growth and activity could be weaker than anticipated or negative.
The economic downturn that began in 2007 and the significant government interventions into the financial markets and fiscal stimulus spending that occurred
in subsequent years have contributed to significantly increased U.S. budget deficits and overall debt levels, and the federal tax reform legislation signed into law in
December 2017 is forecast to further increase budget deficits over the next decade. In addition, under President Trump’s administration, further fiscal stimulus
spending may occur relating to infrastructure, defense, or other areas that Congress and President Trump designate. These increases can put upward pressure on
interest rates and could be among the factors that could lead to higher interest rates over the long-term future. Higher long-term interest rates could adversely affect
our overall business, income, and our ability to pay dividends, as discussed further below under “Interest
rate
fluctuations
can
have
various
negative
effects
on
us
and
could
lead
to
reduced
earnings
and
increased
volatility
in
our
earnings.”
Furthermore, our business and financial results may be harmed by our inability to
accurately anticipate developments associated with changes in, or the outlook for, interest rates. In addition, near-term and long-term U.S. economic conditions
could be impacted by changes in fiscal and tax policy.
Real estate values, and the ability to generate returns by owning or taking credit risk on loans secured by real estate, are important to our business. Following
the financial crisis of 2007-2008, government intervention has been important in supporting real estate markets, the overall U.S. economy, and capital markets.
Mortgage markets have also received substantial U.S. government support. In particular, the government’s support of mortgage markets through its support of
Fannie Mae and Freddie Mac expanded in late 2008, as the U.S. Treasury Department chose to backstop these government-sponsored enterprises. The
governmental support for these entities has contributed to Fannie Mae’s and Freddie Mac’s continued dominance of residential mortgage finance and securitization
activity, inhibiting the return of private sector mortgage securitization. This support may continue for some time and could have potentially negative consequences
to us, since we have traditionally taken an active role in assuming credit risk in the private sector mortgage market, including through investments in Sequoia
securitizations we sponsor.
6
Changes to the U.S. federal income tax laws could have an adverse impact on the U.S. housing market, mortgage finance markets, and our business.
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (the “Tax Act”), which contains significant changes to the Internal
Revenue Code for taxable years beginning in 2018. Among other things, the Tax Act reduced for individuals the annual residential mortgage-interest deduction for
purchase money mortgage debt incurred after December 15, 2017, in taxable years beginning after December 31, 2017, and beginning before January 1, 2026,
from $1,000,000 (or $500,000 in the case of married taxpayers filing separately) to $750,000 (or $375,000 in the case of married taxpayers filing separately), as
well as eliminated for individuals the deduction for interest with respect to home equity indebtedness, with certain exceptions for indebtedness from refinancing
existing indebtedness. The Tax Act also limits the state and local tax deduction for individuals to a combined $10,000 for income, sales, and property taxes (for
both single and married tax filers) in taxable years beginning after December 31, 2017, and beginning before January 1, 2026. The reduction or limitation of these
tax deductions could reduce home affordability and adversely affect home prices nationally and/or in local markets, particularly in states with high state and local
taxes and property values. In addition, such changes could increase taxes payable by certain borrowers, thereby reducing their available cash and adversely
impacting their ability to make payment on the mortgage loans, which in turn, could cause a rise in delinquencies. The limitations on these deductions could have
an adverse impact on the U.S. residential housing market, the market value of residential mortgage loans and residential mortgage-backed securities, and the
volume of future originations of residential mortgage loans, particularly jumbo mortgage loans, all of which could negatively impact our business or financial
results.
Congress and President Trump’s administration have made and may continue to make substantial changes to fiscal, tax, and other federal policies that may
adversely affect our business.
President Trump has called for and, in some cases, already signed into law substantial changes to U.S. fiscal and tax policies, including corporate and
individual tax reform. In addition, President Trump has called for significant changes to U.S. trade, healthcare, immigration, foreign, and government regulatory
policy. Some of the called-for changes would require Congressional approval, while other have already been, and may in the future be, carried out unilaterally by
the executive branch of the U.S. government. To the extent Congress or President Trump implement changes to U.S. policy, those changes may impact, among
other things, the U.S. economy, housing and housing finance markets, international trade, unemployment, immigration, the regulatory environment in the U.S.
including banking regulations and the Dodd-Frank Act, international relations, inflation, unemployment, healthcare, and other areas. Although we cannot predict
the impact, if any, of these changes to our business, they could adversely affect our business. Until we know what policy changes are made and how those changes
impact our business and the business of our competitors over the long-term, we will not know if, overall, we will benefit from them or be negatively affected by
them.
Changing benchmark interest rates, and the Federal Reserve’s actions and statements regarding monetary policy, can affect the fixed income and mortgage
finance markets in ways that could adversely affect our future business and financial results and the value of, and returns on, real estate-related investments
and other assets we own or may acquire.
Statements by the Federal Reserve regarding monetary policy and the actions it takes to set or adjust monetary policy may affect the expectations and outlooks
of market participants in ways that disrupt our business and adversely affect our financial results and the value of, and returns on, our portfolio of real-estate related
investments and the pipeline of residential mortgage loans we own or may acquire. For example, since December 2015, the Federal Reserve has raised the target
federal funds rate four times, bringing it from near zero to the current target level between 1.0% and 1.25%, and signaled that the federal funds rate could be
increased further over the next several years. The increase in the federal funds rate may cause mortgage interest rates to rise. Increases in mortgage interest rates
could reduce the volume of new mortgages originated, in particular the volume of mortgage refinancings. As another example, from 2013 through 2017, statements
made by the Chair and other members of the Board of Governors of the Federal Reserve System and by other Federal Reserve Bank officials regarding the U.S.
economy, future economic growth, the Federal Reserve’s future open market activity and monetary policy had a significant impact on, among other things,
benchmark interest rates, the value of residential mortgage loans, and, more generally, the fixed income markets. These statements and the actions of the Federal
Reserve, and other factors also significantly impacted many market participants’ expectations and outlooks regarding future levels of benchmark interest rates and
the expected yields these market participants would require to invest in fixed income instruments, including most residential mortgages and residential mortgage-
backed securities (RMBS).
7
To the extent benchmark interest rates rise, one of the immediate potential impacts on our business would be a reduction in the overall value of the pool of
residential mortgage loans that we own and the overall value of the pipeline of residential mortgage loans that we have identified for purchase. Rising benchmark
interest rates also generally have a negative impact on the overall cost of short- and long-term borrowings we use to finance our acquisitions and holdings of
residential mortgage loans, including as a result of the requirement to post additional margin (or collateral) to lenders to offset any associated decline in value of
the mortgage loans we finance with short- and long-term borrowings. The short- and long-term borrowings we use to finance our acquisitions and holdings of
residential mortgage loans are uncommitted and have a limited term, which could result in these types of borrowings not being available in the future to fund our
acquisitions and holdings and could result in our being required to sell holdings of residential mortgage loans and incur losses. Similar impacts would also be
expected with respect to the short-term borrowings we use to finance our acquisitions and holdings of RMBS. In addition, any inability to fund acquisitions of
mortgage loans could damage our reputation as a reliable counterparty in the mortgage finance markets.
To the extent benchmark interest rates rise, it would also likely impact the volume of residential mortgage loans available for purchase in the marketplace and
our ability to compete to acquire residential mortgage loans as part of our residential mortgage banking activities. These impacts could result from, among other
things, a lower overall volume of mortgage refinance activity by mortgage borrowers and an increased level of competition from large commercial banks that may
operate with a lower cost of capital than we do, including as a result of Federal Reserve monetary policies that impact banks more favorably than us and other non-
bank institutions. These and other impacts of developments of the type described above have had, and may continue to have, a negative impact on our business and
results of operations and we cannot accurately predict the full extent of these impacts or for how long they may persist.
Federal and state legislative and regulatory developments and the actions of governmental authorities and entities may adversely affect our business and the
value of, and the returns on, mortgages, mortgage-related securities, and other assets we own or may acquire in the future.
As noted above, our business is affected by conditions in the housing, multifamily, and real estate markets and the broader financial markets, as well as by the
financial condition and resources of other participants in these markets. These markets and many of the participants in these markets are subject to, or regulated
under, various federal and state laws and regulations. In some cases, the government or government-sponsored entities, such as Fannie Mae and Freddie Mac,
directly participate in these markets. In particular, because issues relating to residential real estate and housing finance can be areas of political focus, federal, state
and local governments may be more likely to take actions that affect residential real estate, the markets for financing residential real estate, and the participants in
residential real estate-related industries than they would with respect to other industries. As a result of the government’s statutory and regulatory oversight of the
markets we participate in and the government’s direct and indirect participation in these markets, federal and state governmental actions, policies, and directives
can have an adverse effect on these markets and on our business and the value of, and the returns on, mortgages, mortgage-related securities, and other assets we
own or may acquire in the future, which effects may be material.
Furthermore, the financial crisis of 2007-2008 and subsequent financial turmoil prompted the federal government to put into place new statutory and
regulatory frameworks and policies for reforming the U.S. financial system. These financial reforms are aimed at, among other things, promoting robust
supervision and regulation of financial firms, establishing comprehensive supervision of financial markets, protecting consumers and investors from financial
abuse, providing the U.S. government with additional tools to manage financial crises, and raising international regulatory standards and improving international
cooperation, but their scope could be expanded beyond what has been currently enacted, implemented, and proposed. Certain financial reforms focused specifically
on the issuance of asset-backed securities through securitization transactions have not been fully implemented or have not yet, or have only recently, become
effective, but include or are expected to include significantly enhanced disclosure requirements, risk retention requirements, and rules restricting a broad range of
conflicts of interests in regard to these transactions. Implementation of financial reforms, whether through law, regulations, or policy, including changes to the
manner in which financial institutions, financial products, and financial markets operate and are regulated and any related changes in the accounting standards that
govern them, could adversely affect our business and financial results by subjecting us to regulatory oversight, making it more expensive to conduct our business,
reducing or eliminating any competitive advantage we may have, or limiting our ability to expand, or could have other adverse effects on us.
Alternatively, under President Trump’s administration the scope of financial reforms and the regulatory framework governing the financial system has been,
and could continue to be, reduced or refocused. Trump administration policies, federal legislation, or executive or regulatory actions aimed at weakening or
dismantling the Dodd-Frank Act or its regulatory apparatus, including by reducing capital requirements on banking institutions or by weakening or redirecting the
CFPB, its leadership, or its enforcement capabilities or priorities, could result in increased competition from commercial banks and other large financial institutions
that may have advantages due to their size and cost of capital.
8
During and since 2008, the federal government has also made available programs designed to provide homeowners with assistance in avoiding residential
mortgage loan foreclosures, including through loan modification and refinancing programs. In addition, certain mortgage lenders and servicers have voluntarily, or
as part of settlements with law enforcement authorities, established loan modification programs relating to the mortgages they hold or service and adopted new
servicing standards intended to protect homeowners. Changes to servicing standards, whether resulting from a settlement or a change in regulation, are likely to
have the effect of lengthening the time it takes for a servicer to foreclose on the property underlying a delinquent mortgage loan. Loan modification programs and
changes to servicing standards and regulations, as well as future law enforcement and legislative or regulatory actions, may adversely affect the value of, and the
returns on, the mortgage loans and mortgage securities we currently own or may acquire in the future.
Ultimately, we cannot assure you of the impact that governmental actions may have on our business or the financial markets and, in fact, they may adversely
affect us, possibly materially. We cannot predict whether or when such actions may occur or what unintended or unanticipated impacts, if any, such actions could
have on our business and financial results. Even after governmental actions have been taken and we believe we understand the impacts of those actions, we may
not be able to effectively respond to them so as to avoid a negative impact on our business or financial results.
Federal regulations may limit, eliminate, or reduce the attractiveness of our subsidiary’s ability to use borrowings from the Federal Home Loan Bank of
Chicago to finance the mortgage loans and securities it holds and acquires, which could negatively impact our business and operating results.
In June 2014, we announced that our wholly-owned captive insurance company subsidiary, RWT Financial, LLC, was approved as a member of the Federal
Home Loan Bank of Chicago (“FHLBC”). This membership has provided RWT Financial with access to attractive long-term collateralized financing for mortgage
loans and securities it holds and acquires. RWT Financial currently has approximately $2.00 billion of long-term borrowings from the FHLBC to finance its
portfolio of jumbo residential mortgage loans. In January 2016, federal regulations were adopted by the Federal Housing Finance Agency (“FHFA”), which is the
regulator of the Federal Home Loan Bank System, relating to captive insurance company membership in the Federal Home Loan Bank System. Under these
regulations, RWT Financial is eligible to remain as a member of the FHLBC until the expiration of a five-year transition period and its existing $2.00 billion of
FHLB debt is permitted to remain outstanding until stated maturity (even though the scheduled maturity extends beyond the five-year transition period). As
residential loans pledged as collateral for this debt pay down, RWT Financial is permitted to pledge additional loans or other eligible assets to collateralize this
debt; however, we do not expect RWT Financial to be able to increase its FHLB debt above the existing $2.00 billion outstanding.
The final regulations published by the FHFA could negatively impact us in a number of different ways, including, without limitation, by: limiting our ability to
acquire (or the attractiveness of acquiring) residential mortgage loans to hold as long-term investments; limiting our ability to increase net interest income earned
by RWT Financial; and, following the five-year transition period and the scheduled maturity of our currently outstanding advances, requiring us to arrange for
alternative (and, likely, less attractive) financing sources for residential mortgage loans held as long-term investments or, if such alternative financing sources are
not then available, requiring us to liquidate our portfolio of residential loans held as long-term investments, any of which could negatively impact our business and
operating results. In addition, our increased reliance on long-term financing from the FHLBC exposes us to risks of the type described below in Part II, Item 7 of
this Annual Report on Form 10-K under the heading, “Risks
Relating
to
Debt
Incurred
under
Short-
and
Long-Term
Borrowing
Facilities.”
9
Decisions we make about our business strategy and investments, as well as decisions about raising capital or returning capital to shareholders (through
dividends or common stock repurchases), could fail to improve our business and results of operations.
In December 2017 and January 2018, we announced several new initiatives to expand our mortgage banking and investment activities, including by exploring
opportunities to provide expanded financing options to non-bank mortgage loan originators and expanding our mortgage loan purchase activity to include, for
example, loans secured by non-owner occupied rental properties generally made up of one to four units (which we refer to as “business purpose real estate loans”).
These new initiatives are intended to grow our mortgage banking business and allocate capital to profitable business and investment opportunities. These changes
are premised on our outlook for economic and market conditions, secular trends in consumer demand for renting versus owning a residence, as well as competitive
considerations. Over the long-term, the assumptions underlying these trends and changes could turn out to be incorrect or economic and market conditions could
develop in a manner that is not consistent with the outlook we held. As a result, these new initiatives could fail to improve the long-term profitability of Redwood,
could fail to result in capital being available for or deployed into more profitable businesses and investments, or could otherwise damage our business, our
reputation, our ability to access financing, and our ability to raise capital, or could have other unforeseen consequences, any or all of which could result in a
material adverse effect on our business and results of operations in the future. Decisions we make in the future about our business strategy and investments, as well
as decisions about raising capital or returning capital to shareholders (through dividends or common stock repurchases), could also fail to improve our business and
results of operations.
In addition, in February 2016, our Board of Directors approved an additional authorization for the purchase of up to $100 million of Redwood common stock
and also authorized the repurchase of other securities issued by Redwood, including convertible and exchangeable debt securities. Subsequently, between 2016 and
early 2018, we repurchased approximately $50 million of our common stock at an average price per share of $13.87 and approximately $41 million of our
outstanding debt securities. At December 31, 2017, approximately $77 million of this current authorization remained available for the repurchase of shares of our
common stock. In February 2018, our Board of Directors approved an authorization for the repurchase of an additional $39 million of our common stock,
increasing the total amount authorized for repurchases of common stock to $100 million, and also authorized the repurchase of outstanding debt securities,
including convertible and exchangeable debt. If we repurchase shares of Redwood common stock or other securities issued by Redwood, it is because at the time
we believe the shares or securities are trading at attractive levels relative to other uses of capital or investment opportunities then available to us; however, it is
possible that other uses of this capital could have been more accretive to our earnings or book value or that subsequent capital needs arise that were not
contemplated at the time we made these decisions. Our past and future decisions relating to the repurchases of Redwood common stock or other securities issued
by Redwood could fail to improve our results of operations or could negatively impact our ability to execute our business plans, meet financial obligations, access
financing, or raise additional capital, any or all of which could result in a material adverse effect on our business and results of operations in the future.
Risks Related to our Investments and Investing Activity
The nature of the assets we hold and the investments we make expose us to credit risk that could negatively impact the value of those assets and investments,
our earnings, dividends, cash flows, and access to liquidity, or otherwise negatively affect our business.
Overview
of
credit
risk
We assume credit risk primarily through the ownership of securities backed by residential, multifamily, and other real estate loans and through direct
investments in residential real estate loans and other real estate loans. We may also assume similar credit risks through other types of transactions with
counterparties who are seeking to reduce their exposure to credit risk or who are seeking financing for their own holdings of residential real estate loans or
servicing rights relating to residential real estate loans. Credit losses on real estate loans can occur for many reasons, including: fraud; poor underwriting; poor
servicing practices; weak economic conditions; increases in payments required to be made by borrowers; declines in the value of real estate; declining rents on
single- and multifamily residential rental properties; natural disasters, the effects of climate change (including flooding, drought, and severe weather) and other
natural events; uninsured property loss; over-leveraging of the borrower; costs of remediation of environmental conditions, such as indoor mold; changes in zoning
or building codes and the related costs of compliance; acts of war or terrorism; changes in legal protections for lenders and other changes in law or regulation; and
personal events affecting borrowers, such as reduction in income, job loss, divorce, or health problems. In addition, the amount and timing of credit losses could be
affected by loan modifications, delays in the liquidation process, documentation errors, and other action by servicers. Weakness in the U.S. economy or the
housing market could cause our credit losses to increase beyond levels that we currently anticipate.
10
In addition, rising interest rates may increase the credit risks associated with certain residential real estate loans. For example, the interest rate is adjustable for
many of the loans held at securitization entities we have sponsored and for a portion of the loans underlying residential securities we have acquired from
securitizations sponsored by others. In addition, a portion of the loans we have pledged to secure short-term warehouse borrowings may have adjustable interest
rates. Accordingly, when short-term interest rates rise, required monthly payments from homeowners will rise under the terms of these adjustable-rate mortgages,
and this may increase borrowers’ delinquencies and defaults.
Credit losses on business purpose real estate loans and real estate loans collateralizing multifamily securities can occur for many of the reasons noted above
for residential real estate loans. Moreover, these types of real estate loans may not be fully amortizing and, therefore, the borrower’s ability to repay the principal
when due may depend upon the ability of the borrower to refinance or sell the property at maturity. Business purpose real estate loans and real estate loans
collateralizing multifamily securities are particularly sensitive to conditions in the rental housing market and to demand for rental residential properties.
We
may
have
heightened
credit
losses
associated
with
certain
securities
and
investments
we
own.
Within a securitization of residential, multifamily, or business purpose real estate loans, various securities are created, each of which has varying degrees of
credit risk. We may own the securities in which there is more (or the most) concentrated credit risk associated with the underlying real estate loans.
In general, losses on an asset securing a residential, multifamily, or business purpose real estate loan included in a securitization will be borne first by the
owner of the property (i.e., the owner will first lose any equity invested in the property) and, thereafter, by the first-loss security holder, and then by holders of
more senior securities. In the event the losses incurred upon default on the loan exceed any classes of securities junior to those in which we invest (if any), we may
not be able to recover all of our investment in the securities we hold. In addition, if the underlying properties have been overvalued by the originating appraiser or
if the values subsequently decline and, as a result, less collateral is available to satisfy interest and principal payments due on the related security, then the first-loss
securities may suffer a total loss of principal, followed by losses on the second-loss and then third-loss securities (or other residential and commercial securities
that we own). In addition, with respect to residential securities we own, we may be subject to risks associated with the determination by a loan servicer to
discontinue servicing advances (advances of mortgage interest payments not made by a delinquent borrower) if they deem continued advances to be unrecoverable,
which could reduce the value of these securities or impair our ability to project and realize future cash flows from these securities.
For loans or other investments we own directly (not through a securitization structure), we will most likely be in a position to incur credit losses - should they
occur - only after losses are borne by the owner of the property (e.g., by a reduction in the owner’s equity stake in the property). Similar to our exposure to credit
losses on loans we own directly, we have committed to assume credit losses - but only up to a specified amount - on certain conforming residential mortgage loans
that we acquired and then sold to Fannie Mae and Freddie Mac pursuant to risk-sharing arrangements we entered into with those entities, to the extent any such
losses exceed the owner’s equity investment in the property. We may take actions available to us in an attempt to protect our position and mitigate the amount of
credit losses, but these actions may not prove to be successful and could result in our increasing the amount of credit losses we ultimately incur on a loan.
The
nature
of
the
assets
underlying
some
of
the
securities
and
investments
we
hold
could
increase
the
credit
risk
of
those
securities.
For certain types of loans underlying securities we may own or acquire, the loan rate or borrower payment rate may increase over time, increasing the potential
for default. For example, securities may be backed by residential real estate loans that have negative amortization features. The rate at which interest accrues on
these loans may change more frequently or to a greater extent than payment adjustments on an adjustable-rate loan, and adjustments of monthly payments may be
subject to limitations or may be limited by the borrower’s option to pay less than the full accrual rate. As a result, the amount of interest accruing on the remaining
principal balance of the loans at the applicable adjustable mortgage loan rate may exceed the amount of the monthly payment. To the extent we are exposed to it,
this is particularly a risk in a rising interest rate environment. Negative amortization occurs when the resulting excess (of interest owed over interest paid) is added
to the unpaid principal balance of the related adjustable mortgage loan. For certain loans that have a negative amortization feature, the required monthly payment is
increased after a specified number of months or after a maximum amount of negative amortization has occurred in order to amortize fully the loan by the end of its
original term. Other negative amortizing loans limit the amount by which the monthly payment can be increased, which results in a larger final payment at
maturity. As a result, negatively amortizing loans have performance characteristics similar to those of balloon loans. Negative amortization may result in increases
in delinquencies, loan loss severity, and loan defaults, which may, in turn, result in payment delays and credit losses on our investments. Other types of loans and
investments to which we are exposed, such as hybrid loans and adjustable-rate loans, may also have greater credit risk than more traditional amortizing fixed-rate
mortgage loans.
11
Many of the real estate loans collateralizing multifamily securities we own and business purpose real estate loans we may acquire are only partially amortizing
or do not provide for any principal amortization prior to a balloon principal payment at maturity. Commercial loans that only partially amortize or that have a
balloon principal payment at maturity may have a higher risk of default at maturity than fully amortizing loans. In addition, since most of the principal of these
loans is repaid at maturity, the amount of loss upon default is generally greater than on other loans that provide for more principal amortization.
We
have
concentrated
credit
risk
in
certain
geographical
regions
and
may
be
disproportionately
affected
by
an
economic
or
housing
downturn,
natural
disaster,
terrorist
event,
climate
change,
or
any
other
adverse
event
specific
to
those
regions.
A decline in the economy or difficulties in certain real estate markets, such as a high level of foreclosures in a particular area, are likely to cause a decline in
the value of residential and multifamily properties. This, in turn, will increase the risk of delinquency, default, and foreclosure on real estate underlying securities
and loans we hold with properties in those regions, and it will increase the risk of loss on other investments we own. This may then adversely affect our credit loss
experience and other aspects of our business, including our ability to securitize (or otherwise sell) real estate loans and securities.
The occurrence of a natural disaster (such as an earthquake, tornado, hurricane, flood, landslide, or wildfire), or the effects of climate change (including
flooding, drought, and severe weather), may cause decreases in the value of real estate (including sudden or abrupt changes) and would likely reduce the value of
the properties collateralizing real estate loans we own or those underlying the securities or other investments we own. For example, in 2017, hurricanes caused
widespread flooding in Florida and Texas and wildfires and mudslides in northern and southern California destroyed or damaged thousands of homes. Since certain
natural disasters may not typically be covered by the standard hazard insurance policies maintained by borrowers, the borrowers may have to pay for repairs due to
the disasters. Borrowers may not repair their property or may stop paying their mortgage loans under those circumstances, especially if the property is damaged.
This would likely cause foreclosures to increase and lead to higher credit losses on our loans or investments or on the pool of mortgage loans underlying securities
we own.
A significant number of residential real estate loans that underlie the securities we own are secured by properties in California and, thus, we have a higher
concentration of credit risk within California than in other states. Additional states where we have concentrations of residential loan credit risk are set forth in Note
6
to the Financial Statements within this Annual Report on Form 10-K. Balances on real estate loans collateralizing multifamily securities we own and business
purpose real estate loans we may acquire are larger than residential loans and in the past we have had, and may have in the future, a geographically concentrated
portfolio of such loans and securities. Real estate loans collateralizing multifamily securities we currently own are generally concentrated in Texas, California,
Florida, Georgia, and Colorado.
The
timing
of
credit
losses
can
harm
our
economic
returns.
The timing of credit losses can be a material factor in our economic returns from real estate loans, investments, and securities. If unanticipated losses occur
within the first few years after a loan is originated, an investment is made, or a securitization is completed, those losses could have a greater negative impact on our
investment returns than unanticipated losses on more seasoned loans, investments, or securities. In addition, higher levels of delinquencies and cumulative credit
losses within a securitized loan pool can delay our receipt of principal and interest that is due to us under the terms of the securities backed by that pool. This
would also lower our economic returns. The timing of credit losses could be affected by the creditworthiness of the borrower, the borrower’s willingness and
ability to continue to make payments, and new legislation, legal actions, or programs that allow for the modification of loans or ability for borrowers to get relief
through bankruptcy or other avenues.
Our
efforts
to
manage
credit
risks
may
fail.
We attempt to manage risks of credit losses by continually evaluating our investments for impairment indicators and establishing reserves under GAAP for
credit and other risks based upon our assessment of these risks. We cannot establish credit reserves for tax accounting purposes. The amount of reserves that we
establish may prove to be insufficient, which would negatively impact our financial results and would result in decreased earnings. In addition, cash and other
capital we hold to help us manage credit and other risks and liquidity issues may prove to be insufficient. If these increased credit losses are greater than we
anticipated and we need to increase our credit reserves, our GAAP earnings might be reduced. Increased credit losses may also adversely affect our cash flows,
ability to invest, dividend distribution requirements and payments, asset fair values, access to short-term borrowings, and ability to securitize or finance assets.
12
Despite our efforts to manage credit risk, there are many aspects of credit risk that we cannot control. Our quality control and loss mitigation policies and
procedures may not be successful in limiting future delinquencies, defaults, and losses, or they may not be cost effective. Our underwriting reviews may not be
effective. The securitizations in which we have invested may not receive funds that we believe are due from mortgage insurance companies and other
counterparties. Loan servicing companies may not cooperate with our loss mitigation efforts or those efforts may be ineffective. Service providers to
securitizations, such as trustees, loan servicers, bond insurance providers, and custodians, may not perform in a manner that promotes our interests. Delay of
foreclosures could delay resolution and increase ultimate loss severities, as a result.
The value of the homes or properties collateralizing or underlying real estate loans or investments may decline, and rents on single- and multifamily rental
properties may decline. The frequency of default and the loss severity on loans upon default may be greater than we anticipate. Interest-only loans, negative
amortization loans, adjustable-rate loans, larger balance loans, reduced documentation loans, subprime loans, alt-a loans, second lien loans, loans in certain
locations, residential mortgage loans that are not “qualified mortgages” under regulations promulgated by the CFPB, and loans or investments that are partially
collateralized by non-real estate assets may have increased risks and severity of loss. If property securing or underlying loans becomes real estate owned as a result
of foreclosure, we bear the risk of not being able to sell the property and recovering our investment and of being exposed to the risks attendant to the ownership of
real property.
Changes in consumer behavior, bankruptcy laws, tax laws, regulation of the mortgage industry, and other laws may exacerbate loan or investment losses.
Changes in rules that would cause loans owned by a securitization entity to be modified may not be beneficial to our interests if the modifications reduce the
interest we earn and increase the eventual severity of a loss. In some states and circumstances, the securitizations in which we invest have recourse as owner of the
loan against the borrower’s other assets and income in the event of loan default. However, in most cases, the value of the underlying property will be the sole
effective source of funds for any recoveries. Other changes or actions by judges or legislators regarding mortgage loans and contracts, including the voiding of
certain portions of these agreements, may reduce our earnings, impair our ability to mitigate losses, or increase the probability and severity of losses. Any
expansion of our loss mitigation efforts could increase our operating costs and the expanded loss mitigation efforts may not reduce our future credit losses.
Credit
ratings
assigned
to
debt
securities
by
the
credit
rating
agencies
may
not
accurately
reflect
the
risks
associated
with
those
securities.
Furthermore,
downgrades
in
credit
ratings
could
increase
our
credit
risk,
reduce
our
cash
flows,
or
otherwise
adversely
affect
our
business
and
operations.
We generally do not consider credit ratings in assessing our estimates of future cash flows and desirability of our investments (although our assessment of the
quality of an investment may prove to be inaccurate and we may incur credit losses in excess of our initial expectations). The assignment of an “investment grade”
rating to a security by a rating agency does not mean that there is not credit risk associated with the security or that the risk of a credit loss with respect to such
security is necessarily remote. Many of the securities we own do have credit ratings and, to the extent we securitize loans and securities, we expect to retain credit
rating agencies to provide ratings on the securities created by these securitization entities (as we have in the past).
Rating agencies rate debt securities based upon their assessment of the safety of the receipt of principal and interest payments. Rating agencies do not consider
the risks of fluctuations in fair value or other factors that may influence the value of debt securities and, therefore, any assigned credit rating may not fully reflect
the true risks of an investment in securities. Also, rating agencies may fail to make timely adjustments to credit ratings based on available data or changes in
economic outlook or may otherwise fail to make changes in credit ratings in response to subsequent events, so that our investments may be better or worse than the
ratings indicate. Credit rating agencies may change their methods of evaluating credit risk and determining ratings on securities backed by real estate loans and
securities. These changes may occur quickly and often. The market’s ability to understand and absorb these changes and the impact to the securitization market in
general are difficult to predict. Such changes may have an impact on the amount of investment-grade and non-investment-grade securities that are created or placed
on the market in the future. Downgrades to the ratings of securities could have an adverse effect on the value of some of our investments and our cash flows from
those investments.
13
Changes in prepayment rates of mortgage loans could reduce our earnings, dividends, cash flows, and access to liquidity.
The economic returns we earn from most of the real estate securities and loans we own (directly or indirectly) are affected by the rate of prepayment of the
underlying mortgage loans. Prepayments are difficult to accurately predict and adverse changes in the rate of prepayment could reduce our cash flows, earnings,
and dividends. Adverse changes in cash flows would likely reduce the fair values of many of our assets, which could reduce our ability to borrow against our assets
and may cause market valuation adjustments for GAAP purposes, which could reduce our reported earnings. While we estimate prepayment rates to determine the
effective yield of our assets and valuations, these estimates are not precise and prepayment rates do not necessarily change in a predictable manner as a function of
interest rate changes. Prepayment rates can change rapidly. As a result, changes can cause volatility in our financial results, affect our ability to securitize assets,
affect our ability to fund acquisitions, and have other negative impacts on our ability to generate earnings.
We may own securities backed by residential loans that are particularly sensitive to changes in prepayments rates. These securities include interest-only
securities (IOs) that we acquire from third parties and from our Sequoia entities. Faster prepayments than we anticipated on the underlying loans backing these IOs
will have an adverse effect on our returns on these investments and may result in losses. Similarly, we own mortgage servicing rights, or MSRs, associated with
residential mortgage loans that are particularly sensitive to changes in prepayments rates. As the owner of an MSR, we are entitled to a portion of the interest
payments made by the borrower in respect of the associated loan and we are responsible for hiring and compensating a sub-servicer to directly service the
associated loan. Faster prepayments than we anticipate on loans associated with MSRs we own will have an adverse effect on our returns from these MSRs and
may result in losses.
Interest rate fluctuations can have various negative effects on us and could lead to reduced earnings and increased volatility in our earnings.
Changes in interest rates, the interrelationships between various interest rates, and interest rate volatility could have negative effects on our earnings, the fair
value of our assets and liabilities, loan prepayment rates, and our access to liquidity. Changes in interest rates can also harm the credit performance of our assets.
We generally seek to hedge some but not all interest rate risks. Our hedging may not work effectively and we may change our hedging strategies or the degree or
type of interest rate risk we assume.
Some of the loans and securities we own or may acquire have adjustable-rate coupons (i.e., they may earn interest at a rate that adjusts periodically based on
an interest rate index). The cash flows we receive from these assets may vary as a function of interest rates, as may the reported earnings generated by these assets.
We also acquire loans and securities for future sale, as assets we are accumulating for securitization, or as a longer-term investment. We expect to fund assets with
a combination of equity, fixed rate debt and adjustable rate debt. To the extent we use adjustable rate debt to fund assets that have a fixed interest rate (or use fixed
rate debt to fund assets that have an adjustable interest rate), an interest rate mismatch could exist and we could, for example, earn less (and fair values could
decline) if interest rates rise, at least for a time. We may or may not seek to mitigate interest rate mismatches for these assets with hedges such as interest rate
agreements and other derivatives and, to the extent we do use hedging techniques, they may not be successful.
Additionally, in recent periods our residential mortgage banking results have been affected by the combination of estimated market valuation adjustments on
our pipeline of jumbo residential loans identified for purchase, but not yet purchased, and changes in the value of interest rate hedges relating to that pipeline,
which may impact our reported financial results in different reporting periods. See the discussion under the risk factor titled “The
performance
of
the
assets
we
own
and
the
investments
we
make
will
vary
and
may
not
meet
our
earnings
or
cash
flow
expectations.
In
addition,
the
cash
flows
and
earnings
from,
and
market
values
of,
securities,
loans,
and
other
assets
we
own
may
be
volatile.”
Interest rate volatility, particularly at the beginning or end of a reporting period, tends to exacerbate
these impacts on our reported financial results and may contribute to earnings volatility.
Higher interest rates generally reduce the fair value of many of our assets, with the exception of our IOs, MSRs, and adjustable-rate assets. This may affect
our earnings results, reduce our ability to securitize, re-securitize, or sell our assets, or reduce our liquidity. Higher interest rates could reduce the ability of
borrowers to make interest payments or to refinance their loans. Higher interest rates could reduce property values and increased credit losses could result. Higher
interest rates could reduce mortgage originations, thus reducing our opportunities to acquire new assets.
When short-term interest rates are high relative to long-term interest rates, an increase in adjustable-rate residential loan prepayments may occur, which would
likely reduce our returns from owning interest-only securities backed by adjustable-rate residential loans.
14
It can be difficult to predict the impact on interest rates of unexpected and uncertain global political and economic events, such as the election of President
Trump, the U.K. vote to exit the European Union, or changes in the credit rating of the U.S. government, the United Kingdom, or one or more Eurozone nations;
however, increased uncertainty or changes in the economic outlook for, or rating of, the creditworthiness of the U.S. government, the United Kingdom, or
Eurozone nations may have adverse impacts on, among other things, the U.S. economy, financial markets, the cost of borrowing, the financial strength of
counterparties we transact business with, and the value of assets we hold. Any such adverse impacts could negatively impact the availability to us of short-term
debt financing, our cost of short-term debt financing, our business, and our financial results.
We have significant investment and reinvestment risks.
New
assets
we
acquire
may
not
generate
yields
as
attractive
as
yields
on
our
current
assets,
which
could
result
in
a
decline
in
our
earnings
per
share
over
time.
Assets we acquire or invest in may not generate the economic returns and GAAP yields we expect. Realized cash flow could be significantly lower than
expected and returns from new investments and acquisitions could be negative. In order to maintain our portfolio size and our earnings, we must reinvest in new
assets a portion of the cash flows we receive from principal, interest, and sales. We receive monthly payments from many of our assets, consisting of principal and
interest. In addition, occasionally some of our residential securities are called (effectively sold). We may also sell assets from time to time as part of our portfolio
and capital management strategies. Principal payments, calls, and sales reduce the size of our current portfolio and generate cash for us.
If the assets we invest in or acquire in the future earn lower GAAP yields than do the assets we currently own, our reported earnings per share could decline
over time as the older assets are paid down, are called, or are sold, assuming comparable expenses, credit costs, and market valuation adjustments. Under the
effective yield method of accounting that we use for GAAP purposes for some of our assets, we recognize yields on assets based on our assumptions regarding
future cash flows. A portion of the cash flows we receive may be used to reduce our basis in these assets. As a result of these various factors, our basis for GAAP
amortization purposes may be lower than the current fair values of these assets. Assets with a lower GAAP basis than current fair values generate higher GAAP
yields, and such yields are not necessarily available on newly acquired assets. Future economic conditions, including credit results, prepayment patterns, and
interest rate trends, are difficult to project with accuracy over the life of the assets we acquire, so there will be volatility in the reported returns over time.
Our
growth
may
be
limited
if
assets
are
not
available
or
not
available
at
attractive
prices.
To reinvest the proceeds from principal repayments we receive on our existing investments and deploy capital we raise, we must invest in or acquire new
assets. If the availability of new assets is limited, we may not be able to invest in or acquire assets that will generate attractive returns. Generally, asset supply can
be reduced if originations of a particular product are reduced or if there are fewer sales in the secondary market of seasoned product from existing portfolios. In
particular, assets we believe have a favorable risk/reward ratio may not be available for purchase.
We do not originate residential loans; rather, we rely on the origination market to supply the types of loans we seek to invest in. At times, due to increases in
interest rates, heightened credit concerns, strengthened underwriting standards, increased regulation, and/or concerns about economic growth or housing values, the
volume of originations may decrease significantly. For example, in recent years residential mortgage interest rates were generally declining, with the result that a
significant portion of industry-wide origination volumes were related to residential borrowers refinancing existing mortgage loans. To the extent interest rates
continue to increase, the volume of refinance loans is likely to further decline and this volume may not return to previous levels. A reduced volume of loan
originations may make it difficult for us to acquire loans and securities.
The supply of new issue RMBS collateralized by jumbo mortgage loans available for purchase could be adversely affected if the economics of executing
securitizations are not favorable or if the regulations governing the execution of securitizations discourage or preclude certain potential market participants from
engaging in these transactions. In addition, if there is not a robust market for triple-A rated securities, the supply of real estate subordinate securities could be
significantly diminished.
In 2014, we began entering into risk-sharing arrangements with Fannie Mae and Freddie Mac and more recently we have been purchasing credit risk transfer
(CRT) securities issued by Fannie Mae and Freddie Mac under which we are compensated for agreeing to absorb credit losses on new conforming loans or for
engaging in similar types of credit risk-sharing or -transfer structures. While these initiatives represent potential opportunities for future capital deployment,
ultimately these initiatives may not produce sizable investment opportunities due to competition from other investors, regulatory issues, or housing finance reform
at Fannie Mae and Freddie Mac.
15
Investments
in
diverse
types
of
assets
and
businesses
could
expose
us
to
new,
different,
or
increased
risks.
We have invested in and may in the future invest in a variety of real estate and non-real estate related assets that may not be closely related to the types of
investments we have traditionally made. Additionally, we may enter into or engage in various types of securitizations, transactions, services, and other operating
businesses that are different than the types we have traditionally entered into or engaged in. For example, in 2014 our FHLBC-member subsidiary established a
borrowing facility with the FHLBC that provides a source of long-term financing for residential mortgage loans that our subsidiary buys and holds, as a result of
which its holdings of residential whole loans have increased. Also, as noted above, we began entering into risk-sharing arrangements with Fannie Mae and Freddie
Mac in 2014 and more recently we have been purchasing CRT securities issued by Fannie Mae and Freddie Mac under which we are compensated for agreeing to
absorb credit losses on new conforming loans or for engaging in similar types of credit risk-sharing or -transfer structures. As another example, we recently began
exploring opportunities to provide expanded financing options to non-bank mortgage loan originators and expanding our mortgage loan purchase activity to
include, for example, business purpose loans secured by non-owner occupied rental properties. We also recently began exploring opportunities to invest in property
assessed clean energy (PACE) lien investments. Any of these actions may expose us to new, different, or increased investment, operational, financial, or
management risks. We may invest in non-real estate asset-backed securities (ABS), corporate debt, or equity. We have invested in diverse types of IOs from
residential and commercial securitizations sponsored by us or by others. The higher credit and prepayment risks associated with these types of investments may
increase our exposure to losses. We may invest in non-U.S. assets that may expose us to currency risks (which we may choose not to hedge) and different types of
credit, prepayment, hedging, interest rate, liquidity, legal, and other risks.
In addition, when investing in assets or businesses we are exposed to the risk that those assets, or interest income or revenue generated by those assets or
businesses, result in our not meeting the requirements to maintain our REIT status or our status as exempt from registration under the Investment Company Act of
1940, as amended (Investment Company Act), as further described in the risk factors titled “We
have
elected
to
be
a
REIT
and,
as
such,
are
required
to
meet
certain
tests
in
order
to
maintain
our
REIT
status.
This
adds
complexity
and
costs
to
running
our
business
and
exposes
us
to
additional
risks”
and
“Conducting
our
business
in
a
manner
so
that
we
are
exempt
from
registration
under,
and
in
compliance
with,
the
Investment
Company
Act
may
reduce
our
flexibility
and
could
limit
our
ability
to
pursue
certain
opportunities.
At
the
same
time,
failure
to
continue
to
qualify
for
exemption
from
the
Investment
Company
Act
could
adversely
affect
us.”
We
may
change
our
investment
strategy
or
financing
plans,
which
may
result
in
riskier
investments
and
diminished
returns.
We may change our investment strategy or financing plans at any time, which could result in our making investments that are different from, and possibly
riskier than, the investments we have previously made or described. A change in our investment strategy or financing plans may increase our exposure to interest
rate and default risk and real estate market fluctuations. Decisions to employ additional leverage could increase the risk inherent in our investment strategy.
Furthermore, a change in our investment strategy could result in our making investments in new asset categories or in different proportions among asset categories
than we previously have. For example, as noted above, in December 2017 and January 2018, we announced several new initiatives to expand our mortgage
banking and investment activities, including by exploring opportunities to provide expanded financing options to non-bank mortgage loan originators and
expanding our mortgage loan purchase activity to include, for example, business purpose loans secured by non-owner occupied rental properties. As another
example, in the future, we could determine to invest a greater proportion of our assets in securities backed by non-prime or subprime residential mortgage loans.
These changes could result in our making riskier investments, which could ultimately have an adverse effect on our financial returns. Alternatively, we could
determine to change our investment strategy or financing plans to be more risk averse, resulting in potentially lower returns, which could also have an adverse
effect on our financial returns.
16
The performance of the assets we own and the investments we make will vary and may not meet our earnings or cash flow expectations. In addition, the cash
flows and earnings from, and market values of, securities, loans, and other assets we own may be volatile.
We seek to manage certain of the risks associated with acquiring, holding, selling, and managing real estate loans and securities and other real estate-related
investments. No amount of risk management or mitigation, however, can change the variable nature of the cash flows of, fair values of, and financial results
generated by these loans, securities, and other assets. Changes in the credit performance of, or the prepayments on, these investments, including real estate loans
and the loans underlying these securities, and changes in interest rates impact the cash flows on these securities and investments, and the impact could be
significant for our loans, securities, and other assets with concentrated risks. Changes in cash flows lead to changes in our return on investment and also to
potential variability in and level of reported income. The revenue recognized on some of our assets is based on an estimate of the yield over the remaining life of
the asset. Thus, changes in our estimates of expected cash flow from an asset will result in changes in our reported earnings on that asset in the current reporting
period. We may be forced to recognize adverse changes in expected future cash flows as a current expense, further adding to earnings volatility. Additionally, our
non-GAAP measures of financial performance and our earnings calculated in accordance with GAAP may be subject to volatility. Moreover, the Securities and
Exchange Commission has increasingly been focused on the use of non-GAAP financial metrics and may require us to change the presentation or method of
calculation of our non-GAAP metrics which may result in variability and volatility.
Changes
in
the
fair
values
of
our
assets,
liabilities,
and
derivatives
can
have
various
negative
effects
on
us,
including
reduced
earnings,
increased
earnings
volatility,
and
volatility
in
our
book
value.
Fair values for our assets and liabilities, including derivatives, can be volatile and our revenue and income can be impacted by changes in fair values. The fair
values can change rapidly and significantly and changes can result from changes in interest rates, perceived risk, supply, demand, and actual and projected cash
flows, prepayments, and credit performance. A decrease in fair value may not necessarily be the result of deterioration in future cash flows. Fair values for illiquid
assets can be difficult to estimate, which may lead to volatility and uncertainty of earnings and book value.
For GAAP purposes, we may mark to market some, but not all, of the assets and liabilities on our consolidated balance sheet. In addition, valuation
adjustments on certain consolidated assets and many of our derivatives are reflected in our consolidated statement of income. Assets that are funded with certain
liabilities and hedges may have differing mark-to-market treatment than the liability or hedge. If we sell an asset that has not been marked to market through our
consolidated statement of income at a reduced market price relative to its cost basis, our reported earnings will be reduced.
Our loan sale profit margins are generally reflective of gains (or losses) over the period from when we identify a loan for purchase until we subsequently sell
or securitize the loan. These profit margins may encompass elements of positive or negative market valuation adjustments on loans, hedging gains or losses
associated with related risk management activities, and any other related transaction expenses; however, under GAAP, the differing elements may be realized
unevenly over the course of one or more quarters for financial reporting purposes, with the result that our financial results may be more volatile and less reflective
of the underlying economics of our business activity.
Our
calculations
of
the
fair
value
of
the
securities,
loans,
MSRs,
derivatives,
and
certain
other
assets
we
own
or
consolidate
are
based
upon
assumptions
that
are
inherently
subjective
and
involve
a
high
degree
of
management
judgment.
We report the fair values of securities, loans, MSRs, derivatives, and certain other assets on our consolidated balance sheets. In computing the fair values for
these assets we may make a number of market-based assumptions, including assumptions regarding future interest rates, prepayment rates, discount rates, credit
loss rates, and the timing of credit losses. These assumptions are inherently subjective and involve a high degree of management judgment, particularly for illiquid
securities and other assets for which market prices are not readily determinable. For further information regarding our assets recorded at fair value see Note 5 to the
Financial Statements within this Annual Report on Form 10-K. Use of different assumptions could materially affect our fair value calculations and our financial
results. Further discussion of the risk of our ownership and valuation of illiquid securities is set forth in the immediately following risk factor.
17
Investments we make, hedging transactions that we enter into, and the manner in which we finance our investments and operations expose us to various risks,
including liquidity risk, risks associated with the use of leverage, market risks, and counterparty risk.
Many
of
our
investments
have
limited
liquidity.
Many of the residential, multifamily, and commercial securities we own or may own are generally illiquid - that is, there is not a significant pool of potential
investors that are likely to invest in these, or similar, securities. This illiquidity can also exist for the real estate loans we may hold. At times, the vast majority of
the assets we own are illiquid. In turbulent markets, it is likely that the securities, loans, and other assets we own may become even less liquid. As a result, we may
not be able to sell certain assets at opportune times or at attractive prices or we may incur significant losses upon sale of these assets, should we want or need to sell
them.
Our
level
of
indebtedness
and
liabilities
could
limit
cash
flow
available
for
our
operations,
expose
us
to
risks
that
could
adversely
affect
our
business,
financial
condition
and
results
of
operations
and
impair
our
ability
to
satisfy
our
obligations
under
our
convertible
notes
and
other
debt
instruments.
At December 31, 2017, our total consolidated liabilities (excluding indebtedness associated with asset-backed securities issued by consolidated Sequoia
entities, for which we are not liable) was $4.66 billion. We may also incur additional indebtedness to meet future financing needs. Our indebtedness could have
significant negative consequences for our business, results of operations and financial condition, including:
•
•
•
•
•
•
•
increasing our vulnerability to adverse economic and industry conditions;
limiting our ability to obtain additional financing;
requiring the dedication of a substantial portion of our cash flow from operations to service our indebtedness, thereby reducing the amount of our cash
flow available for other purposes;
requiring asset sales to fund maturing debt;
limiting our flexibility in planning for, or reacting to, changes in our business;
dilution experienced by our existing stockholders as a result of the conversion of the convertible notes or exchangeable securities into shares of common
stock; and
placing us at a possible competitive disadvantage with less leveraged competitors and competitors that may have better access to capital resources.
We cannot assure you that we will be able to continue to maintain sufficient cash reserves or continue to generate cash flow from operations at levels
sufficient to permit us to pay principal, premium, if any, and interest on our indebtedness, or that our cash needs will not increase. If we are unable to generate
sufficient cash flow or otherwise obtain funds necessary to make required payments, or if we fail to comply with the various requirements of our indebtedness then
outstanding, we would be in default, which would permit the holders of the affected indebtedness to accelerate the maturity of such indebtedness and could cause
defaults under our other indebtedness. Any default under any indebtedness could have a material adverse effect on our business, results of operations and financial
condition. For an additional discussion of our outstanding indebtedness, see Part II, Item 7 of this Annual Report on Form 10-K under the heading “Risks
Relating
to
Debt
Incurred
under
Short-
and
Long-Term
Borrowing
Facilities."
18
Our
use
of
financial
leverage
could
expose
us
to
increased
risks.
We fund the residential loans we acquire in anticipation of a future sale or securitization with a combination of equity and short-term debt. In addition, we also
make investments in securities and loans financed with short- and long-term debt. By incurring this debt (i.e., by applying financial leverage), we expect to
generate more attractive returns on our invested equity capital. However, as a result of using financial leverage (whether for the accumulation of loans or related to
longer-term investments), we could also incur significant losses if our borrowing costs increase relative to the earnings on our assets and costs of any related
hedges. Financing facility creditors may also force us to sell assets pledged as collateral under adverse market conditions to meet margin calls, for example, in the
event of a decrease in the fair values of the assets pledged as collateral. Liquidation of the collateral could create negative tax consequences and raise REIT
qualification issues. Further discussion of the risk associated with maintaining our REIT status is set forth in the risk factor titled “We
have
elected
to
be
a
REIT
and,
as
such,
are
required
to
meet
certain
tests
in
order
to
maintain
our
REIT
status.
This
adds
complexity
and
costs
to
running
our
business
and
exposes
us
to
additional
risks.”
In addition, we make financial covenants to creditors in connection with incurring short- and long-term debt, such as covenants relating to our
maintaining a minimum amount of tangible net worth or stockholders’ equity and/or a minimum amount of liquid assets. If we fail to comply with these financial
covenants we would be in default under our financing facilities, which could result in, among other things, the liquidation of collateral we have pledged pursuant to
these facilities under adverse market conditions and the inability to incur additional borrowings to finance our business activities. A further discussion of financial
covenants we are subject to and related risks associated with our use of short-term debt is set forth in Part II, Item 7 of this Annual Report on Form 10-K under the
heading, “Risks
Relating
to
Debt
Incurred
Under
Short-
and
Long-Term
Borrowing
Facilities.”
Additionally, our ability to increase our borrowing limits under our
debt financing facilities (and therefore increase our investment capacity) may be limited by our ability to raise equity capital, which we may not be able to raise at
attractive prices or at all.
The
inability
to
access
financial
leverage
through
warehouse
and
repurchase
facilities,
credit
facilities,
our
FHLB-member
subsidiary’s
borrowing
facility
with
the
FHLBC,
or
other
forms
of
debt
financing
may
inhibit
our
ability
to
execute
our
business
plan,
which
could
have
a
material
adverse
effect
on
our
financial
results,
financial
condition,
and
business.
Our ability to fund our business and our investment strategy depends on our securing warehouse, repurchase, or other forms of debt financing (or leverage) on
acceptable terms. For example, pending the sale or securitization of a pool of mortgage loans or other assets we generally fund the acquisition of those mortgage
loans or other assets through borrowings from warehouse, repurchase, and credit facilities, and other forms of short-term financing.
We cannot assure you that we will be successful in establishing sufficient sources of short-term debt when needed. In addition, because of its short-term
nature, lenders may decline to renew our short-term debt upon maturity or expiration, and it may be difficult for us to obtain continued short-term financing.
During certain periods, lenders may curtail their willingness to provide financing, as liquidity in short-term debt markets, including repurchase facilities and
commercial paper markets, can be withdrawn suddenly, making it difficult or expensive to renew short-term borrowings as they mature. To the extent our business
or investment strategy calls for us to access financing and counterparties are unable or unwilling to lend to us, then our business and financial results will be
adversely affected. In addition, it is possible that lenders who provide us with financing could experience changes in their ability to advance funds to us,
independent of our performance or the performance of our investments, in which case funds we had planned to be able to access may not be available to us.
Additionally, federal regulations were adopted by the Federal Housing Finance Agency in January 2016 relating to captive insurance company membership in the
Federal Home Loan Bank System. Under these regulations, our captive insurance company subsidiary, RWT Financial, LLC, which is currently a member of the
Federal Home Loan Bank of Chicago (FHLBC), is only eligible to remain as a member of the FHLBC for a five-year transition period and may not be able to
obtain additional advances or increases to its borrowing capacity from the FHLBC. Although FHLBC is permitted to allow advances that were outstanding to RWT
Financial prior to effectiveness of the regulations to remain outstanding until scheduled maturity (even if that scheduled maturity extends beyond the five-year
transition period), these regulations may limit RWT Financial’s ability to increase the size of its portfolio of residential mortgage loans and thereby may impact the
ability to increase net interest income generated by RWT Financial’s portfolio of held-for-investment loans, and could otherwise have an adverse effect on our
business and results of operations, as further described under the risk factor titled “Federal
regulations
may
limit,
eliminate,
or
reduce
the
attractiveness
of
our
subsidiary’s
ability
to
use
borrowings
from
the
Federal
Home
Loan
Bank
of
Chicago
to
finance
the
mortgage
loans
and
securities
it
holds
and
acquires,
which
could
negatively
impact
our
business
and
operating
results.”
Additionally, our ability to increase borrowing limits under our debt financing facilities (and
therefore increase our investment capacity) may be limited by our ability to raise equity capital, which we may not be able to raise at attractive prices or at all.
19
Hedging
activities
may
reduce
earnings,
may
fail
to
reduce
earnings
volatility,
and
may
fail
to
protect
our
capital
in
difficult
economic
environments.
We attempt to hedge certain interest rate risks (and, at times, prepayment risks and fair values) by balancing the characteristics of our assets and associated
(existing and anticipated) liabilities with respect to those risks and entering into various interest rate agreements. The number and scope of the interest rate
agreements we utilize may vary significantly over time. We generally seek to enter into interest rate agreements that provide an appropriate and efficient method
for hedging certain risks related to changes in interest rates.
The use of interest rate agreements and other instruments to hedge certain of our risks may well have the effect over time of lowering long-term earnings to the
extent these risks do not materialize. To the extent that we hedge, it is usually to seek to protect us from some of the effects of short-term interest rate volatility, to
lower short-term earnings volatility, to stabilize liability costs or fair values, to stabilize our economic returns from or meet rating agency requirements with respect
to a securitization transaction, or to stabilize the future cost of anticipated issuance of securities by a securitization entity. Hedging may not achieve our desired
goals. Hedging with respect to the pipeline of loans we plan to purchase may not be effective due to loan fallout or other reasons. Using interest rate agreements as
a hedge may increase short-term earnings volatility, especially if we do not elect certain accounting treatments for our hedges. Reductions in fair values of interest
rate agreements may not be offset by increases in fair values of the assets or liabilities being hedged. Conversely, increases in fair values of interest rate agreements
may not fully offset declines in fair values of assets or liabilities being hedged. Changes in fair values of interest rate agreements may require us to pledge
significant amounts of cash or other acceptable forms of collateral.
We also may hedge by taking short, forward, or long positions in U.S. Treasuries, mortgage securities, or other cash instruments. We may take both long and
short positions in credit derivative transactions linked to real estate assets. These derivatives may have additional risks to us, such as: liquidity risk, due to the fact
that there may not be a ready market into which we could sell these derivatives if needed; basis risk, which could result in a decline in value or a requirement to
make a cash payment as a result of changes in interest rates; and the risk that a counterparty to a derivative is not willing or able to perform its obligations to us due
to its financial condition or otherwise.
Our earnings may be subject to fluctuations from quarter to quarter as a result of the accounting treatment for certain derivatives or for assets or liabilities
whose terms do not necessarily match those used for derivatives, or as a result of our inability to meet the requirements necessary to obtain specific hedge
accounting treatment for certain derivatives.
We
enter
into
derivative
contracts
that
may
expose
us
to
contingent
liabilities
and
those
contingent
liabilities
may
not
appear
on
our
balance
sheet.
We
may
invest
in
synthetic
securities,
credit
default
swaps,
and
other
credit
derivatives,
which
expose
us
to
additional
risks.
We enter into derivative contracts, including interest rate swaps, options, and futures, that could require us to make cash payments in certain circumstances.
Potential payment obligations would be contingent liabilities and may not appear on our balance sheet. Our ability to satisfy these contingent liabilities depends on
the liquidity of our assets and our access to capital and cash. The need to fund these contingent liabilities could adversely impact our financial condition.
We may in the future invest in synthetic securities, credit default swaps, and other credit derivatives that reference other real estate securities or indices.
These investments may present risks in excess of those resulting from the referenced security or index. These investments are typically contractual relationships
with counterparties and not acquisitions of referenced securities or other assets. In these types of investments, we have no right directly to enforce compliance with
the terms of the referenced security or other assets and we have no voting or other consensual rights of ownership with respect to the referenced security or other
assets. In the event of insolvency of a counterparty, we will be treated as a general creditor of the counterparty and will have no claim of title with respect to the
referenced security.
Hedging
activities
may
subject
us
to
increased
regulation.
Under the Dodd-Frank Act, there is increased regulation of companies, such as Redwood and certain of our subsidiaries, that enter into interest rate hedging
agreements and other hedging instruments and derivatives. This increased regulation could result in Redwood or certain of our subsidiaries being required to
register and be regulated as a commodity pool operator or a commodity trading advisor. If we are not able to maintain an exemption from these regulations, it
could have a negative impact on our business or financial results. Moreover, rules requiring central clearing of certain interest rate swap and other transactions, as
well as rules relating to margin and capital requirements for swap transactions and regulated participants in the swap markets, as well as other swap market
regulatory reforms, may increase the cost or decrease the availability to us of hedging transactions, and may also limit our ability to include swaps in our
securitization transactions.
20
Our
results
could
be
adversely
affected
by
counterparty
credit
risk.
We have credit risks that are generally related to the counterparties with which we do business. There is a risk that counterparties will fail to perform under
their contractual arrangements with us and this risk is usually more pronounced during an economic downturn. Counterparties may seek to eliminate credit
exposure by entering into offsetting, or “back-to-back,” hedging transactions, and the ability of a counterparty to settle a synthetic transaction may be dependent on
whether the counterparties to the back-to-back transactions perform their delivery obligations. Those risks of non-performance may differ materially from the risks
entailed in exchange-traded transactions, which generally are backed by clearing organization guarantees, daily mark-to-market and settlement of positions, and
segregation and minimum capital requirements applicable to intermediaries. Transactions entered into directly between parties generally do not benefit from those
protections, and expose the parties to the risk of counterparty default. Furthermore, there may be practical and timing problems associated with enforcing our rights
to assets in the case of an insolvency of a counterparty.
In the event a counterparty to our short-term borrowings becomes insolvent, we may fail to recover the full value of our pledged collateral, thus reducing our
earnings and liquidity. In the event a counterparty to our interest rate agreements or other derivatives becomes insolvent or interprets our agreements with it in a
manner unfavorable to us, our ability to realize benefits from the hedge transaction may be diminished, any cash or collateral we pledged to the counterparty may
be unrecoverable, and we may be forced to unwind these agreements at a loss. In the event a counterparty that sells us residential mortgage loans becomes
insolvent or is acquired by a third party, we may be unable to enforce our loan repurchase rights in connection with a breach of loan representations and warranties
and we may suffer losses if we must repurchase delinquent loans. In the event that one of our sub-servicers becomes insolvent or fails to perform, loan
delinquencies and credit losses may increase and we may not receive the funds to which we are entitled. We attempt to diversify our counterparty exposure and
(except with respect to loan representations and warranties) attempt to limit our counterparty exposure to counterparties with investment-grade credit ratings,
although we may not always be able to do so. Our counterparty risk management strategy may prove ineffective and, accordingly, our earnings and cash flows
could be adversely affected.
Business, Operational and Other Risks
Through certain of our wholly-owned subsidiaries we have engaged in the past, and plan to continue to engage, in acquiring residential mortgage loans with
the intent to sell these loans to third parties or hold them as investments. Similarly, we have engaged in the past, and may continue to engage, in acquiring
residential MSRs. These types of transactions and investments expose us to potentially material risks.
Acquiring mortgage loans with intent to sell these loans to third parties generally requires us to incur short-term debt, either on a recourse or non-recourse
basis, to finance the accumulation of loans or other assets prior to sale. This type of debt may not be available to us, or may only be available to us on an
uncommitted basis, including in circumstances where a line of credit had previously been made available or committed to us. In addition, the terms of any available
debt may be unfavorable to us or impose restrictive covenants that could limit our business and operations or the violation of which could lead to losses and inhibit
our ability to borrow in the future. We expect to pledge assets we acquire to secure the short-term debt we incur. To the extent this debt is recourse to us, if the fair
value of the assets pledged as collateral declines, we would be required to increase the amount of collateral pledged to secure the debt or to repay all or a portion of
the debt. In addition, when we acquire assets for a sale, we make assumptions about the cash flows that will be generated from those assets and the market value of
those assets. If these assumptions are wrong, or if market values change or other conditions change, it could result in a sale that is less favorable to us than initially
assumed, which would typically have a negative impact on our financial results.
Furthermore, if we are unable to complete the sale of these types of assets, it could have a negative impact on our business and financial results. We have a
limited capacity to hold residential loans on our balance sheet as investments, and our business is not structured to buy-and-hold the full volume of loans that we
routinely acquire with the intent to sell. If demand for buying whole-loans weakens, we may be forced to incur additional debt on unfavorable terms or may be
unable to borrow to finance these assets, which may in turn impact our ability to continue acquiring loans over the short or long term.
21
Prior to acquiring loans or other assets for sale, we may undertake underwriting and due diligence efforts with respect to various aspects of the loan or asset.
When underwriting or conducting due diligence, we rely on resources and data available to us, which may be limited, and we rely on investigations by third parties.
We may also only conduct due diligence on a sample of a pool of loans or assets we are acquiring and assume that the sample is representative of the entire pool.
Our underwriting and due diligence efforts may not reveal matters which could lead to losses. If our underwriting process is not robust enough or if we do not
conduct adequate due diligence, or the scope of our underwriting or due diligence is limited, we may incur losses. Losses could occur due to the fact that a
counterparty that sold us a loan or other asset refuses or is unable (e.g., due to its financial condition) to repurchase that loan or asset or pay damages to us if we
determine subsequent to purchase that one or more of the representations or warranties made to us in connection with the sale was inaccurate.
In addition, when selling residential mortgage loans or acquiring servicing rights associated with residential mortgage loans, we typically make representations
and warranties to the purchaser or to other third parties regarding, among other things, certain characteristics of those assets, including characteristics we seek to
verify through our underwriting and due diligence efforts. If our representations and warranties are inaccurate with respect to any asset, we may be obligated to
repurchase that asset or pay damages, which may result in a loss. We generally only establish reserves for potential liabilities relating to representations and
warranties we make if we believe that those liabilities are both probable and estimable, as determined in accordance with GAAP. As a result, we may not have
reserves relating to these potential liabilities or any reserves we may establish could be inadequate. Even if we obtain representations and warranties from the
counterparties from whom we acquired the loans or other assets, they may not parallel the representations and warranties we make or may otherwise not protect us
from losses, including, for example, due to the fact that the counterparty may be insolvent or otherwise unable to make a payment to us at the time we claim
damages for a breach of representation or warranty. Furthermore, to the extent we claim that counterparties we have acquired loans from have breached their
representations and warranties to us, it may adversely impact our business relationship with those counterparties, including by reducing the volume of business we
conduct with those counterparties, which could negatively impact our ability to acquire loans and our business. To the extent we have significant exposure to
representations and warranties made to us by one or more counterparties we acquire loans from, we may determine, as a matter of risk management, to reduce or
discontinue loan acquisitions from those counterparties, which could reduce the volume of residential loans we acquire and negatively impact our business and
financial results.
RWT Financial, our FHLB-member subsidiary, maintains a portfolio of residential mortgage loans it holds for investment with long-term financing provided
by the FHLBC. At December 31, 2017, RWT Financial had approximately $2.00 billion of long-term borrowings outstanding from the FHLBC, which were
collateralized by residential mortgage loans. RWT Financial has effectively reached its maximum borrowing capacity from the FHLBC of $2.00 billion, and it may
not be able to obtain any increase in its borrowing capacity in the future. FHLBC financing has enabled RWT Financial to earn attractive returns on loans held as
long-term investments, contributing a significant amount to our 2017 earnings. RWT Financial’s ability to increase the size of its portfolio of residential mortgage
loans may be limited by the lack of availability of attractive financing and this may impact the ability to increase net interest income generated by RWT Financial,
as further described under the risk factor titled “Federal
regulations
may
limit,
eliminate,
or
reduce
the
attractiveness
of
our
subsidiary’s
ability
to
use
borrowings
from
the
Federal
Home
Loan
Bank
of
Chicago
to
finance
the
mortgage
loans
and
securities
it
holds
and
acquires,
which
could
negatively
impact
our
business
and
operating
results.”
Additionally, the portfolio of residential mortgage loans held as long-term investments exposes us to the risk of loss on the full balance of those
loans, which is typically not the case with respect to securities we retain from securitization transactions we sponsor. The materialization of any of these risks
related to RWT Financial’s investment activity and FHLB financing could significantly impact our financial and operating results.
22
Through certain of our wholly-owned subsidiaries we have engaged in the past, and expect to continue to engage in, securitization transactions relating to real
estate mortgage loans. In addition, we have invested in and continue to invest in mortgage-backed securities and other ABS issued in securitization
transactions sponsored by other companies. These types of transactions and investments expose us to potentially material risks.
Engaging in securitization transactions and other similar transactions generally requires us to incur short-term debt on a recourse basis to finance the
accumulation of loans or other assets prior to securitization. If demand for investing in securitization transactions weakens, we may be unable to complete the
securitization of loans accumulated for that purpose, which may hurt our business or financial results. In addition, in connection with engaging in securitization
transactions, we engage in due diligence with respect to the loans or other assets we are securitizing and make representations and warranties relating to those loans
and assets. The risks associated with incurring this type of debt in connection with securitization activity, the risks related to our ability to complete securitization
transactions after we have accumulated loans for that purpose, and the risks associated with the due diligence we conduct, and the representations and warranties
we make, in connection with securitization activity are similar to the risks associated with acquiring loans with the intent to sell them to third parties, as described
in the immediately preceding risk factor titled “ Through
certain
of
our
wholly-owned
subsidiaries
we
have
engaged
in
the
past,
and
plan
to
continue
to
engage,
in
acquiring
residential
mortgage
loans
with
the
intent
to
sell
these
loans
to
third
parties
or
hold
them
as
investments.
Similarly,
we
have
engaged
in
the
past,
and
continue
to
engage,
in
acquiring
residential
MSRs.
These
types
of
transactions
and
investments
expose
us
to
potentially
material
risks.
”
When engaging in securitization transactions, we also prepare marketing and disclosure documentation, including term sheets and prospectuses, that include
disclosures regarding the securitization transactions and the assets being securitized. If our marketing and disclosure documentation are alleged or found to contain
inaccuracies or omissions, we may be liable under federal and state securities laws (or under other laws) for damages to third parties that invest in these
securitization transactions, including in circumstances where we relied on a third party in preparing accurate disclosures, or we may incur other expenses and costs
in connection with disputing these allegations or settling claims. We have also engaged in selling or contributing commercial real estate loans to third parties who,
in turn, have securitized those loans. In these circumstances, we have in the past and may in the future also prepare marketing and disclosure documentation,
including documentation that is included in term sheets and prospectuses relating to those securitization transactions. We could be liable under federal and state
securities laws (or under other laws) for damages to third parties that invest in these securitization transactions, including liability for disclosures prepared by third
parties or with respect to loans that we did not sell or contribute to the securitization. Additionally, we typically retain various third-party service providers when
we engage in securitization transactions, including underwriters or initial purchasers, trustees, administrative and paying agents, and custodians, among others. We
frequently contractually agree to indemnify these service providers against various claims and losses they may suffer in connection with the provision of services
to us and/or the securitization trust. To the extent any of these service providers are liable for damages to third parties that have invested in these securitization
transactions, we may incur costs and expenses as a result of these indemnities.
In recent years there has also been debate as to whether there are defects in the legal process and legal documents governing transactions in which
securitization trusts and other secondary purchasers take legal ownership of residential mortgage loans and establish their rights as first priority lien holders on
underlying mortgaged property. To the extent there are problems with the manner in which title and lien priority rights were established or transferred,
securitization transactions that we sponsored and third-party sponsored securitizations that we hold investments in may experience losses, which could expose us to
losses and could damage our ability to engage in future securitization transactions.
In connection with our operating and investment activity, we rely on third parties to perform certain services, comply with applicable laws and regulations, and
carry out contractual covenants and terms, the failure of which by any of these third parties may adversely impact our business and financial results.
In connection with our business of acquiring loans, engaging in securitization transactions, and investing in third-party issued securities and other assets, we
rely on third party service providers to perform certain services, comply with applicable laws and regulations, and carry out contractual covenants and terms. As a
result, we are subject to the risks associated with a third party’s failure to perform, including failure to perform due to reasons such as fraud, negligence, errors,
miscalculations, or insolvency. For example, if loan servicers experience higher volumes of delinquent loans than they have in the past, there is a risk that, as a
result, their operational infrastructures may not be able to properly process this increased volume. Many loan servicers have been accused of improprieties in the
handling of the loan modification or foreclosure process with respect to residential mortgage loans that have gone into default. To the extent a third-party loan
servicer fails to fully and properly perform its obligations, loans and securities that we hold as investments may experience losses and securitizations that we have
sponsored may experience poor performance, and our ability to engage in future securitization transactions could be harmed.
23
For some of the loans that we hold and for some of the loans we sell or securitize, we hold the right to service those loans and we retain a sub-servicer to
service those loans. In these circumstances we are exposed to certain risks, including, without limitation, that we may not be able to enter into subservicing
agreements on favorable terms to us or at all, or that the sub-servicer may not properly service the loan in compliance with applicable laws and regulations or the
contractual provisions governing their sub-servicing role, and that we would be held liable for the sub-servicer’s improper acts or omissions. Additionally, in its
capacity as a servicer of residential mortgage loans, a sub-servicer will have access to borrowers’ non-public personal information, and we could incur liability in
connection with a data breach relating to a sub-servicer, as discussed further below under the risk factor titled “Our
technology
infrastructure
and
systems
are
important
and
any
significant
disruption
or
breach
of
the
security
of
this
infrastructure
or
these
systems
could
have
an
adverse
effect
on
our
business.
We
also
rely
on
technology
infrastructure
and
systems
of
third
parties
who
provide
services
to
us
and
with
whom
we
transact
business.”
When we retain a sub-servicer we are
generally also obligated to fund any obligation of the sub-servicer to make advances on behalf of a delinquent loan obligor. To the extent any one sub-servicer
counterparty services a significant percentage of the loans with respect to which we own the servicing rights, the risks associated with our use of that sub-servicer
are concentrated around this single sub-servicer counterparty. To the extent that there are significant amounts of advances that need to be funded in respect of loans
where we own the servicing right, it could have a material adverse effect on our business and financial results.
We also rely on corporate trustees to act on behalf of us and other holders of ABS in enforcing our rights as security holders. Under the terms of most ABS we
hold, we do not have the right to directly enforce remedies against the issuer of the security, but instead must rely on a trustee to act on behalf of us and other
security holders. Should a trustee not be required to take action under the terms of the securities, or fail to take action, we could experience losses.
Our ability to execute or participate in future securitization transactions, including, in particular, securitizations of residential mortgage loans, could be
delayed, limited, or precluded by legislative and regulatory reforms applicable to asset-backed securities and the institutions that sponsor, service, rate, or
otherwise participate in or contribute to the successful execution of a securitization transaction. Other factors could also limit, delay, or preclude our ability to
execute securitization transactions. These legislative, regulatory, and other factors could also reduce the returns we would otherwise expect to earn in
connection with executing securitization transactions.
In July 2010, the Dodd-Frank Act was enacted. Provisions of the Dodd-Frank Act require, among other things, significant revisions to the legal and regulatory
framework under which ABS, including residential mortgage-backed securities (RMBS), are issued through the execution of securitization transactions. Some of
the provisions of the Dodd-Frank Act have become effective or been implemented, while others are in the process of being implemented or will become effective
soon. In addition, prior to the passage of the Dodd-Frank Act, the Securities and Exchange Commission (SEC) and the Federal Deposit Insurance Corporation had
already published proposed and final regulations under already existing legislative authority relating to the issuance of ABS, including RMBS. Additional federal
or state laws and regulations that could affect our ability to execute future securitization transactions could be proposed, enacted, or implemented. In addition,
various federal and state agencies and law enforcement authorities, as well as private litigants, have initiated and may, in the future, initiate additional broad-based
enforcement actions or claims, the resolution of which may include industry-wide changes to the way residential mortgage loans are originated, transferred,
serviced, and securitized, and any of these changes could also affect our ability to execute future securitization transactions. For an example, please refer to the risk
factor titled “Federal
and
state
legislative
and
regulatory
developments
and
the
actions
of
governmental
authorities
and
entities
may
adversely
affect
our
business
and
the
value
of,
and
the
returns
on,
mortgages,
mortgage-related
securities,
and
other
assets
we
own
or
may
acquire
in
the
future.”
24
Rating agencies can affect our ability to execute or participate in a securitization transaction, or reduce the returns we would otherwise expect to earn from
executing securitization transactions, not only by deciding not to publish ratings for our securitization transactions (or deciding not to consent to the inclusion of
those ratings in the prospectuses or other documents we file with the SEC relating to securitization transactions), but also by altering the criteria and process they
follow in publishing ratings. Rating agencies could alter their ratings processes or criteria after we have accumulated loans or other assets for securitization in a
manner that effectively reduces the value of those previously acquired loans or requires that we incur additional costs to comply with those processes and criteria.
For example, to the extent investors in a securitization transaction would have significant exposure to representations and warranties made by us or by one or more
counterparties we acquire loans from, rating agencies may determine that this exposure increases investment risks relating to the securitization transaction. Rating
agencies could reach this conclusion either because of our financial condition or the financial condition of one or more counterparties we acquire loans from, or
because of the aggregate amount of residential loan-related representations and warranties (or other contingent liabilities) we, or one or more counterparties we
acquire loans from, have made or have exposure to. In addition, our ability to continue to securitize residential mortgage loans in the future will depend, in part, on
the rating agencies’ assessment of the investment risks that result from the ability-to-repay regulations and the TILA-RESPA Integrated Disclosure Rule (TRID).
This includes, for example, how they assess investment risks associated with (a) non-material errors in loan-related disclosures made to mortgage borrowers, (b)
residential mortgage loans that have an interest-only payment feature, or (c) loans under which the borrower has a debt-to-income ratio of more than 43%. These
types of loans have historically accounted for a significant amount of the loans we have securitized, but they are not considered “qualified mortgages” under the
ability-to-repay regulations. Since these provisions were implemented over the past several years, the rating agencies’ assessment of these risks has generally been
consistent with ours, but to the extent their assessments diverge from ours, this could negatively impact our ability to execute securitization transactions. If, as a
result of any of the foregoing issues, rating agencies place limitations on our ability to execute future securitization transactions or impose unfavorable ratings
levels or conditions on our securitization transactions, it could reduce the returns we would otherwise expect to earn from executing these transactions and
negatively impact our business and financial results.
Furthermore, other matters, such as (i) accounting standards applicable to securitization transactions and (ii) capital and leverage requirements applicable to
banks’ and other regulated financial institutions’ holdings of ABS, could result in less investor demand for securities issued through securitization transactions we
execute or increased competition from other institutions that originate, acquire, and hold commercial real estate loans, residential mortgage loans, and other types
of assets and execute securitization transactions.
Our ability to profitably execute or participate in future securitizations transactions, including, in particular, securitizations of residential mortgage loans, is
dependent on numerous factors and if we are not able to achieve our desired level of profitability or if we incur losses in connection with executing or
participating in future securitizations it could have a material adverse impact on our business and financial results.
There are a number of factors that can have a significant impact on whether a securitization transaction that we execute or participate in is profitable to us or
results in a loss. One of these factors is the price we pay for the mortgage loans that we securitize, which, in the case of residential mortgage loans, is impacted by
the level of competition in the marketplace for acquiring residential mortgage loans and the relative desirability to originators of retaining residential mortgage
loans as investments or selling them to third parties such as us. Another factor that impacts the profitability of a securitization transaction is the cost to us of the
short-term debt that we use to finance our holdings of mortgage loans prior to securitization, which cost is affected by a number of factors including the availability
of this type of financing to us, the interest rate on this type of financing, the duration of the financing we incur, and the percentage of our mortgage loans for which
third parties are willing to provide short-term financing.
After we acquire mortgage loans that we intend to securitize, we can also suffer losses if the value of those loans declines prior to securitization. Declines in
the value of a residential mortgage loan, for example, can be due to, among other things, changes in interest rates, changes in the credit quality of the loan, and
changes in the projected yields required by investors to invest in securitization transactions. To the extent we seek to hedge against a decline in loan value due to
changes in interest rates, there is a cost of hedging that also affects whether a securitization is profitable. Other factors that can significantly affect whether a
securitization transaction is profitable to us include the criteria and conditions that rating agencies apply and require when they assign ratings to the mortgage-
backed securities issued in our securitization transactions, including the percentage of mortgage-backed securities issued in a securitization transaction that the
rating agencies will assign a triple-A rating to, which is also referred to as a rating agency subordination level. Rating agency subordination levels can be impacted
by numerous factors, including, without limitation, the credit quality of the loans securitized, the geographic distribution of the loans to be securitized, and the
structure of the securitization transaction and other applicable rating agency criteria. All other factors being equal, the greater the percentage of the mortgage-
backed securities issued in a securitization transaction that the rating agencies will assign a triple-A rating to, the more profitable the transaction will be to us.
25
The price that investors in mortgage-backed securities will pay for securities issued in our securitization transactions also has a significant impact on the
profitability of the transactions to us, and these prices are impacted by numerous market forces and factors. In addition, the underwriter(s) or placement agent(s) we
select for securitization transactions, and the terms of their engagement, can also impact the profitability of our securitization transactions. Also, transaction costs
incurred in executing transactions impact the profitability of our securitization transactions and any liability that we may incur, or may be required to reserve for, in
connection with executing a transaction can cause a loss to us. To the extent that we are not able to profitably execute future securitizations of residential mortgage
loans or other assets, including for the reasons described above or for other reasons, it could have a material adverse impact on our business and financial results.
Our past and future securitization activities or other past and future business or operating activities or practices could expose us to litigation, which may
adversely affect our business and financial results.
Through certain of our wholly-owned subsidiaries we have in the past engaged in or participated in securitization transactions relating to residential mortgage
loans, commercial mortgage loans, commercial real estate loans, and other types of assets. In the future we expect to continue to engage in or participate in
securitization transactions, including, in particular, securitization transactions relating to residential mortgage loans, and may also engage in other types of
securitization transactions or similar transactions. Sequoia securitization entities we sponsored issued ABS backed by residential mortgage loans held by these
Sequoia entities. In Acacia securitization transactions we participated in, Acacia securitization entities issued ABS backed by securities and other assets held by
these Acacia entities. As a result of declining property values, increasing defaults, changes in interest rates, and other factors, the aggregate cash flows from the
loans held by the Sequoia entities and the securities and other assets held by the Acacia entities may be insufficient to repay in full the principal amount of ABS
issued by these securitization entities. We are not directly liable for any of the ABS issued by these entities. Nonetheless, third parties who hold the ABS issued by
these entities may try to hold us liable for any losses they experience, including through claims under federal and state securities laws or claims for breaches of
representations and warranties we made in connection with engaging in these securitization transactions.
For example, as discussed below in Part I, Item 3 of this Annual Report on Form 10-K, on December 23, 2009, the Federal Home Loan Bank of Seattle filed a
claim in the Superior Court for the State of Washington against us and our subsidiary, Sequoia Residential Funding, Inc. The complaint related in part to residential
mortgage-backed securities that were issued by a Sequoia securitization entity and alleged that, at the time of issuance, we, Sequoia Residential Funding, Inc. and
the underwriters made various misstatements and omissions about these securities in violation of Washington state law. We have also been named in other similar
lawsuits. A further discussion of these lawsuits is set forth in Note 15 to the Financial Statements within this Annual Report on Form 10-K. For another example,
refer to the risk factor below, titled “Recent
developments
in
ongoing
litigation
against
various
trustees
of
residential
mortgage-backed
securitization
transactions
issued
prior
to
financial
crisis
of
2007-2008
(“RMBS
trustee
litigation”)
have
negatively
impacted,
and
could
further
negatively
impact,
the
value
of
securities
we
hold,
could
expose
us
to
indemnification
claims,
and
could
impact
the
profitability
of
our
participation
in
future
securitization
transactions.”
Other aspects of our business operations or practices could also expose us to litigation. In the ordinary course of our business we enter into agreements
relating to, among other things, loans we acquire and investments we make, assets and loans we sell, financing transactions, third parties we retain to provide us
with goods and services, and our leased office space. We also regularly enter into confidentiality agreements with third parties under which we receive confidential
information. If we breach any of these agreements, we could be subject to claims for damages and related litigation. We are also subject to various laws and
regulations relating to our business and operations, including, without limitation, privacy laws and regulations and labor and employment laws and regulations, and
if we fail to comply with these laws and regulations we could also be subjected to claims for damages and litigation. In particular, if we fail to maintain the
confidentiality of consumers’ personal or financial information we obtain in the course of our business (such as social security numbers), we could be exposed to
losses. A further discussion of some of these risks is set forth in the risk factor titled “ Maintaining
cybersecurity
is
important
to
our
business
and
a
breach
of
our
cybersecurity
could
have
a
material
adverse
impact.
Our
technology
infrastructure
and
systems
are
important
and
any
significant
disruption
or
breach
of
the
security
of
this
infrastructure
or
these
systems
could
have
an
adverse
effect
on
our
business.
We
also
rely
on
technology
infrastructure
and
systems
of
third
parties
who
provide
services
to
us
and
with
whom
we
transact
business.
”
Defending a lawsuit can consume significant resources and may divert management’s attention from our operations. We may be required to establish or
increase reserves for potential losses from litigation, which could be material. To the extent we are unsuccessful in our defense of any lawsuit, we could suffer
losses which could be in excess of any reserves established relating to that lawsuit) and these losses could be material.
26
Developments in ongoing litigation against various trustees of residential mortgage-backed securitization transactions issued prior to financial crisis of 2007-
2008 (“RMBS trustee litigation”) during 2017 negatively impacted, and could further negatively impact, the value of securities we hold, could expose us to
indemnification claims, and could impact the profitability of our participation in future securitization transactions.
The ongoing RMBS trustee litigation relates to, among other things, claims by certain investors in the RMBS issued in those transactions that the trustees of
those transactions breached their obligations to investors by, among other things, not appropriately investigating and pursuing remedies against the originators and
servicers of the underlying mortgage loans. We are not a party to any RMBS trustee litigation; however, developments in the ongoing RMBS trustee litigation
during 2017 negatively impacted the value of certain residential mortgage-backed securities issued prior to the crisis (“legacy RMBS”) that were held in our
investment portfolio during the year ended December 31, 2017. The value of other legacy RMBS we continue to hold or acquire could be impacted in the future. In
particular, trustees of various legacy RMBS transactions that are the subject of the ongoing RMBS trustee litigation have withheld funds from investors in the
RMBS issued in those transactions by asserting that, pursuant to their indemnification rights against the securitization trusts established under the applicable
transaction documents, they are entitled to apply those funds to offset litigation expenses - and one trustee asserted that its indemnification rights entitle it to
withhold large lump sum amounts to hold and apply to anticipated future litigation expenses. During the year ended December 31, 2017, this holdback resulted in
an aggregate loss to the value of our portfolio of securities of approximately $0.5 million, and other or similar holdbacks by that trustee or other trustees of legacy
RMBS transactions could result in further losses to the value of our portfolio of securities in the future, which losses could be material.
Our cash balances and cash flows may be insufficient relative to our cash needs.
We need cash to make interest payments, to post as collateral to counterparties and lenders who provide us with short-term debt financing and who engage in
other transactions with us, for working capital, to fund REIT dividend distribution requirements, to comply with financial covenants and regulatory requirements,
and for other needs and purposes. We may also need cash to repay short-term borrowings when due or in the event the fair values of assets that serve as collateral
for that debt decline, the terms of short-term debt become less attractive, or for other reasons. In addition, we may need to use cash to post in response to margin
calls relating to various derivative instruments we hold as the values of these derivatives change. Over the near and longer term, we may need cash to fund the
repayment of outstanding convertible notes and exchangeable securities that mature in 2018, 2019, and 2023.
Our sources of cash flow include the principal and interest payments on the loans and securities we own, asset sales, securitizations, short-term borrowing,
issuing long-term debt, and issuing stock. Our sources of cash may not be sufficient to satisfy our cash needs. Cash flows from principal repayments could be
reduced if prepayments slow or if credit quality deteriorates. For example, for some of our assets, cash flows are “locked-out” and we receive less than our pro-rata
share of principal payment cash flows in the early years of the investment.
Our minimum dividend distribution requirements could exceed our cash flows if our income as calculated for tax purposes significantly exceeds our net cash
flows. This could occur when taxable income (including non-cash income such as discount amortization and interest accrued on negative amortizing loans) exceeds
cash flows received. The Internal Revenue Code provides a limited relief provision concerning certain items of non-cash income; however, this provision may not
sufficiently reduce our cash dividend distribution requirement. In the event that our liquidity needs exceed our access to liquidity, we may need to sell assets at an
inopportune time, thus reducing our earnings. In an adverse cash flow situation, we may not be able to sell assets effectively and our REIT status or our solvency
could be threatened. Further discussion of the risk associated with maintaining our REIT status is set forth in the risk factor titled “We
have
elected
to
be
a
REIT
and,
as
such,
are
required
to
meet
certain
tests
in
order
to
maintain
our
REIT
status.
This
adds
complexity
and
costs
to
running
our
business
and
exposes
us
to
additional
risks.”
We are subject to competition and we may not compete successfully.
We are subject to competition in seeking investments, acquiring and selling residential loans, engaging in securitization transactions, and in other aspects of
our business. Our competitors include commercial banks, other mortgage REITs, Fannie Mae, Freddie Mac, regional and community banks, broker-dealers,
insurance companies, and other financial institutions, as well as investment funds and other investors in real estate-related assets. In addition, other companies may
be formed that will compete with us. Some of our competitors have greater resources than us and we may not be able to compete successfully with them.
Furthermore, competition for investments, making loans, acquiring and selling loans, and engaging in securitization transactions may lead to a decrease in the
opportunities and returns available to us.
27
In addition, there are significant competitive threats to our business from governmental actions and initiatives that have already been undertaken or which may
be undertaken in the future. Sustained competition from governmental actions and initiatives could have a material adverse effect on us. For example, Fannie Mae
and Freddie Mac are, among other things, engaged in the business of acquiring loans and engaging in securitization transactions. Until 2008, competition from
Fannie Mae and Freddie Mac was limited to some extent due to the fact that they were statutorily prohibited from purchasing loans for single unit residences in the
continental United States with a principal amount in excess of $417,000, while much of our business had historically focused on acquiring residential loans with a
principal amount in excess of that amount. In February 2008, Congress passed an economic stimulus package that temporarily increased the size of certain loans
these entities could purchase to up to $729,750, if the loans were made to secure real estate purchases in certain high-cost areas of the U.S. Since 2008, the loan
size limits for Fannie Mae and Freddie Mac purchases have been adjusted up and down, and as of December 31, 2017, the maximum loan size limit was $679,650,
which is an amount that continues to be above the historical loan size limit. In addition, in September 2008, Fannie Mae and Freddie Mac were placed into
conservatorship and have become, in effect, instruments of the U.S. federal government.
Furthermore, it is unclear whether the Trump administration’s policies, and any future federal legislation or executive or regulatory actions, regarding Fannie
Mae and Freddie Mac will continue to maintain, or increase, the role of those entities in the housing finance market. As long as there is governmental support for
these entities to continue to operate and provide financing to a significant portion of the mortgage finance market, they will represent significant business
competition due to, among other things, their large size and low cost of funding. Additionally, Trump administration policies, federal legislation, or executive or
regulatory actions aimed at weakening or dismantling the Dodd-Frank Act and its regulatory apparatus, including by reducing capital requirements on banking
institutions or by weakening the CFPB, its leadership, or its enforcement capabilities or priorities, could result in increased competition from commercial banks
and other large financial institutions that may have similar advantages due to their size and cost of capital. Further discussion is set forth in the risk factor titled
“Congress
and
President
Trump’s
administration
may
make
substantial
changes
to
fiscal,
tax,
and
other
federal
policies
that
may
adversely
affect
our
business.”
To the extent that laws, regulations, or policies governing the business activities of Fannie Mae and Freddie Mac are not changed to limit their role in housing
finance (such as a change in these loan size limits or in the guarantee fees they charge), or the competition from these two governmental entities will remain
significant or could increase. In addition, to the extent that property values decline while these loan size limits remain the same, it may have the same effect as an
increase in this limit, as a greater percentage of loans would likely be within the size limit. Any increase in the loan size limit, or in the overall percentage of loans
that are within the limit, allows Fannie Mae and Freddie Mac to compete against us to a greater extent than they had been able to compete previously and our
business could be adversely affected. Additionally, the Federal Housing Administration (FHA) and the Department of Veterans Affairs (VA) guarantee qualified
residential mortgages, and FHA and VA loans accounted for approximately 23% of the aggregate dollar value of residential loans originated in the U.S. in 2016.
The federal government’s ability to provide financing to a significant portion of the mortgage finance market through these entities represents significant business
competition due to, among other things, their size and low cost of funding.
Our business model and business strategies, and the actions we take (or fail to take) to implement them and adapt them to changing circumstances involve risk
and may not be successful.
U.S. real estate markets, the mortgage industry and the related capital markets have undergone significant changes since the U.S. financial crisis, including due
to the significant governmental interventions in these areas and changes to the laws and regulations that govern the banking and mortgage finance industry.
Additionally, it remains unclear how the Trump administration’s policies, and any future federal legislation or executive or regulatory actions, regarding Fannie
Mae and Freddie Mac and the housing finance market more broadly will impact that market and our business. Additional factors, including a rising or steady
interest rate environment, which may cause the volume of refinance loans to decline, and secular trends in consumer demand for renting versus owning a residence,
may also contribute to evolving conditions in the mortgage industry and capital markets. Our methods of, and model for, doing business and financing our
investments are changing and if we fail to develop, enhance, and implement strategies to adapt to changing conditions in the mortgage industry and capital
markets, our business and financial results may be adversely affected. Furthermore, changes we make to our business to respond to changing circumstances may
expose us to new or different risks than we were previously exposed to and we may not effectively identify or manage those risks. Further discussion is set forth in
the risk factor titled “Decisions
we
make
about
our
business
strategy
and
investments,
as
well
as
decisions
about
raising
capital
or
returning
capital
to
shareholders
(through
dividends
or
common
stock
repurchases),
could
fail
to
improve
our
business
and
results
of
operations.”
28
Similarly, the competitive landscape in which we operate and the products and investments for which we compete are also affected by changing conditions.
There may be trends or sudden changes in our industry or regulatory environment, changes in the role of government-sponsored entities, such as Fannie Mae and
Freddie Mac, changes in the role of credit rating agencies or their rating criteria or processes, or changes in the U.S. economy more generally. If we do not
effectively respond to these changes or if our strategies to respond to these changes are not successful, our ability to effectively compete in the marketplace may be
negatively impacted, which would likely result in our business and financial results being adversely affected.
We have historically depended upon the issuance of mortgage-backed securities by the securitization entities we sponsor as a funding source for our
residential real estate-related business. However, due to market conditions, we did not engage in residential mortgage securitization transactions in 2008 or 2009
and we only engaged in one residential mortgage securitization transaction in 2010 and two residential mortgage securitization transactions in 2011. While we
engaged in numerous residential mortgage securitization transactions from 2012 through 2017, we do not know if market conditions will allow us to continue to
regularly engage in these types of securitization transactions and any disruption of this market may adversely affect our earnings and growth. For example, in each
of 2014 and 2015, we completed four securitization transactions, and in 2016 we completed three securitization transactions, as compared to 12 securitizations in
2013, and nine securitizations in 2017. Even if regular residential mortgage securitization activity continues among market participants other than government-
sponsored entities, we do not know if it will continue to be on terms and conditions that will permit us to participate or be favorable to us. Even if conditions are
favorable to us, we may not be able to return to or sustain the volume of securitization activity we previously conducted.
Initiating new business activities or significantly expanding existing business activities may expose us to new risks and will increase our cost of doing business.
Initiating new business activities or significantly expanding existing business activities are two ways to grow our business and respond to changing
circumstances in our industry; however, they may expose us to new risks and regulatory compliance requirements. We cannot be certain that we will be able to
manage these risks and compliance requirements effectively. Furthermore, our efforts may not succeed and any revenues we earn from any new or expanded
business initiative may not be sufficient to offset the initial and ongoing costs of that initiative, which would result in a loss with respect to that initiative.
For example, in December 2017 and January 2018, we announced several new initiatives to expand our mortgage banking and investment activities, including
by exploring opportunities to provide expanded financing options to non-bank mortgage loan originators and expanding our mortgage loan purchase activity to
include, for example, business purpose loans secured by non-owner occupied rental properties. Further discussion of these business changes is set forth in the risk
factor titled “Decisions
we
make
about
our
business
strategy
and
investments,
as
well
as
decisions
about
raising
capital
or
returning
capital
to
shareholders
(through
dividends
or
common
stock
repurchases),
could
fail
to
improve
our
business
and
results
of
operations.”
In connection with initiating new business activities or expanding existing business activities, or for other business reasons, we may create new subsidiaries.
Generally, these subsidiaries would be wholly-owned, directly or indirectly, by Redwood. The creation of those subsidiaries may increase our administrative costs
and expose us to other legal and reporting obligations, including, for example, because they may be incorporated in states other than Maryland or may be
established in a foreign jurisdiction. Any new subsidiary we create may elect, together with us, to be treated as our taxable REIT subsidiary. Taxable REIT
subsidiaries are wholly-owned or partially-owned subsidiaries of a REIT that pay corporate income tax on the income they generate. A taxable REIT subsidiary is
not able to deduct its dividends paid to its parent in determining its taxable income and any dividends paid to the parent are generally recognized as income at the
parent level.
Our future success depends on our ability to attract and retain key personnel.
Our future success depends on the continued service and availability of skilled personnel, including members of our executive management team such as our
Chief Executive Officer, President, Executive Vice President, General Counsel, Chief Financial Officer, Chief Investment Officer, and Managing Director-Head of
Residential. To the extent personnel we attempt to hire are concerned that economic, regulatory, or other factors could impact our ability to maintain or expand our
current level of business, it could negatively impact our ability to hire the personnel we need to operate our business. We cannot assure you that we will be able to
attract and retain key personnel.
Additionally, in December 2017, we announced that our Chief Executive Officer will retire from that position effective as of May 22, 2018, at which time
each of our current President and our Executive Vice President will be promoted to the positions of Chief Executive Officer and President, respectively. If this
leadership transition causes instability or is ultimately not successful, our business and financial results may be adversely impacted.
29
We may not be able to obtain or maintain the governmental licenses required to operate our business and we may fail to comply with various state and federal
laws and regulations applicable to our business of acquiring residential mortgage loans and servicing rights. We are approved to service residential mortgage
loans sold to Freddie Mac and Fannie Mae and failure to maintain our status as an approved servicer could harm our business.
While we are not required to obtain licenses to purchase mortgage-backed securities, the purchase of residential mortgage loans and certain business purpose
mortgage loans in the secondary market may, in some circumstances, require us to maintain various state licenses. Acquiring the right to service residential
mortgage loans and certain business purpose mortgage loans may also, in some circumstances, require us to maintain various state licenses even though we
currently do not expect to directly engage in loan servicing ourselves. As a result, we could be delayed in conducting certain business if we were first required to
obtain a state license. We cannot assure you that we will be able to obtain all of the licenses we need or that we would not experience significant delays in
obtaining these licenses. Furthermore, once licenses are issued we are required to comply with various information reporting and other regulatory requirements to
maintain those licenses, and there is no assurance that we will be able to satisfy those requirements or other regulatory requirements applicable to our business of
acquiring mortgage loans on an ongoing basis. Our failure to obtain or maintain required licenses or our failure to comply with regulatory requirements that are
applicable to our business of acquiring mortgage loans may restrict our business and investment options and could harm our business and expose us to penalties or
other claims.
For example, under the Dodd-Frank Act, the CFPB also has regulatory authority over certain aspects of our business as a result of our residential mortgage
banking activities, including, without limitation, authority to bring an enforcement action against us for failure to comply with regulations promulgated by the
Bureau that are applicable to our business. One of the Bureau’s areas of focus has been on whether companies like Redwood take appropriate steps to ensure that
business arrangements with service providers do not present risks to consumers. The sub-servicers we retain to directly service residential mortgage loans (when
we own the associated MSRs) are among our most significant service providers with respect to our residential mortgage banking activities and our failure to take
steps to ensure that these sub-servicers are servicing these residential mortgage loans in accordance with applicable law and regulation could result in enforcement
action by the Bureau against us that could restrict our business, expose us to penalties or other claims, negatively impact our financial results, and damage our
reputation.
As another example, new rules under the Home Mortgage Disclosure Act (HMDA) that took effect in January 2018 impose expanded data collection
requirements and additional reporting obligations on mortgage lenders and purchasers of residential mortgage loans. The expanded data collection requirements
may result in a higher frequency of data errors, which in turn could be perceived by regulators as an indication of inadequate controls and poor compliance
processes, and could lead to monetary civil penalties. Additionally, the availability of increased amounts of data may increase regulatory scrutiny of our mortgage
loan purchasing patterns. In addition, the Equal Credit Opportunity Act, and other Federal and state laws and regulations that apply to certain of our investment and
business activities, include consumer protections relating to discrimination, abusive and deceptive practices, and other consumer-related matters. To the extent
these laws and regulations apply to us, our failure to comply with them, even if not intentional, could give rise to liabilities, fines, and remediation requirements,
which could be material. Failure to comply with these laws and regulations could also result for incorrectly concluding that certain aspects of our investment and
business activities are not subject to certain laws or regulations.
In addition, we are a servicer approved to service residential mortgage loans sold to Freddie Mac and Fannie Mae. As an approved servicer, we are required to
conduct certain aspects of our operations in accordance with applicable policies and guidelines published by Freddie Mac and Fannie Mae. Failure to maintain our
status as an approved servicer would mean we would not be able to service mortgage loans for these entities, or could otherwise restrict our business and
investment options and could harm our business and expose us to losses or other claims.
30
With respect to mortgage loans we own, or which we have purchased and subsequently sold, we may be subject to liability for potential violations of the
CFPB’s TILA-RESPA Integrated Disclosure rule (also referred to as “TRID”) or other similar consumer protection laws and regulations, which could
adversely impact our business and financial results.
Federal consumer protection laws and regulations have been enacted and promulgated that are designed to regulate residential mortgage loan underwriting and
originators’ lending processes, standards, and disclosures to borrowers. These laws and regulations include the CFPB’s “TRID”, “ability-to-repay” and “qualified
mortgage” regulations. In addition, there are various other federal, state, and local laws and regulations that are intended to discourage predatory lending practices
by residential mortgage loan originators. For example, the federal Home Ownership and Equity Protection Act of 1994 (HOEPA) prohibits inclusion of certain
provisions in residential mortgage loans that have mortgage rates or origination costs in excess of prescribed levels and requires that borrowers be given certain
disclosures prior to origination. Some states have enacted, or may enact, similar laws or regulations, which in some cases may impose restrictions and requirements
greater than those in place under federal laws and regulations. In addition, under the anti-predatory lending laws of some states, the origination of certain
residential mortgage loans, including loans that are classified as “high cost” loans under applicable law, must satisfy a net tangible benefits test with respect to the
borrower. This test, as well as certain standards set forth in the “ability-to-repay” and “qualified mortgage” regulations, may be highly subjective and open to
interpretation. As a result, a court may determine that a residential mortgage loan did not meet the standard or test even if the originator reasonably believed such
standard or test had been satisfied. Failure of residential mortgage loan originators or servicers to comply with these laws and regulations could subject us, as an
assignee or purchaser of these loans (or as an investor in securities backed by these loans), to monetary penalties and defenses to foreclosure, including by
recoupment or setoff of finance charges and fees collected, and could result in rescission of the affected residential mortgage loans, which could adversely impact
our business and financial results.
Environmental protection laws that apply to properties that secure or underlie our loan and investment portfolio could result in losses to us. We may also be
exposed to environmental liabilities with respect to properties we become direct or indirect owners of or to which we take title, which could adversely affect our
business and financial results.
Under the laws of several states, contamination of a property may give rise to a lien on the property to secure recovery of the cleanup costs. In certain of these
states, such a lien has priority over the lien of an existing mortgage against the property, which could impair the value of an investment in a security we own
backed by such a property or could reduce the value of such a property that underlies loans we have made or own. In addition, under the laws of some states and
under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, we may be liable for costs of addressing releases or
threatened releases of hazardous substances that require remedy at a property securing or underlying a loan we hold if our agents or employees have become
sufficiently involved in the hazardous waste aspects of the operations of the borrower of that loan, regardless of whether or not the environmental damage or threat
was caused by us or the borrower.
In the course of our business, we may take title to real estate or may otherwise become direct or indirect owners of real estate. If we do take title or become a
direct or indirect owner, we could be subject to environmental liabilities with respect to the property, including liability to a governmental entity or third parties for
property damage, personal injury, investigation, and clean-up costs. In addition, we may be required to investigate or clean up hazardous or toxic substances or
chemical releases at a property. The costs associated with investigation or remediation activities could be substantial. If we ever become subject to significant
environmental liabilities, our business and financial results could be materially and adversely affected.
31
Maintaining cybersecurity is important to our business and a breach of our cybersecurity could have a material adverse impact. Our technology infrastructure
and systems are important and any significant disruption or breach of the security of this infrastructure or these systems could have an adverse effect on our
business. We also rely on technology infrastructure and systems of third parties who provide services to us and with whom we transact business.
When we acquire real estate mortgage loans, or the rights to service mortgage loans, we come into possession of borrower non-public personal information
that an identity thief could utilize in engaging in fraudulent activity or theft. We may share this information with third party service providers, including loan sub-
servicers, or with third parties interested in acquiring such loans from us. We have acquired more than 100,000 residential mortgage loans and rights to service
residential mortgage loans since 2010 and also acquired thousands of residential mortgage loans prior to 2010. While we have security measures in place to protect
this information and prevent security breaches, these security measures may be compromised as a result of third-party action, including intentional misconduct by
computer hackers, cyber-attacks, service provider or vendor error, or malfeasance or other intentional or unintentional acts by third parties. Furthermore, borrower
data, including personally identifiable information, may be lost, exposed, or subject to unauthorized access or use as a result of accidents, errors, or malfeasance by
our employees, independent contractors, or others working with us or on our behalf. Our servers and systems, and those of our service providers, may be
vulnerable to computer malware, break-ins, denial-of-service attacks, and similar disruptions from unauthorized tampering with our computer systems, which
could result in someone obtaining unauthorized access to borrowers’ data or our data, including other confidential business information. Because the techniques
used to obtain unauthorized access to, or to sabotage, systems change frequently and often are not recognized until launched against a target, we may be unable to
anticipate these techniques or implement adequate preventative measures. We may also experience security breaches that may remain undetected for an extended
period.
We may be liable for losses suffered by individuals whose identities are stolen as a result of a breach of the security of the systems that we or third-party
service providers of ours store this information on, and any such liability could be material. Even if we are not liable for such losses, any breach of these systems
could expose us to material costs in notifying affected individuals and providing credit monitoring services to them, as well as regulatory fines or penalties. In
addition, any breach of these systems could disrupt our normal business operations and expose us to reputational damage and lost business, revenues, and profits.
Any insurance we maintain against the risk of this type of loss may not be sufficient to cover actual losses, or may not apply to the circumstances relating to any
particular breach.
In addition, in order to analyze, acquire, and manage our investments, manage the operations and risks associated with our business, assets, and liabilities, and
prepare our financial statements we rely upon computer hardware and software systems. Some of these systems are located at our offices and some are maintained
by third party vendors or located at facilities maintained by third parties. We also rely on technology infrastructure and systems of third parties who provide
services to us and with whom we transact business. Any significant interruption in the availability or functionality of these systems could impair our access to
liquidity, damage our reputation, and have an adverse effect on our operations and on our ability to timely and accurately report our financial results.
In addition, any breach of the security of these systems could have an adverse effect on our operations and the preparation of our financial statements. Steps
we have taken to provide for the security of our systems and data may not effectively prevent others from obtaining improper access to our systems data. Improper
access could expose us to risks of data loss, reputational damage, increased regulatory scrutiny, litigation, and liabilities to third parties, and otherwise disrupt our
operations.
Our business could be adversely affected by deficiencies in our disclosure controls and procedures or internal controls over financial reporting.
The design and effectiveness of our disclosure controls and procedures and internal controls over financial reporting may not prevent all errors, misstatements,
or misrepresentations. While management continues to review the effectiveness of our disclosure controls and procedures and internal controls over financial
reporting, there can be no assurance that our disclosure controls and procedures or internal controls over financial reporting will be effective in accomplishing all
control objectives all of the time. Deficiencies, particularly material weaknesses or significant deficiencies, in internal controls over financial reporting which have
occurred or which may occur in the future could result in misstatements of our financial results, restatements of our financial statements, a decline in our stock
price, or an otherwise material and adverse effect on our business, reputation, financial results, or liquidity and could cause investors and creditors to lose
confidence in our reported financial results.
32
Our risk management efforts may not be effective.
We could incur substantial losses and our business operations could be disrupted if we are unable to effectively identify, manage, monitor, and mitigate
financial risks, such as credit risk, interest rate risk, prepayment risk, liquidity risk, and other market-related risks, as well as operational risks related to our
business, assets, and liabilities. Our risk management policies, procedures, and techniques may not be sufficient to identify all of the risks we are exposed to,
mitigate the risks we have identified for mitigation, or to identify additional risks to which we may become subject in the future. Expansion of our business
activities may also result in our being exposed to risks that we have not previously been exposed to or may increase our exposure to certain types of risks and we
may not effectively identify, manage, monitor, and mitigate these risks as our business activity changes or increases. Further discussion is set forth in the risk factor
titled “Initiating
new
business
activities
or
significantly
expanding
existing
business
activities
may
expose
us
to
new
risks
and
will
increase
our
cost
of
doing
business.”
We could be harmed by misconduct or fraud that is difficult to detect.
We are exposed to risks relating to misconduct by our employees, contractors we use, or other third parties with whom we have relationships. For example,
our employees could execute unauthorized transactions, use our assets improperly or without authorization, perform improper activities, use confidential
information for improper purposes, or mis-record or otherwise try to hide improper activities from us. This type of misconduct could also relate to assets we
manage for others through our investment advisory subsidiary. This type of misconduct can be difficult to detect and if not prevented or detected could result in
claims or enforcement actions against us or losses. Accordingly, misconduct by employees, contractors, or others could subject us to losses or regulatory sanctions
and seriously harm our reputation. Our controls may not be effective in detecting this type of activity.
Inadvertent errors, including, for example, errors in the implementation of information technology systems, could subject us to financial loss, litigation, or
regulatory action.
Our employees, contractors we use, or other third parties with whom we have relationships may make inadvertent errors that could subject us to financial
losses, claims, or enforcement actions. These types of errors could include, but are not limited to, mistakes in executing, recording, or reporting transactions we
enter into for ourselves or with respect to assets we manage for others. Errors in the implementation of information technology systems, compliance systems and
procedures, or other operational systems and procedures could also interrupt our business or subject us to financial losses, claims, or enforcement actions. Errors
could also result in the inadvertent disclosure of mortgage-borrower non-public personal information. Inadvertent errors expose us to the risk of material losses
until the errors are detected and remedied prior to the incurrence of any loss. The risk of errors may be greater for business activities that are new for us or have
non-standardized terms, for areas of our business that we are expanding, or for areas of our business that rely on new employees or on third parties that we have
only recently established relationships with.
Our business may be adversely affected if our reputation is harmed.
Our business is subject to significant reputational risks. If we fail, or appear to fail, to address various issues that may affect our reputation, our business could
be harmed. Issues could include real or perceived legal or regulatory violations or be the result of a failure in governance, risk-management, technology, or
operations. Similarly, market rumors and actual or perceived association with counterparties whose own reputation is under question could harm our business.
Lawsuits brought against us (or the resolution of lawsuits brought against us), claims of employee misconduct, claims of wrongful termination, adverse publicity,
conflicts of interest, ethical issues, or failure to maintain the security of our information technology systems or to protect non-public personal information could
also cause significant reputational damages. Such reputational damage could result not only in an immediate financial loss, but could also result in a loss of
business relationships, the ability to raise capital, and the ability to access liquidity through borrowing facilities.
33
Our financial results are determined and reported in accordance with generally accepted accounting principles (and related conventions and interpretations),
or GAAP, and are based on estimates and assumptions made in accordance with those principles, conventions, and interpretations. Furthermore, the amount
of dividends we are required to distribute as a REIT is driven by the determination of our income in accordance with the Internal Revenue Code rather than
GAAP.
Our
reported
GAAP
financial
results
differ
from
the
taxable
income
results
that
drive
our
dividend
distribution
requirements
and,
therefore,
our
GAAP
results
may
not
be
an
accurate
indicator
of
taxable
income
and
dividend
distributions.
Generally, the cumulative income we report relating to an investment asset will be the same for GAAP and tax purposes, although the timing of this
recognition over the life of the asset could be materially different. There are, however, certain permanent differences in the recognition of certain expenses under
the respective accounting principles applied for GAAP and tax purposes and these differences could be material. Thus, the amount of GAAP earnings reported in
any given period may not be indicative of future dividend distributions. A further explanation of differences between our GAAP and taxable income is presented in
“Management’s
Discussion
and
Analysis
of
Financial
Condition
and
Results
of
Operations,”
which is set forth in Part II, Item 7 of this Annual Report on Form
10-K.
Our minimum dividend distribution requirements are determined under the REIT tax laws and are based on our REIT taxable income as calculated for tax
purposes pursuant to the Internal Revenue Code. Our Board of Directors may also decide to distribute more dividends than required based on these determinations.
One should not expect that our retained GAAP earnings will equal cumulative distributions, as the Board of Directors’ dividend distribution decisions, permanent
differences in GAAP and tax accounting, and even temporary differences may result in material differences in these balances.
Over
time,
accounting
principles,
conventions,
rules,
and
interpretations
may
change,
which
could
affect
our
reported
GAAP
and
taxable
earnings
and
stockholders’
equity.
Accounting rules for the various aspects of our business change from time to time. Changes in GAAP, or the accepted interpretation of these accounting
principles, can affect our reported income, earnings, and stockholders’ equity. In addition, changes in tax accounting rules or the interpretations thereof could affect
our taxable income and our dividend distribution requirements. Predicting and planning for these changes can be difficult.
Risks Related to Redwood's Capital, REIT and Legal/Organizational Structure
We have elected to be taxed as a REIT and, as such, are required to meet certain tests in order to maintain our REIT status. This adds complexity and costs to
running our business and exposes us to additional risks.
Failure
to
qualify
as
a
REIT
could
adversely
affect
our
net
income
and
dividend
distributions
and
could
adversely
affect
the
value
of
our
common
stock.
We have elected to be taxed as a REIT for federal income tax purposes for all tax years since 1994. However, many of the requirements for qualification as a
REIT are highly technical and complex and require an analysis of particular facts and an application of the legal requirements to those facts in situations where
there is only limited judicial and administrative guidance. Thus, we cannot assure you that the Internal Revenue Service (the “IRS”) or a court would agree with
our conclusion that we have qualified as a REIT historically, or that changes to our investments or business or the law will not cause us to fail to qualify as a REIT
in the future. Furthermore, in an environment where assets may quickly change in value, previous planning for compliance with REIT qualification rules may be
disrupted. If we failed to qualify as a REIT for federal income tax purposes and did not meet the requirements for statutory relief, we would be subject to federal
corporate income tax on our taxable income, and we would not be allowed a deduction for distributions to shareholders in computing our taxable income. In such a
case, we may need to borrow money or sell assets in order to pay the taxes due, even if the market conditions are not favorable for such sales or borrowings. In
addition, unless we are entitled to relief under applicable statutory provisions, we could not elect to be taxed as a REIT for four years thereafter. Failure to qualify
as a REIT could adversely affect our dividend distributions and could adversely affect the value of our common stock.
34
Maintaining
REIT
status
and
avoiding
the
generation
of
excess
inclusion
income
at
Redwood
Trust,
Inc.
and
certain
of
our
subsidiaries
may
reduce
our
flexibility
and
could
limit
our
ability
to
pursue
certain
opportunities.
Failure
to
appropriately
structure
our
business
and
transactions
to
comply
with
laws
and
regulations
applicable
to
REITs
could
have
adverse
consequences.
To maintain REIT status, we must follow certain rules and meet certain tests. In doing so, our flexibility to manage our operations may be reduced. For
instance:
•
•
•
Compliance with the REIT income and asset rules, or uncertainty about the application of those rules to certain investments, may result in our holding
investments in our taxable REIT subsidiaries (where any income they produce is subject to corporate-level taxation) when we would prefer to hold those
investments in an entity that is taxed as a REIT (where they would not be subject to corporate-level taxation.
Compliance with the REIT income and asset rules may limit the type or extent of financing or hedging that we can undertake.
Our ability to own non-real estate assets and earn non-real estate related income is limited, and the rules for classifying assets and income are
complicated. Our ability to own equity interests in other entities is also limited. If we fail to comply with these limits, we may be forced to liquidate
attractive investments on short notice on unfavorable terms in order to maintain our REIT status.
• We generally use taxable REIT subsidiaries to own non-real estate assets and engage in activities that may give rise to non-real estate related income
under the REIT rules. However, our ability to invest in taxable REIT subsidiaries is limited under the REIT rules. No more than 25% (20% for taxable
years beginning after December 31, 2017) of the value of our total assets can be represented by securities of one or more taxable REIT subsidiaries.
Maintaining compliance with this limit could require us to constrain the growth of our taxable REIT subsidiaries (and the business and investing activities
they conduct) in the future.
• Meeting minimum REIT dividend distribution requirements could reduce our liquidity. We may earn non-cash REIT taxable income due to timing and/or
character mismatches between the computation of our income for tax and accounting purposes. Earning non-cash REIT taxable income could necessitate
our selling assets, incurring debt, or raising new equity in order to fund dividend distributions.
• We could be viewed as a “dealer” with respect to certain transactions and become subject to a 100% prohibited transaction tax or other entity-level taxes
on income from such transactions.
Furthermore, the rules we must follow and the tests we must satisfy to maintain our REIT status may change, or the interpretation of these rules and tests by
the IRS may change.
In addition, our stated goal has been to not generate excess inclusion income at Redwood Trust, Inc. and certain of its subsidiaries that would be taxable as
unrelated business taxable income (“UBTI”) to our tax-exempt shareholders. Achieving this goal has limited, and may continue to limit, our flexibility in pursuing
certain transactions or has resulted in, and may continue to result in, our having to pursue certain transactions through a taxable REIT subsidiary, which would
reduce the net returns on these transactions by the associated tax liabilities payable by such subsidiary. Despite our efforts to do so, we may not be able to avoid
creating or distributing UBTI to our shareholders.
35
To
maintain
our
REIT
status,
we
may
be
forced
to
borrow
funds
during
unfavorable
market
conditions,
and
the
unavailability
of
such
capital
on
favorable
terms
at
the
desired
times,
or
at
all,
may
cause
us
to
curtail
our
investment
activities
and/or
to
dispose
of
assets
at
inopportune
times,
which
could
adversely
affect
our
financial
condition,
results
of
operations,
cash
flow
and
per
share
trading
price
of
our
common
stock.
To qualify as a REIT, we generally must distribute to our shareholders at least 90% of our net taxable income each year (excluding any net capital gains), and
we will be subject to regular corporate income taxes to the extent that we distribute less than 100% of our net taxable income each year. In addition, we will be
subject to a 4% nondeductible excise tax on the amount, if any, by which distributions we pay in any calendar year are less than the sum of 85% of our ordinary
income, 95% of our net capital gains, and 100% of our undistributed income from prior years. To maintain our REIT status and avoid the payment of federal
income and excise taxes, we may need to borrow funds to meet the REIT distribution requirements, even if the then-prevailing market conditions are not favorable
for these borrowings. These borrowing needs could result from differences in timing between the actual receipt of income and inclusion of income for federal
income tax purposes. For example, we may be required to accrue interest and discount income on mortgage loans, MBS, and other types of debt securities or
interests in debt securities before we receive any payments of interest or principal on such assets. Our access to third-party sources of capital depends on a number
of factors, including the market’s perception of our growth potential, our current debt levels, the market price of our common stock, and our current and potential
future earnings. We cannot assure you that we will have access to such capital on favorable terms at the desired times, or at all, which may cause us to curtail our
investment activities and/or to dispose of assets at inopportune times, and could adversely affect our financial condition, results of operations, cash flow and per
share trading price of our common stock.
Dividends
payable
by
REITs,
including
us,
generally
do
not
qualify
for
the
reduced
tax
rates
available
for
some
dividends.
The maximum U.S. federal income tax rate for qualified dividends paid by domestic non-REIT corporations to U.S. stockholders that are individuals, trust or
estates is generally 20%. Dividends paid by REITs to such stockholders are generally not eligible for that rate, subject to limited exceptions, but under the Tax Act,
such stockholders may deduct up to 20% of ordinary dividends from a REIT for taxable years beginning after December 31, 2017 and before January 1, 2026.
Although this deduction reduces the effective tax rate applicable to certain dividends paid by REITs, such tax rate is still higher than the tax rate applicable to
regular corporate qualified dividends. This may cause investors to view REIT investments as less attractive than investments in non-REIT corporations, which in
turn may adversely affect the value of shares of REITs, including the shares of our common stock.
The
failure
of
mortgage
loans
or
MBS
subject
to
a
repurchase
agreement
or
a
mezzanine
loan
to
qualify
as
a
real
estate
asset
would
adversely
affect
our
ability
to
qualify
as
a
REIT.
When we enter into short-term financing arrangements in the form of repurchase agreements, we will sell certain of our assets to a counterparty and
simultaneously enter into an agreement to repurchase the sold assets. We believe that we will be treated for U.S. federal income tax purposes as the owner of the
assets that are the subject of any such agreements notwithstanding that such agreements may transfer record ownership of the assets to the counterparty during the
term of the agreement. It is possible, however, that the IRS could assert that we did not own the assets during the term of the repurchase agreement, in which case
we could fail to qualify as a REIT.
In addition, although we no longer originate commercial mezzanine loans and we sold our commercial mezzanine loan portfolio, in the past we have
originated and retained as investments commercial mezzanine loans. Commercial mezzanine loans are loans secured by equity interests in a partnership or limited
liability company that directly or indirectly owns commercial real estate. In Revenue Procedure 2003-65, the IRS provided a safe harbor pursuant to which a
mezzanine loan, if it meets each of the requirements contained in the Revenue Procedure, will be treated by the IRS as a real estate asset for purposes of the REIT
asset tests, and interest derived from the mezzanine loan will be treated as qualifying mortgage interest for purposes of the REIT 75% gross income test. Although
the Revenue Procedure provides a safe harbor on which taxpayers may rely, it does not prescribe rules of substantive tax law. We believe that the mezzanine loans
that we have treated as real estate assets generally met all of the requirements for reliance on this safe harbor. However, there can be no assurance that the IRS will
not challenge the tax treatment of these mezzanine loans, and if such a challenge were sustained, we could in certain circumstances be required to pay a penalty tax
or fail to qualify as a REIT.
36
Changes
in
tax
rules
could
adversely
affect
REITs
and
could
adversely
affect
the
value
of
our
common
stock.
The rules addressing federal income taxation are constantly under review by persons involved in the legislative process and by the IRS and the U.S.
Department of the Treasury. Any such future changes in the regulations or tax laws applicable to REITs or to mortgage related financial products could negatively
impact our operations or reduce any competitive advantages we may have relative to non-REIT entities, either of which could reduce the value of our common
stock.
The Tax Act has significantly changed the U.S. federal income taxation of U.S. businesses and their owners, including REITs and their stockholders. Changes
made by the Tax Act that could affect us and our stockholders include:
•
•
•
•
•
•
•
temporarily reducing individual U.S. federal income tax rates on ordinary income; the highest individual U.S. federal income tax rate has been reduced
from 39.6% to 37% for taxable years beginning after December 31, 2017 and before January 1, 2026;
permanently eliminating the progressive corporate tax rate structure, which previously imposed a maximum corporate tax rate of 35%, and replacing it
with a flat corporate tax rate of 21%;
permitting a deduction for certain pass-through business income, including dividends received by our stockholders from us that are not designated by us
as capital gain dividends or qualified dividend income, which will allow individuals, trusts, and estates to deduct up to 20% of such amounts for taxable
years beginning after December 31, 2017 and before January 1, 2026;
reducing the highest rate of withholding with respect to our distributions to non-U.S. stockholders that are treated as attributable to gains from the sale or
exchange of U.S. real property interests from 35% to 21%;
limiting our deduction for net operating losses arising in taxable years beginning after December 31, 2017 to 80% of REIT taxable income (determined
without regard to the dividends paid deduction);
generally limiting the deduction for net business interest expense in excess of 30% of a business’s “adjusted taxable income,” except for taxpayers that
engage in certain real estate businesses (including most equity REITs) and elect out of this rule (provided that such electing taxpayers must use an
alternative depreciation system with longer depreciation periods); and
eliminating the corporate alternative minimum tax.
Many of these changes that are applicable to us are effective beginning with our 2018 taxable year, without any transition periods or grandfathering for
existing transactions. The legislation is unclear in many respects and could be subject to potential amendments and technical corrections, as well as interpretations
and implementing regulations by the Treasury and IRS, any of which could lessen or increase the impact of the legislation. In addition, it is unclear how these U.S.
federal income tax changes will affect state and local taxation, which often uses federal taxable income as a starting point for computing state and local tax
liabilities. Some of the changes made by the tax legislation may adversely affect us in one or more reporting periods and prospectively. We continue to work with
our tax advisors and auditors to determine the full impact that the Tax Act as a whole will have on us.
The
application
of
the
tax
laws
to
our
business
is
complicated,
and
we
may
not
interpret
and
apply
some
of
the
rules
and
regulations
correctly.
In
addition,
we
may
not
make
all
available
elections,
which
could
result
in
our
not
being
able
to
fully
benefit
from
available
deductions
or
benefits.
Furthermore,
the
elections,
interpretations
and
applications
we
do
make
could
be
deemed
by
the
IRS
to
be
incorrect
and
could
have
adverse
impacts
on
our
GAAP
earnings
and
potentially
on
our
REIT
status.
The Internal Revenue Code may change and/or the interpretation of the rules and regulations by the IRS may change. In circumstances where the application
of these rules and regulations affecting our business is not clear, we may have to interpret them and their application to us. We seek the advice of outside tax
advisors in arriving at these interpretations, but our interpretations may prove to be wrong, which could have adverse consequences.
Our tax payments and dividend distributions, which are intended to meet the REIT distribution requirements, are based in large part on our estimate of taxable
income which includes the application and interpretation of a variety of tax rules and regulations. While there are some relief provisions should we incorrectly
interpret certain rules and regulations, we may not be able to fully take advantage of these provisions, and this could have an adverse effect on our REIT status. In
addition, our GAAP earnings include tax provisions and benefits based on our estimates of taxable income and should our estimates prove to be wrong, we could
have to make an adjustment to our tax provisions and this adjustment could be material.
37
Our decisions about raising, managing, and distributing our capital may adversely affect our business and financial results. Furthermore, our growth may be
limited if we are not able to raise additional capital.
We are required to distribute at least 90% of our REIT taxable income as dividends to shareholders. Thus, we do not generally have the ability to retain all of
the earnings generated by our REIT and, to a large extent, we rely on our ability to raise capital to grow. We may raise capital through the issuance of new shares
of our common stock, either through our direct stock purchase and dividend reinvestment plan or through public or private offerings. We may also raise capital by
issuing other types of securities, such as preferred stock, convertible or exchangeable debt, or other types of debt securities. As of January 1, 2018, we had
approximately 103 million unissued shares of stock authorized for issuance under our charter (although approximately $50 million of these shares are reserved for
issuance under our equity compensation plans, dividend reinvestment and stock purchase plan, and outstanding convertible notes and exchangeable notes). The
number of our unissued shares of stock authorized for issuance establishes a limit on the amount of capital we can raise through issuances of shares of stock or
securities convertible into, or exchangeable for, shares of stock, unless we seek and receive approval from our shareholders to increase the authorized number of
our shares in our charter. Also, certain stock change of ownership tests may limit our ability to raise significant amounts of equity capital or could limit our future
use of tax losses to offset income tax obligations if we raise significant amounts of equity capital.
In addition, we may not be able to raise capital at times when we need capital or see opportunities to invest capital. Many of the same factors that could make
the pricing for investments in real estate loans and securities attractive, such as the availability of assets from distressed owners who need to liquidate them at
reduced prices, and uncertainty about credit risk, housing, and the economy, may limit investors’ and lenders’ willingness to provide us with additional capital on
terms that are favorable to us, if at all. There may be other reasons we are not able to raise capital and, as a result, may not be able to finance growth in our business
and in our portfolio of assets. If we are unable to raise capital and expand our business and our portfolio of investments, our growth may be limited, we may have
to forgo attractive business and investment opportunities, and our operating expenses may increase significantly relative to our capital base. Alternatively, we may
need to raise capital on unfavorable terms, which may lead to greater dilution of existing shareholders, higher interest costs, or higher transaction costs.
To the extent we have capital that is available for investment, we have broad discretion over how to invest that capital and our shareholders and other investors
will be relying on the judgment of our management regarding its use. To the extent we invest capital in our business or in portfolio assets, we may not be
successful in achieving favorable returns.
Conducting our business in a manner so that we are exempt from registration under, and in compliance with, the Investment Company Act may reduce our
flexibility and could limit our ability to pursue certain opportunities. At the same time, failure to continue to qualify for exemption from the Investment
Company Act could adversely affect us.
Under the Investment Company Act, an investment company is required to register with the SEC and is subject to extensive restrictive and potentially adverse
regulations relating to, among other things, operating methods, management, capital structure, dividends, and transactions with affiliates. However, companies
primarily engaged in the business of acquiring mortgages and other liens on and interests in real estate are generally exempt from the requirements of the
Investment Company Act. We believe that we have conducted our business so that we are not subject to the registration requirements of the Investment Company
Act. In order to continue to do so, however, Redwood and each of our subsidiaries must either operate so as to fall outside the definition of an investment company
under the Investment Company Act or satisfy its own exclusion under the Investment Company Act. For example, to avoid being defined as an investment
company, an entity may limit its ownership or holdings of investment securities to less than 40% of its total assets. In order to satisfy an exclusion from being
defined as an investment company, other entities, among other things, maintain at least 55% of their assets in certain qualifying real estate assets (the 55%
Requirement) and also maintain an additional 25% of their assets in such qualifying real estate assets or certain other types of real estate-related assets (the 25%
Requirement). Rapid changes in the values of assets we own, however, can disrupt prior efforts to conduct our business to meet these requirements.
If Redwood or one of our subsidiaries fell within the definition of an investment company under the Investment Company Act and failed to qualify for an
exclusion or exemption, including, for example, if it failed to meet the 55% Requirement or the 25% Requirement, we could, among other things, be required
either (i) to change the manner in which we conduct our operations to avoid being required to register as an investment company or (ii) to register as an investment
company, either of which could adversely affect us by, among other things, requiring us to dispose of certain assets or to change the structure of our business in
ways that we may not believe to be in our best interests. Legislative or regulatory changes relating to the Investment Company Act or which affect our efforts to
qualify for exclusions or exemptions, including our ability to comply with the 55% Requirement and the 25% Requirement, could also result in these adverse
effects on us.
38
If we were deemed an unregistered investment company, we could be subject to monetary penalties and injunctive relief and we could be unable to enforce
contracts with third parties and third parties could seek to obtain rescission of transactions undertaken during the period we were deemed an unregistered
investment company, unless the court found that under the circumstances, enforcement (or denial of rescission) would produce a more equitable result than no
enforcement (or grant of rescission) and would not be inconsistent with the Investment Company Act.
An
SEC
review,
initiated
in
2011,
of
one
section
of
the
Investment
Company
Act
and
the
regulations
and
regulatory
interpretations
promulgated
thereunder
that
we
rely
on
to
exempt
us
from
registration
and
regulation
as
an
investment
company
under
the
Investment
Company
Act
could
eventually
result
in
legislative
or
regulatory
changes,
which
could
require
us
to
change
our
business
and
operations
in
order
for
us
to
continue
to
rely
on
that
exemption
or
operate
without
the
benefit
of
that
exemption.
In August 2011, the SEC published a Concept Release within which it reviewed interpretive issues under the Investment Company Act relating to the status
under the Investment Company Act of companies that are engaged in the business of acquiring mortgages and mortgage-related instruments and that rely on the
exemption set forth in Section 3(c)(5)(C) of the Investment Company Act from requirements under the Investment Company Act. Among other things, the SEC
expressed in the Concept Release that it was “concerned that certain types of mortgage-related pools today appear to resemble in many respects investment
companies such as closed-end funds and may not be the kinds of companies that were intended to be excluded from regulation under the Investment Company Act
by Section 3(c)(5)(C).” To the extent we rely on Section 3(c)(5)(C) of the Investment Company Act to exempt us from regulation under the Investment Company
Act, we believe that our reliance is proper. However, additional SEC review and action could eventually lead to legislative or regulatory changes that could affect
our ability to rely on that exemption or could eventually require us to change our business and operations in order for us to continue to rely on that exemption.
Even if the SEC’s review of this exemption does not eventually have these effects on us, in the interim, while the SEC’s Concept Release is outstanding, any
uncertainty created by the SEC’s review process could negatively impact the ability of companies, such as us, that rely on this exemption to raise capital, borrow
money, or engage in certain other types of business transactions, which could negatively impact our business and financial results.
Provisions in our charter and bylaws and provisions of Maryland law may limit a change in control or deter a takeover that might otherwise result in a
premium price being paid to our shareholders for their shares in Redwood.
In order to maintain our status as a REIT, not more than 50% in value of our outstanding capital stock may be owned, actually or constructively, by five or
fewer individuals (defined in the Internal Revenue Code to include certain entities). In order to protect us against the risk of losing our status as a REIT due to
concentration of ownership among our shareholders and for other reasons, our charter generally prohibits any single shareholder, or any group of affiliated
shareholders, from beneficially owning more than 9.8% of the outstanding shares of any class of our stock, unless our Board of Directors waives or modifies this
ownership limit. This limitation may have the effect of precluding an acquisition of control of us by a third party without the consent of our Board of Directors.
Our Board of Directors has granted a limited number of waivers to institutional investors to own shares in excess of this 9.8% limit, which waivers are subject to
certain terms and conditions. Our Board of Directors may amend these existing waivers to permit additional share ownership or may grant waivers to additional
shareholders at any time.
Certain other provisions contained in our charter and bylaws and in the Maryland General Corporation Law (“MGCL”) may have the effect of discouraging a
third party from making an acquisition proposal for us and may therefore inhibit a change in control. For example, our charter includes provisions granting our
Board of Directors the authority to issue preferred stock from time to time and to establish the terms, preferences, and rights of the preferred stock without the
approval of our shareholders. Provisions in our charter and the MGCL also restrict our shareholders’ ability to remove directors and fill vacancies on our Board of
Directors and restrict unsolicited share acquisitions. These provisions and others may deter offers to acquire our stock or large blocks of our stock upon terms
attractive to our shareholders, thereby limiting the opportunity for shareholders to receive a premium for their shares over then-prevailing market prices.
39
The ability to take action against our directors and officers is limited by our charter and bylaws and provisions of Maryland law and we may (or, in some cases,
are obligated to) indemnify our current and former directors and officers against certain losses relating to their service to us.
Our charter limits the liability of our directors and officers to us and to shareholders for pecuniary damages to the fullest extent permitted by Maryland law. In
addition, our charter and bylaws together require us to indemnify our officers and directors (and those of our subsidiaries and affiliates) to the maximum extent
permitted by Maryland law in the defense of any proceeding to which he or she is made, or threatened to be made, a party because of his or her service to us. In
addition, we have entered into, and may in the future enter into, indemnification agreements with our directors and certain of our officers and the directors and
certain of the officers of certain of our subsidiaries and affiliates which obligate us to indemnify them against certain losses relating to their service to us and the
related costs of defense.
Other Risks Related to Ownership of Our Common Stock
Investing in our common stock may involve a high degree of risk. Investors in our common stock may experience losses, volatility, and poor liquidity, and we
may reduce our dividends in a variety of circumstances.
An investment in our common stock may involve a high degree of risk, particularly when compared to other types of investments. Risks related to the
economy, the financial markets, our industry, our investing activity, our other business activities, our financial results, the amount of dividends we distribute, the
manner in which we conduct our business, and the way we have structured our operations could result in a reduction in, or the elimination of, the value of our
common stock. The level of risk associated with an investment in our common stock may not be suitable for the risk tolerance of many investors. Investors may
experience volatile returns and material losses. In addition, the trading volume of our common stock (i.e., its liquidity) may be insufficient to allow investors to sell
their common stock when they want to or at a price they consider reasonable.
Our earnings, cash flows, book value, and dividends can be volatile and difficult to predict. Investors in our common stock should not rely on our estimates,
projections, or predictions, or on management’s beliefs about future events. In particular, the sustainability of our earnings and our cash flows will depend on
numerous factors, including our level of business and investment activity, our access to debt and equity financing, the returns we earn, the amount and timing of
credit losses, prepayments, the expense of running our business, and other factors, including the risk factors described herein. As a consequence, although we seek
to pay a regular common stock dividend that is sustainable, we may reduce our regular dividend rate, or stop paying dividends, in the future for a variety of
reasons. We may not provide public warnings of dividend reductions prior to their occurrence. Although we have paid special dividends in the past, we have not
paid a special dividend since 2007 and we may not do so in the future. Changes to the amount of dividends we distribute may result in a reduction in the value of
our common stock.
A limited number of institutional shareholders own a significant percentage of our common stock, which could have adverse consequences to other holders of
our common stock.
As of February 23, 2018, based on filings of Schedules 13D and 13G with the SEC, we believe that six institutional shareholders each owned approximately
5% or more of our outstanding common stock and we believe based on data obtained from other public sources that, overall, institutional shareholders owned, in
the aggregate, more than 85% of our outstanding common stock. Furthermore, one or more of these investors or other investors could significantly increase their
ownership of our common stock, including through the conversion of outstanding convertible or exchangeable notes into shares of common stock. Significant
ownership stakes held by these individual institutions or other investors could have adverse consequences for other shareholders because each of these shareholders
will have a significant influence over the outcome of matters submitted to a vote of our shareholders, including the election of our directors and transactions
involving a change in control. In addition, should any of these significant shareholders determine to liquidate all or a significant portion of their holdings of our
common stock, it could have an adverse effect on the market price of our common stock.
Although, under our charter, shareholders are generally precluded from beneficially owning more than 9.8% of our outstanding common stock, our Board of
Directors may amend existing ownership-limitation waivers or grant waivers to other shareholders in the future, in each case in a manner which may allow for
increases in the concentration of the ownership of our common stock held by one or more shareholders.
40
Future sales of our common stock by us or by our officers and directors may have adverse consequences for investors.
We may issue additional shares of common stock, or securities convertible into, or exchangeable for, shares of common stock, in public offerings or private
placements, and holders of our outstanding convertible notes or exchangeable securities may convert those securities into shares of common stock. In addition, we
may issue additional shares of common stock to participants in our direct stock purchase and dividend reinvestment plan and to our directors, officers, and
employees under our employee stock purchase plan, our incentive plan, or other similar plans, including upon the exercise of, or in respect of, distributions on
equity awards previously granted thereunder. We are not required to offer any such shares to existing shareholders on a preemptive basis. Therefore, it may not be
possible for existing shareholders to participate in future share issuances, which may dilute existing shareholders’ interests in us. In addition, if market participants
buy shares of common stock, or securities convertible into, or exchangeable for, shares of common stock, in issuances by us in the future, it may reduce or
eliminate any purchases of our common stock they might otherwise make in the open market, which in turn could have the effect of reducing the volume of shares
of our common stock traded in the marketplace, which could have the effect of reducing the market price and liquidity of our common stock.
At February 23, 2018, our directors and executive officers beneficially owned, in the aggregate, approximately 3% of our common stock. Sales of shares of
our common stock by these individuals are generally required to be publicly reported and are tracked by many market participants as a factor in making their own
investment decisions. As a result, future sales by these individuals could negatively affect the market price of our common stock.
There is a risk that you may not receive dividend distributions or that dividend distributions may decrease over time. Changes in the amount of dividend
distributions we pay, in the tax characterization of dividend distributions we pay, or in the rate at which holders of our common stock are taxed on dividend
distributions we pay, may adversely affect the market price of our common stock or may result in holders of our common stock being taxed on dividend
distributions at a higher rate than initially expected.
Our dividend distributions are driven by a variety of factors, including our minimum dividend distribution requirements under the REIT tax laws and our
REIT taxable income as calculated for tax purposes pursuant to the Internal Revenue Code. We generally intend to distribute to our shareholders at least 90% of
our REIT taxable income, although our reported financial results for GAAP purposes may differ materially from our REIT taxable income.
For 2017, we maintained our regular dividend at a rate of $0.28 per share per quarter and in December 2017 our Board of Directors announced its intention to
continue to pay regular dividends during 2018 at a rate of $0.28 per share per quarter. The announcement of the Board's intention does not create an obligation to
maintain the regular quarterly dividend at this rate, and despite this intention, we may reduce or eliminate our regular quarterly dividend during 2018. Our ability to
pay a dividend of $0.28 per share per quarter in 2018 may be adversely affected by a number of factors, including the risk factors described herein. These same
factors may affect our ability to pay other future dividends. In addition, to the extent we determine that future dividends would represent a return of capital to
investors, rather than the distribution of income, we may determine to discontinue dividend payments until such time that dividends would again represent a
distribution of income. Any reduction or elimination of our payment of dividend distributions would not only reduce the amount of dividends you would receive as
a holder of our common stock, but could also have the effect of reducing the market price of our common stock.
The rate at which holders of our common stock are taxed on dividends we pay and the characterization of our dividends - as ordinary income, capital gains, or
a return of capital - could have an impact on the market price of our common stock. In addition, after we announce the expected characterization of dividend
distributions we have paid, the actual characterization (and, therefore, the rate at which holders of our common stock are taxed on the dividend distributions they
have received) could vary from our expectation, including due to errors, changes made in the course of preparing our corporate tax returns, or changes made in
response to an IRS audit), with the result that holders of our common stock could incur greater income tax liabilities than expected.
The market price of our common stock could be negatively affected by various factors, including broad market fluctuations.
The market price of our common stock may be negatively affected by various factors, which change from time to time. Some of these factors are:
•
•
Our actual or anticipated financial condition, performance, and prospects and those of our competitors.
The market for similar securities issued by other REITs and other competitors of ours.
41
•
•
•
•
•
Changes in the manner that investors and securities analysts who provide research to the marketplace on us analyze the value of our common stock.
Changes in recommendations or in estimated financial results published by securities analysts who provide research to the marketplace on us, our
competitors, or our industry.
General economic and financial market conditions, including, among other things, actual and projected interest rates, prepayments, and credit
performance and the markets for the types of assets we hold or invest in.
Proposals to significantly change the manner in which financial markets, financial institutions, and related industries, or financial products are regulated
under applicable law, or the enactment of such proposals into law or regulation.
Other events or circumstances which undermine confidence in the financial markets or otherwise have a broad impact on financial markets, such as the
sudden instability or collapse of large financial institutions or other significant corporations (whether due to fraud or other factors), terrorist attacks,
natural or man-made disasters, or threatened or actual armed conflicts.
Furthermore, these fluctuations do not always relate directly to the financial performance of the companies whose stock prices may be affected. As a result of
these and other factors, investors who own our common stock could experience a decrease in the value of their investment, including decreases unrelated to our
financial results or prospects.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
42
ITEM 2. PROPERTIES
Our principal executive and administrative office is located in Mill Valley, California and we have additional administrative offices at the locations listed
below. We do not own any properties and lease the space we utilize for our offices. Additional information on our leases is included in Note
14
to the Financial
Statements within this Annual Report on Form 10-K. The following table presents the locations and remaining lease terms of our primary offices.
Executive and Administrative Office Locations and Lease Expirations
Location
One Belvedere Place, Suite 300
Mill Valley, CA 94941
8310 South Valley Highway, Suite 425
Englewood, CO 80112
225 W. Washington St., Suite 1440
Chicago, IL 60606
ITEM 3. LEGAL PROCEEDINGS
Lease
Expiration
2028
2021
2019
On or about December 23, 2009, the Federal Home Loan Bank of Seattle (the “FHLB-Seattle”) filed a complaint in the Superior Court for the State of
Washington (case number 09-2-46348-4 SEA) against Redwood Trust, Inc., our subsidiary, Sequoia Residential Funding, Inc. (“SRF”), Morgan Stanley & Co.,
and Morgan Stanley Capital I, Inc. (collectively, the “FHLB-Seattle Defendants”), which alleged that the FHLB-Seattle Defendants made false or misleading
statements in offering materials for a mortgage pass-through certificate (the “Seattle Certificate”) issued in the Sequoia Mortgage Trust 2005-4 securitization
transaction (the “2005-4 RMBS”) and purchased by the FHLB-Seattle. Specifically, the complaint alleged that the alleged misstatements concerned the (1) loan-to-
value ratio of mortgage loans and the appraisals of the properties that secured loans supporting the 2005-4 RMBS, (2) occupancy status of the properties, (3)
standards used to underwrite the loans, and (4) ratings assigned to the Seattle Certificate. The FHLB-Seattle alleged claims under the Securities Act of Washington
(Section 21.20.005, et seq.) and sought to rescind the purchase of the Seattle Certificate and to collect interest on the original purchase price at the statutory interest
rate of 8% per annum from the date of original purchase (net of interest received) as well as attorneys’ fees and costs. The Seattle Certificate was issued with an
original principal amount of approximately $133 million , and, at December 31, 2017 , approximately $125 million of principal and $11 million of interest
payments had been made in respect of the Seattle Certificate. As of December 31, 2017 , the Seattle Certificate had a remaining outstanding principal amount of
approximately $8 million . The matter was subsequently resolved and the claims were dismissed by the FHLB Seattle as to all the FHLB Seattle Defendants. At the
time the Seattle Certificate was issued, Redwood agreed to indemnify the underwriters of the 2005-4 RMBS, which underwriters were named as defendants in the
action, for certain losses and expenses they might incur as a result of claims made against them relating to this RMBS, including, without limitation, certain legal
expenses. Regardless of the resolution of this litigation, we could incur a loss as a result of these indemnities.
On or about July 15, 2010, The Charles Schwab Corporation (“Schwab”) filed a complaint in the Superior Court for the State of California in San Francisco
(case number CGC-10-501610) against SRF and 26 other defendants (collectively, the “Schwab Defendants”), which alleged that the Schwab Defendants made
false or misleading statements in offering materials for various residential mortgage-backed securities sold or issued by the Schwab Defendants. Schwab alleged
only a claim for negligent misrepresentation under California state law against SRF and sought unspecified damages and attorneys’ fees and costs from SRF.
Schwab claimed that SRF made false or misleading statements in offering materials for a mortgage pass-through certificate (the “Schwab Certificate”) issued in the
2005-4 RMBS and purchased by Schwab. Specifically, the complaint alleged that the misstatements for the 2005-4 RMBS concerned the (1) loan-to-value ratio of
mortgage loans and the appraisals of the properties that secured loans supporting the 2005-4 RMBS, (2) occupancy status of the properties, (3) standards used to
underwrite the loans, and (4) ratings assigned to the Schwab Certificate. The Schwab Certificate was issued with an original principal amount of approximately
$15 million , and, at December 31, 2017 , approximately $14 million of principal and $1 million of interest payments had been made in respect of the Schwab
Certificate. As of December 31, 2017 , the Schwab Certificate had a remaining outstanding principal amount of approximately $1 million . At the time the Schwab
Certificate was issued, Redwood agreed to indemnify the underwriters of the 2005-4 RMBS, which underwriters were also named as defendants in the action,
43
for certain losses and expenses they might incur as a result of claims made against them relating to this RMBS, including, without limitation, certain legal
expenses. Regardless of the resolution of this litigation, Redwood could incur a loss as a result of these indemnities.
Through certain of our wholly-owned subsidiaries, we have in the past engaged in, and expect to continue to engage in, activities relating to the acquisition
and securitization of residential mortgage loans. In addition, certain of our wholly-owned subsidiaries have in the past engaged in activities relating to the
acquisition and securitization of debt obligations and other assets through the issuance of collateralized debt obligations (commonly referred to as CDO
transactions). Because of this involvement in the securitization and CDO businesses, we could become the subject of litigation relating to these businesses,
including additional litigation of the type described above, and we could also become the subject of governmental investigations, enforcement actions, or lawsuits,
and governmental authorities could allege that we violated applicable law or regulation in the conduct of our business. As an example, in July 2016 we became
aware of a complaint filed by the State of California on April 1, 2016 against Morgan Stanley & Co. and certain of its affiliates alleging, among other things, that
there were misleading statements contained in offering materials for 28 different mortgage pass-through certificates purchased by various California investors,
including various California public pension systems, from Morgan Stanley and alleging that Morgan Stanley made false or fraudulent claims in connection with the
sale of those certificates. Of the 28 mortgage pass-through certificates that were the subject of the complaint, two were Sequoia mortgage pass-through certificates
issued in 2004 and two were Sequoia mortgage pass-through certificates issued in 2007. With respect to each of those certificates, our wholly-owned subsidiary,
RWT Holdings, Inc., was the sponsor and our wholly-owned subsidiary, Sequoia Residential Funding, Inc., was the depositor. The plaintiffs subsequently
withdrew from the litigation their claims based on eight of the 28 mortgage pass-through certificates, including one of the Sequoia mortgage pass-through
certificates issued in 2004. At the time these Sequoia mortgage pass-through certificates were issued, Sequoia Residential Funding, Inc. and Redwood Trust agreed
to indemnify the underwriters of these certificates for certain losses and expenses they might incur as a result of claims made against them relating to these
certificates, including, without limitation, certain legal expenses. Regardless of the outcome of this litigation, we could incur a loss as a result of these indemnities.
In accordance with GAAP, we review the need for any loss contingency reserves and establish reserves when, in the opinion of management, it is probable
that a matter would result in a liability and the amount of loss, if any, can be reasonably estimated. Additionally, we record receivables for insurance recoveries
relating to litigation-related losses and expenses if and when such amounts are covered by insurance and recovery of such losses or expenses are due. At
December 31, 2017 , the aggregate amount of loss contingency reserves established in respect of the FHLB-Seattle and Schwab litigation matters described above
was $2 million . We review our litigation matters each quarter to assess these loss contingency reserves and make adjustments in these reserves, upwards or
downwards, as appropriate, in accordance with GAAP based on our review.
In the ordinary course of any litigation matter, including certain of the above-referenced matters, we have engaged and may continue to engage in formal or
informal settlement communications with the plaintiffs or co-defendants. Settlement communications we have engaged in relating to certain of the above-
referenced litigation matters are one of the factors that have resulted in our determination to establish the loss contingency reserves described above. We cannot be
certain that any of these matters will be resolved through a settlement prior to trial and we cannot be certain that the resolution of these matters, whether through
trial or settlement, will not have a material adverse effect on our financial condition or results of operations in any future period.
Future developments (including resolution of substantive pre-trial motions relating to these matters, receipt of additional information and documents relating
to these matters (such as through pre-trial discovery), new or additional settlement communications with plaintiffs relating to these matters, or resolutions of
similar claims against other defendants in these matters) could result in our concluding in the future to establish additional loss contingency reserves or to disclose
an estimate of reasonably possible losses in excess of our established reserves with respect to these matters. Our actual losses with respect to the above-referenced
litigation matters may be materially higher than the aggregate amount of loss contingency reserves we have established in respect of these litigation matters,
including in the event that any of these matters proceeds to trial and the plaintiff prevails. Other factors that could result in our concluding to establish additional
loss contingency reserves or estimate additional reasonably possible losses, or could result in our actual losses with respect to the above-referenced litigation
matters being materially higher than the aggregate amount of loss contingency reserves we have established in respect of these litigation matters include that: there
are significant factual and legal issues to be resolved; information obtained or rulings made during the lawsuits could affect the methodology for calculation of the
available remedies; and we may have additional obligations pursuant to indemnity agreements, representations and warranties, and other contractual provisions
with other parties relating to these litigation matters that could increase our potential losses.
ITEM 4. MINE SAFETY DISCLOSURES
Not applicable.
44
PART II
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS, AND ISSUER PURCHASES OF EQUITY
SECURITIES
Our common stock is listed and traded on the NYSE under the symbol RWT. At February 15, 2018, our common stock was held by approximately 663
holders of record and the total number of beneficial stockholders holding stock through depository companies was approximately 17,552 . At February 26, 2018 ,
there were 75,557,381 shares of common stock outstanding.
The high and low sales prices of shares of our common stock, as reported by the Bloomberg Financial Markets service, and the cash dividends declared on our
common stock for each full quarterly period during 2017 and 2016 were as follows:
Year Ended December 31, 2017
Fourth Quarter
Third Quarter
Second Quarter
First Quarter
Year Ended December 31, 2016
Fourth Quarter
Third Quarter
Second Quarter
First Quarter
Stock Prices
Common Dividends Declared
High
Low
Record
Date
Payable
Date
Per
Share
Dividend
Type
$
$
$
$
$
$
$
$
16.86 $
17.45 $
17.43 $
17.05 $
16.20 $
15.07 $
14.53 $
13.92 $
14.29
12/15/2017
12/28/2017
15.74
9/15/2017
16.20
6/16/2017
14.85
3/16/2017
9/29/2017
6/30/2017
3/31/2017
13.49
12/15/2016
12/29/2016
13.29
9/15/2016
12.49
6/16/2016
9.36
3/16/2016
9/30/2016
6/30/2016
3/31/2016
$
$
$
$
$
$
$
$
0.28
0.28
0.28
0.28
0.28
0.28
0.28
0.28
Regular
Regular
Regular
Regular
Regular
Regular
Regular
Regular
All dividend distributions are made with the authorization of the board of directors at its discretion and will depend on such items as our GAAP net income,
REIT taxable earnings, financial condition, maintenance of REIT status, and other factors that the board of directors may deem relevant from time to time. The
holders of our common stock share proportionally on a per share basis in all declared dividends on common stock. As reported on our Current Report on Form 8-K
on January 25, 2018 , for dividend distributions made in 2017 , we expect our dividends paid in 2017 to be characterized as 71% ordinary dividend income and
29% qualified dividend income. None of the dividend distributions made in 2017 are expected to be characterized for federal income tax purposes as return of
capital or long-term capital gain dividends.
During the year ended December 31, 2017 , we did not sell any equity securities that were not registered under the Securities Act of 1933, as amended. In
February 2016, our Board of Directors approved an authorization for the repurchase of up to $100 million of our common stock and also authorized the repurchase
of outstanding debt securities, including convertible and exchangeable debt. This authorization replaced all previous share repurchase plans and has no expiration
date. During the year ended December 31, 2017 , we repurchased 610,342 shares of our common stock pursuant to this authorization for $9 million . At
December 31, 2017 , approximately $77 million of this current authorization remained available for the repurchase of shares of our common stock. During the
period between December 31, 2017 and February 26, 2018, we repurchased 1,040,829 shares of our common stock pursuant to this authorization for $16 million .
In February 2018, our Board of Directors approved an authorization for the repurchase of an additional $39 million of our common stock, increasing the total
amount authorized for repurchases of common stock to $100 million, and also authorized the repurchase of outstanding debt securities, including convertible and
exchangeable debt. As noted above, this authorization increased the previous share repurchase authorization approved in February 2016 and has no expiration date.
This repurchase authorization does not obligate us to acquire any specific number of shares or securities. Under this authorization, shares or securities may be
repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of
1934, as amended. At February 26, 2018, approximately $100 million of this current authorization remained available for repurchases of shares of our common
stock. Like other investments we may make, any repurchases of our common stock or debt securities under this authorization would reduce our available capital
described above.
45
The following table contains information on the shares of our common stock that we purchased or otherwise acquired during the three months ended
December 31, 2017 .
(In Thousands, except Per Share Data)
October 1, 2017 - October 31, 2017
November 1, 2017 - November 30, 2017
December 1, 2017 - December 31, 2017
Total
Total Number
of Shares
Purchased or
Acquired
Average
Price per
Share Paid
(1
)
$
—
—
610
610
$
$
$
16.29
—
15.05
15.05
Total Number of
Shares Purchased as
Part of Publicly
Announced Plans or
Programs
Maximum Number
(or approximate
dollar value) of Shares
that May Yet be
Purchased under the
Plans or Programs
— $
$
$
—
610
610
—
—
76,922 (2)
(1) Represents fewer than 1,000 shares reacquired to satisfy tax withholding requirements related to the vesting of restricted shares.
(2)
In February 2018, our Board of Directors approved an authorization for the repurchase of an additional $39 million of our common stock, increasing the total amount
authorized for repurchases of common stock to $100 million , and also authorized the repurchase of outstanding debt securities, including convertible and exchangeable
debt.
Information with respect to compensation plans under which equity securities of the registrant are authorized for issuance is set forth in Part II, Item 12 of this
Annual Report on Form 10-K.
46
Performance Graph
The following graph presents a cumulative total return comparison of our common stock, over the last five years, to the S&P Composite-500 Stock Index and
the National Association of Real Estate Investment Trusts, Inc. (“NAREIT”) Mortgage REIT index. The total returns reflect stock price appreciation and the
reinvestment of dividends for our common stock and for each of the comparative indices, assuming that $100 was invested in each on December 31, 2012. The
information has been obtained from sources believed to be reliable; but neither its accuracy nor its completeness is guaranteed. The total return performance shown
on the graph is not necessarily indicative of future performance of our common stock.
Redwood Trust, Inc.
NAREIT Mortgage REIT Index
S&P Composite-500 Index
2012
100
100
100
2013
121
98
132
47
2014
131
115
150
2015
94
105
153
2016
118
129
171
2017
123
155
208
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are qualified in their entirety by, and should be read in conjunction with, the more detailed information contained in the
Consolidated Financial Statements and Notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations included
elsewhere in this Annual Report on Form 10-K and in our Annual Reports on Form 10-K as of and for each of the years ended December 31, 2016 , 2015 , 2014 ,
and 2013 . Certain amounts for prior periods have been reclassified to conform to the 2017 presentation.
(In Thousands, except Share Data)
2017
2016
2015
2014
2013
Selected Statement of Operations Data:
Interest income
Interest expense
Net Interest Income
Reversal of (provision for) loan losses
Net Interest Income after Provision
Non-interest Income
Mortgage banking activities, net
Mortgage servicing rights income (loss), net
Investment fair value changes, net
Other income
Realized gains, net
Total non-interest income, net
Operating expenses
Other expense
Net Income before Provision for Income Taxes
(Provision for) benefit from income taxes
Net Income
Average common shares – basic
Earnings per share – basic
Average common shares – diluted (1)
Earnings per share – diluted
Regular dividends declared per common share
Selected Balance Sheet Data:
Earning assets
Total assets
Short-term debt
Asset-backed securities issued –
Resecuritization, net (2)
Asset-backed securities issued, net –
Commercial
Asset-backed securities issued, net – Sequoia
Long-term debt, net (2)
Total liabilities
Total stockholders’ equity
Number of common shares outstanding
Book value per common share
Other Selected Data:
Average assets (3)
Average debt and ABS issued outstanding (3)
Average stockholders’ equity
$
248,057
$
246,355
$
259,432
$
242,070
$
(108,816)
139,241
—
139,241
53,908
7,860
10,374
4,576
13,355
90,073
(77,156)
—
152,158
(11,752)
(88,528)
157,827
7,102
164,929
38,691
14,353
(28,574)
6,338
28,009
58,817
(88,786)
(95,883)
163,549
355
163,904
10,972
(3,922)
(21,357)
3,192
36,369
25,254
(97,416)
(87,463)
154,607
(961)
153,646
34,994
(4,261)
(10,202)
1,781
15,478
37,790
(90,123)
—
—
—
134,960
(3,708)
91,742
10,346
101,313
(744)
140,406
$
131,252
$
102,088
$
100,569
$
226,156
(80,971)
145,185
(4,737)
140,448
102,532
20,309
(5,747)
—
25,259
142,353
(86,607)
(12,000)
184,194
(10,948)
173,246
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
76,792,957
76,747,047
82,945,103
82,837,369
81,985,897
1.78
$
1.66
$
1.20
$
1.18
$
2.05
101,975,008
97,909,090
84,518,395
85,098,579
93,694,924
1.60
1.12
6,799,981
7,039,822
1,938,682
$
$
$
$
$
1.54
1.12
5,240,560
5,483,477
791,539
$
$
$
$
$
1.18
1.12
5,976,911
6,220,047
1,855,003
$
$
$
$
$
1.15
1.12
5,753,753
5,902,916
1,793,825
$
$
$
$
$
1.94
1.12
4,519,775
4,595,075
862,763
— $
— $
— $
44,909
$
94,542
— $
— $
1,164,585
2,575,023
5,827,535
1,212,287
$
$
$
$
773,462
2,620,683
4,334,049
1,149,428
$
$
$
$
52,595
996,820
2,027,737
5,073,782
1,146,265
$
$
$
$
$
81,760
1,416,090
1,180,877
4,646,775
1,256,141
$
$
$
$
$
150,796
1,692,941
467,697
3,349,292
1,245,783
76,599,972
76,834,663
78,162,765
83,443,141
82,504,801
15.83
$
14.96
$
14.67
$
15.05
$
15.10
5,918,233
4,544,694
1,181,056
$
$
$
5,893,998
4,617,956
1,112,313
$
$
$
6,015,420
4,505,079
1,240,345
$
$
$
5,356,839
3,871,404
1,250,627
$
$
$
4,904,878
3,571,389
1,200,461
Net income/average stockholders’ equity
11.9%
11.8%
8.2%
8.0%
14.4%
(1) Diluted average common shares for 2017, 2016, and 2013 include certain convertible notes that were determined to be dilutive for those years.
(2) At December 31, 2017 , 2016, 2015, 2014, and 2013, Asset-backed securities issued, net included $0, $0, $542, $2,360, and $4,683, respectively, of deferred debt issuance costs, and long-
term debt, net included $10,240, $7,081, $10,438, $13,690, and $8,770, respectively, of deferred debt issuance costs.
(3) Average assets and Average debt and ABS issued outstanding presented above do not include deferred debt issuance costs.
48
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
INTRODUCTION
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is intended to provide a reader of our financial
statements with a narrative from the perspective of our management on our financial condition, results of operations, liquidity and certain other factors that may
affect our future results. Our MD&A is presented in six main sections:
•
•
•
•
•
•
Overview
Results of Operations
Liquidity and Capital Resources
Off Balance Sheet Arrangements and Contractual Obligations
Critical Accounting Policies and Estimates
New Accounting Standards
Our MD&A should be read in conjunction with the Consolidated Financial Statements and related Notes included in Part II, Item 8, Financial Statements and
Supplementary Data of this Annual Report on Form 10-K. References herein to “Redwood,” the “company,” “we,” “us,” and “our” include Redwood Trust, Inc.
and its consolidated subsidiaries, unless the context otherwise requires. The discussion in this MD&A contains forward-looking statements that involve substantial
risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, such as
those discussed in the Cautionary Statement in Part 1, Item 1, Business
and in Part 1, Item 1A, Risk
Factors
of this Annual Report on Form 10-K.
OVERVIEW
Our Business
Redwood Trust, Inc., together with its subsidiaries, focuses on investing in mortgages and other real estate-related assets and engaging in mortgage banking
activities. We seek to invest in real estate-related assets that have the potential to generate attractive cash flow returns over time and to generate income through
our mortgage banking activities. During 2017 , we operated our business in two segments: Investment Portfolio and Residential Mortgage Banking.
Our primary sources of income are net interest income from our investment portfolio and non-interest income from our mortgage banking activities. Net
interest income consists of the interest income we earn on investments less the interest expense we incur on borrowed funds and other liabilities. Income from
mortgage banking activities consists of the profit we seek to generate through the acquisition of loans and their subsequent sale or securitization. Redwood Trust,
Inc. has elected to be taxed as a real estate investment trust (“REIT”). We generally refer, collectively, to Redwood Trust, Inc. and those of its subsidiaries that are
not subject to subsidiary-level corporate income tax as “the REIT” or “our REIT.” We generally refer to subsidiaries of Redwood Trust, Inc. that are subject to
subsidiary-level corporate income tax as “our operating subsidiaries” or “our taxable REIT subsidiaries” or “TRS.”
For additional information on our business, refer to Part I, Item 1, Business
of this Annual Report on Form 10-K.
49
Business Update
During the past few years, the financial markets have steadily ascended, as equity markets reached historical levels, volatility remained subdued, credit spreads
steadily tightened, and long-term interest rates remained low. Meanwhile, policy makers have not achieved any meaningful fiscal policy reforms.
This dynamic has changed recently, as equities have been under pressure, volatility has increased, long-term rates are trending higher, Congress passed tax
reform legislation, regulation is easing, and GSE reform is being considered once again. Overall, we believe the net impact of these changes to Redwood is
favorable.
It is against this backdrop that we move forward, mindful of market forces but confident in our operating plan. At our core, we remain patient, long-term credit
investors who measure outcomes in years, not quarters. Our strengths continue to lie where they always have: in sourcing and analyzing housing credit risk,
prudent management of our capital base, and our ability to execute in the marketplace. In an era where demand for residential mortgage credit risk continues to
exceed supply, our ability to organically create investments that we could not otherwise source remains a key competitive advantage.
Capital and Investing
We deployed $511 million of capital in 2017 (including $37 million of debt repurchases and $9 million of share repurchases). As credit spreads tightened,
particularly in the second half of 2017, we were active in optimizing our portfolio, selling $281 million of mostly lower yielding securities and the remainder of our
conforming MSR portfolio, capturing gains and freeing up $167 million of capital for redeployment into higher-yielding investments.
At December 31, 2017, we estimate that our capital available for investments was approximately $280 million. Subsequent to year-end, we have continued to
optimize our portfolio and have sufficient capital to repay our maturing convertible debt due in April 2018.
Residential Mortgage Banking
Our full-year total purchase volume was $5.7 billion - an increase of over 20% from our 2016 volume. Choice loans represented almost 30% of our full-year
loan purchase commitment volume and was a key driver of our year-over-year growth. We sponsored nine Sequoia securitization transactions in 2017, including
seven Select transactions and two Choice transactions. Securitization execution was profitable throughout the year, and after a slight decrease in the level of
profitability during the fourth quarter of 2017, pricing on securitization activity during the first quarter of 2018 has started off strong.
For 2018, our focus continues to be on growing our Choice loan acquisition volume while maintaining our competitive position in the private label RMBS
market for securitization transactions backed by prime Select loans through speed, reliability and deepening relationships with our loan sellers. While our recent
success in the securitization market has attracted competition from both new and existing conduit platforms, we continue to drive operational efficiencies and
enhance our program to maintain our competitive advantages.
Tax Reform
Overall, our view is that the tax reform legislation will have a positive impact on our business. The most direct benefit to Redwood is the reduction in the
corporate tax rate from 35% to 21%, which benefits our mortgage banking activities and non-REIT eligible investments, both of which are conducted within our
taxable REIT subsidiaries. This rate reduction also resulted in a $8 million benefit to our fourth quarter results from the reduction of our net federal deferred tax
liabilities.
Additionally, beginning in 2018, individual taxpayers may deduct 20% of their ordinary REIT dividends from taxable income. This results in a maximum
federal effective tax rate of 29.6% on an individual taxpayer’s ordinary REIT dividends, compared to the highest marginal rate of 37%.
The broader impact from tax reform on the housing market remains unclear. Although existing mortgages up to $1 million will remain eligible for the full
mortgage interest deduction, the new legislation decreases the annual residential mortgage interest deduction for purchase-money mortgage debt to $750,000 of
unpaid principal balance, and will remain limited to two homes. Property tax and state and local income tax deductions will be limited to $10,000 and the standard
deduction will roughly double. Although households with jumbo mortgages will likely not take the standard deduction, these changes could potentially have a
marginally negative impact on home demand and jumbo loan origination volume. They may also impact the decision to rent versus buy for newly-formed
households, further broadening financing needs for housing investors.
50
2018 Outlook
We continue to operate in an environment that rewards creativity, execution, and rigorous risk management. To succeed, we will continue to leverage our core
strengths to further enhance our strategic value to the housing finance market. We will expand on our core mortgage credit strategies, with an emphasis on our
Redwood Choice loan program. Additionally, we will pursue initiatives that are responsive to secular trends in the housing market and consistent with our core
competencies, including financing single-family housing investors and providing new types of capital solutions to our seller base.
We are confident that our strategy is durable and built to succeed for the long-term. Our priorities for the remainder of 2018 are to generate strong earnings by
growing our residential loan purchase volume while maintaining our long-term gross margins, and maintaining our strong capital deployment trends. Moving
forward in 2018, we anticipate deploying capital towards new initiatives in a manner conducive to our long-term success.
51
2017 Financial Overview
This section includes an overview of our 2017 financial results. A detailed discussion of our results of operations is presented in the next section of this
MD&A. The following table presents selected financial highlights from 2017 and 2016 .
Table 1 – Key Earnings and Return Metrics
(In Thousands, except per Share Data)
Net income
Net income per diluted common share (EPS)
GAAP return on equity (ROE)
REIT taxable income per share
Dividends per share
Book value per share
Years Ended December 31,
2017
140,406
1.60
$
$
11.9%
1.15
1.12
15.83
$
$
$
2016
131,252
1.54
11.8%
1.27
1.12
14.96
$
$
$
$
$
We had a productive year in 2017, generating strong financial results while laying the groundwork that we believe will enable us to scale our business more
profitably in the future. We generated an 11.9% GAAP return on equity, and increased our GAAP book value per share by $0.87 to $15.83 at year-end 2017. This
represented the largest annual increase in book value since 2013, and importantly was driven in part by the excess of earnings over our dividend. We generated
GAAP earnings per share of $1.60, as compared with $1.54 in 2016 and consistent with 2016, we paid cumulative dividends of $1.12 per share in 2017.
Table 1.1 – Key Operational Metrics
(In Thousands)
Capital Deployed
Residential Loans Purchased
Residential Loans Sold
Years Ended December 31,
2017
2016
$
$
$
511,125 $
5,741,651 $
3,982,683 $
419,356
4,747,564
3,813,538
During 2017 , we deployed $511 million of capital into new investments, including $464 million for portfolio investments, $37 million towards repurchasing
our convertible debt, and $9 million of share repurchases. Our $464 million of portfolio investments included $77 million of investments sourced from our
mortgage banking activities and $387 million of investments acquired from third parties.
We purchased $5.74 billion of residential jumbo loans during 2017, representing an increase of over 20% from 2016. Redwood Choice loans accounted for
approximately 30% of our residential loans identified for purchase in 2017, as compared to 9% in 2016. In 2017, through our Sequoia platform, we completed
seven Select securitizations, which included $2.64 billion of loans, and our first two Choice securitizations, which included $646 million of loans. Additionally, we
sold $1.35 billion of jumbo loans to third parties. Our pipeline of loans identified for purchase at December 31, 2017 included $1.25 billion of jumbo loans.
52
Book Value per Share
The following table sets forth the changes in our book value per share for the year ended December 31, 2017 .
Table 2 – Changes in Book Value per Share
(In Dollars, per share basis)
Beginning book value per share
Net income
Changes in unrealized gains on securities, net from:
Realized gains recognized in net income
Amortization income recognized in net income
Mark-to-market adjustments, net
Total change in unrealized gains on securities, net
Dividends
Changes in unrealized losses on derivatives hedging long-term debt
Other, net
Ending Book Value per Share
Year Ended
December 31, 2017
14.96
1.60
(0.13)
(0.18)
0.58
0.27
(1.12)
0.01
0.11
15.83
$
$
Our GAAP book value per share increased $0.87 to $15.83 during 2017 . This increase was primarily driven by our full year earnings exceeding our dividend
payments, and an increase in the value of our available-for-sale securities, primarily due to tightening credit spreads.
53
Capital Allocation Summary
This section provides an overview of our capital position and how it was allocated at the end of 2017 . A detailed discussion of our liquidity and capital
resources is provided in the Liquidity and Capital Resources section of this MD&A that follows.
We use a combination of equity and corporate debt (which we collectively refer to as “capital”) to fund our business. Our total capital was $1.79 billion at
December 31, 2017 , and included $1.21 billion of equity capital and $0.58 billion of the total $2.58 billion of long-term debt on our consolidated balance sheet.
This portion of debt included $201 million of exchangeable debt due in 2019, $245 million of convertible debt due in 2023, and $140 million of trust-preferred
securities due in 2037.
We also utilize various forms of collateralized short-term and long-term debt to finance certain investments and to warehouse some of our inventory of
residential loans held-for-sale. We do not consider this collateralized debt as "capital" and, therefore, it is presented separately from allocated capital in the table
below. The following table presents how our capital was allocated between business segments and investment types at December 31, 2017 .
Table 3 – Capital Allocation Summary
At December 31, 2017
(Dollars in Thousands)
Investment portfolio
Residential loans (1)
Residential securities (2)
Commercial/Multifamily securities (3)
Mortgage servicing rights
Other assets/(other liabilities)
Cash and liquidity capital
(Capital allocated to convertible notes repayment)
Total investment portfolio
Residential mortgage banking
Total
(1)
Includes $43 million of FHLB stock.
Fair Value
Collateralized Debt Allocated Capital
% of Total Capital
$
2,477,779 $
(1,999,999) $
1,230,407
324,025
63,598
105,924
(409,022)
(239,724)
—
(40,287)
$
4,201,733 $
(2,689,032)
$
477,780
821,385
84,301
63,598
65,637
325,000
(250,000)
1,587,701
200,000
1,787,701
27%
46%
5%
4%
4%
N/A
N/A
89%
11%
100%
(2) Residential securities presented above includes our $78 million net economic investment in our consolidated Sequoia Choice securitizations. This net investment represents
the fair value of the securities we retained from these securitizations. For GAAP purposes we consolidated $620 million of residential loans and $542 million of non-
recourse ABS debt associated with these retained securities.
(3)
Includes $292 million of multifamily securities, $20 million of investment grade CMBS, and $12 million of single-family securities.
At the end of the fourth quarter we increased the capital allocated to our residential mortgage banking operations to $200 million from $170 million to
accommodate an anticipated increase in loan purchase volume in 2018.
As of December 31, 2017 , our cash and liquidity capital included $280 million of capital available for investment or debt repayment. Subsequent to year-end
we have generated additional capital through portfolio optimization and we currently have sufficient capital to repay our maturing convertible debt in April
2018. To fund new investments going forward, we will consider the most efficient sources of capital both from optimization within our portfolio and from the
capital markets.
54
RESULTS OF OPERATIONS
Within this Results
of
Operations
section, we provide commentary that compares results year-over-year for 2017 , 2016 , and 2015 . Most tables include
"changes" columns that show the amounts by which the year's results are greater or less than the results from the prior year. Unless otherwise specified, references
in this section to increases or decreases in 2017 refer to the change in results from 2016 to 2017 , and increases or decreases in 2016 refer to the change in results
from 2015 to 2016 .
The following table presents the components of our net income for the years ended December 31, 2017 , 2016 , and 2015 .
Table 4 – Net Income
(In Thousands, except per Share Data)
Net Interest Income
Reversal of provision for loan losses
Net Interest Income After Provision
Non-interest Income
Mortgage banking activities, net
MSR income (loss), net
Investment fair value changes, net
Other income
Realized gains, net
Total non-interest income, net
Operating expenses
Net income before income taxes
(Provision for) benefit from income taxes
Net Income
Net
Interest
Income
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
139,241 $
157,827 $
163,549 $
(18,586) $
(5,722)
—
7,102
355
(7,102)
139,241
164,929
163,904
(25,688)
53,908
7,860
10,374
4,576
13,355
90,073
(77,156)
152,158
(11,752)
38,691
14,353
10,972
(3,922)
(28,574)
(21,357)
15,217
(6,493)
38,948
(1,762)
6,338
28,009
58,817
(88,786)
134,960
(3,708)
3,192
36,369
(14,654)
25,254
(97,416)
91,742
10,346
31,256
11,630
17,198
(8,044)
6,747
1,025
27,719
18,275
(7,217)
3,146
(8,360)
33,563
8,630
43,218
(14,054)
$
140,406 $
131,252 $
102,088 $
9,154 $
29,164
The $19 million decrease in net interest income in 2017 was primarily due to the sale of our commercial mezzanine loans during 2016, which resulted in a $26
million reduction in net interest income. This decline was partially offset by higher net interest income from our residential investments as a result of capital
redeployment during late 2016 and 2017.
The $6 million decrease in net interest income in 2016 was primarily due to lower average balances of securities, conforming loans, and commercial loans
during 2016. The decrease in the balances of securities resulted from net dispositions, as we reallocated capital to investments in residential jumbo loans. The
decrease in conforming and commercial loan balances resulted from the wind-down of our residential conforming and commercial mortgage banking operations
during the first quarter of 2016 as well as the sale of our commercial mezzanine loan portfolio in the second half of 2016. This overall decrease in net interest
income was partially offset by higher net interest income from a higher average balance of residential loans held-for-investment by our FHLB-member subsidiary
and financed with FHLBC advances during 2016.
Additional detail on changes in net interest income is provided in the “Net
Interest
Income
” section that follows.
Provision
for
Loan
Losses
The reversal of provision for loan losses in 2016 was related to our commercial mezzanine loans. Prior to their sale in 2016, the commercial loans were
reclassified to held-for-sale status, at which point the allowance for loan losses was reversed and no longer maintained for these loans.
55
Mortgage
Banking
Activities,
Net
Income from mortgage banking activities, net includes results from our residential jumbo mortgage banking operations and, prior to the second quarter of
2016, results from our residential conforming and commercial mortgage banking operations. The increase in 2017 was predominantly due to higher jumbo loan
purchase volume in 2017, relative to 2016, on similar gross margins.
The increase in 2016 was predominantly due to higher gross margins from our jumbo residential mortgage banking activities on similar volume, which
resulted in a $32 million increase from 2015. This increase was partially offset by a $5 million decline in income from commercial mortgage banking activities for
2016, as we wound down those operations during the first quarter of 2016.
A more detailed analysis of the changes in this line item is included in the “ Results
of
Operations
b
y Segment
” section that follows.
MSR
Income
(Loss),
Net
MSR income (loss), net is comprised of the net fee income we earn from our MSR investments, changes in their market value and, beginning in the second
quarter of 2015, changes in the market value of derivatives used to hedge our exposure to interest rate risk from our MSR investments.
MSR income before the effect of changes in interest rates and other assumptions was $10 million in 2017 , as compared to $13 million in 2016 and $14
million in 2015 . These amounts were primarily driven by the average balances of loans being serviced each year, which declined during 2017 due to sales, and
were relatively consistent in 2016 and 2015.
The impact to MSR income from the net effect of changes in assumptions and rates was negative $2 million in 2017 , positive $1 million in 2016 , and
negative $18 million in 2015 . As discussed above, prior to the second quarter of 2015, MSR income did not include the effect of hedges. The loss in 2015
primarily reflects the negative change in market value of our MSRs during the first quarter of 2015, resulting from the decrease in market interest rates during that
period. The offsetting increase in the value of assets and derivatives that effectively served as hedges to the MSRs during the first quarter of 2015 are presented in
Investment fair value changes, net.
Additional detail on our investment in MSRs is included in the Investment Portfolio portion of the “ Results
of
Operations
by
Segment
” section that follows.
Investment
Fair
Value
Changes,
Net
Investment fair value changes, net, is primarily comprised of the change in fair values of our residential loans held-for-investment and financed with FHLB
borrowings, our investment securities classified as trading, and interest rate hedges associated with each of these investments.
During 2017 , the positive investment fair value changes primarily resulted from net increases in the fair value of our trading securities net of their associated
hedges, which were primarily due to tightening credit spreads on these securities during the year. This increase was partially offset by net decreases in the fair
value of our residential loans held-for-investment and their associated hedges, primarily resulting from principal paydowns and hedging costs.
During 2016 , the negative investment fair value changes primarily resulted from decreases in the fair value of our loans held for investment and their
associated hedges. These decreases were primarily the result of hedging costs due to interest rate volatility experienced throughout 2016, as well as from the write-
off of premium from loan repayments. These decreases were partially offset by positive valuation changes of trading securities that benefited from tightening credit
spreads during the year.
During 2015, the negative investment fair value changes primarily resulted from decreases in the fair value of our trading securities as well as hedging costs
for our securities and held-for-investment loans. In addition, during the first quarter of 2015, this line item also included the change in fair value of certain assets
and derivatives we used to hedge our MSRs, as we did not begin to specifically identify derivatives for hedging MSRs until the second quarter of 2015.
Additional detail on our investment fair value changes is included in the Investment Portfolio portion of the “ Results
of
Operations
by
Segment
” section that
follows.
Other
Income
Other income in 2017 , 2016 and 2015 was primarily comprised of income from our residential loan risk-sharing arrangements with Fannie Mae and Freddie
Mac that were completed in the second half of 2015. The $2 million decrease in other income in 2017 primarily resulted from a decline during 2017 in
prepayments of loans underlying the risk-share transactions.
56
Realized
Gains,
Net
For 2017 , we realized gains of $13 million , primarily from the sale of $90 million of AFS securities. For 2016, we realized gains of $28 million, which
included $23 million from the sale of $253 million of AFS securities and $5 million from the sale of $218 million of commercial mezzanine loans. Net gains of
$36 million recorded in 2015 primarily resulted from the sale of $366 million of AFS securities during the year.
Additional detail on realized gains is included in the Investment Portfolio portion of the “ Results
of
Operations
by
Segment
” section that follows.
Operating
Expenses
The decrease s in operating expenses in both 2017 and 2016 were primarily due to the restructuring of our residential conforming and commercial mortgage
banking operations during the first quarter of 2016, which resulted in restructuring costs of $10 million and a lower run-rate of expenses subsequent to the
restructuring.
See Note
10
of our Notes
to
Consolidated
Financial
Statements
in Part II, Item 8 of this Annual Report on Form 10-K for additional detail of these
restructuring charges.
(Provision
for)
Benefit
From
Income
Taxes
Our provision for income taxes results almost entirely from activities at our taxable REIT subsidiaries, which primarily includes our mortgage banking
activities, MSR investments, as well as certain other investment and hedging activities. The increase in the provision for income taxes in 2017 resulted primarily
from higher mortgage banking income during the year. This increase was offset by a tax benefit of $8 million from the reduction of our net federal deferred tax
liabilities as a result of the Tax Cuts and Jobs Act of 2017 (the "Tax Act") that was passed in December 2017. Additionally, 2016 benefited from the release of a
valuation allowance recorded against our deferred tax assets during that year.
The benefit from income taxes in 2015 resulted from GAAP losses generated at our TRS, which was reduced by a valuation allowance we established on
certain net deferred tax assets in that year. For additional detail on income taxes, see the “ Taxable
Income
” section that follows.
57
Net Interest Income
The following tables present the components of net interest income for the years ended December 31, 2017 , 2016 , and 2015 .
Table 5 – Net Interest Income
(Dollars in Thousands)
Interest Income
Residential loans, held-for-sale
Residential loans - HFI at Redwood (2)
Residential loans - HFI at Legacy
Sequoia (2)
Residential loans - HFI at Sequoia
Choice (2)
Commercial loans
Trading securities
Available-for-sale securities
Other interest income
Total interest income
Interest Expense
Short-term debt facilities
Short-term debt - convertible notes, net
ABS issued - Redwood
ABS issued - Legacy Sequoia (2)
ABS issued - Sequoia Choice (2)
Long-term debt - FHLBC
Long-term debt - other
Total interest expense
Net Interest Income
2017
2016
2015
Interest
Income/
(Expense)
Average
Balance (1)
Yield
Interest
Income/
(Expense)
Average
Balance (1)
Yield
Interest
Income/
(Expense)
Average
Balance (1)
Yield
Years Ended December 31,
$
38,854 $
939,273
4.1 % $
33,120 $
908,353
3.6 % $
47,221 $ 1,289,684
90,970
2,316,375
3.9 %
85,147
2,193,619
3.9 %
42,680
1,107,603
3.7 %
3.9 %
19,405
700,746
2.8 %
19,537
882,079
2.2 %
24,814
1,224,857
2.0 %
5,133
345
47,419
43,384
109,463
4.7 %
1,065
N/A
713,945
6.6 %
430,395
10.1 %
—
30,496
22,484
54,389
—
— %
258,041
11.8 %
299,912
7.5 %
530,357
10.3 %
2,547
224,545
248,057
5,435,807
1.1 %
4.6 %
1,182
294,830
246,355
5,367,191
0.4 %
4.6 %
—
46,933
17,613
79,835
336
—
504,685
— %
9.3 %
150,372
11.7 %
886,966
225,292
259,432
5,389,459
(28,015)
1,075,430
(8,836)
182,551
—
—
(14,833)
684,733
(4,275)
97,158
(21,769)
1,999,999
(31,088)
504,822
(108,816)
4,544,693
(2.6)%
(4.8)%
— %
(2.2)%
(4.4)%
(1.1)%
(6.2)%
(2.4)%
(22,287)
1,089,352
(2.0)%
(30,572)
1,671,184
—
—
(1,560)
21,159
(13,175)
861,020
—
—
(11,579)
1,980,971
(39,927)
665,453
(88,528)
4,617,955
— %
(7.4)%
(1.5)%
— %
(0.6)%
(6.0)%
(1.9)%
—
—
(5,822)
87,982
(15,647)
1,164,887
—
(2,848)
(40,994)
—
894,671
686,354
(95,883)
4,505,078
$ 139,241
$
157,827
$ 163,549
9.0 %
0.1 %
4.8 %
(1.8)%
— %
(6.6)%
(1.3)%
— %
(0.3)%
(6.0)%
(2.1)%
(1) Average balances for residential loans held-for-sale, residential loans held-for-investment and trading securities are calculated based upon carrying values, which represent
estimated fair values. Average balances for available-for-sale securities and debt are calculated based upon amortized historical cost, except for ABS issued, which is
based upon fair value.
(2)
Interest income from residential loans held-for-investment ("HFI") at Redwood exclude loans HFI at consolidated Sequoia entities. Interest income from residential loans -
HFI at Legacy Sequoia and the interest expense from ABS issued - Legacy Sequoia represent activity from our consolidated Legacy Sequoia entities. Interest income from
residential loans - HFI at Sequoia Choice and the interest expense from ABS issued - Sequoia Choice represent activity from our consolidated Sequoia Choice entities.
58
The following table details how net interest income changed on a consolidated basis as a result of changes in average investment balances (“volume”) and
changes in interest yields (“rate”).
Table 6 – Net Interest Income - Volume and Rate Changes
(In Thousands)
Net Interest Income for the Beginning of the Year
Impact of Changes in Interest Income
Change in Net Interest Income
For the Years Ended December 31,
Volume
2017
Rate
Total
Volume
$
157,827
2016
Rate
Total
$
163,549
Residential loans - HFS
$
1,127 $
4,607
5,734 $
(13,962) $
(139)
Residential loans - HFI at Redwood
Residential loans - HFI at Legacy Sequoia
Residential loans - HFI at Sequoia Choice
Commercial loans
Trading securities
Available-for-sale securities
Other Interest Income
Net changes in interest income
Impact of Changes in Interest Expense
Short-term debt facilities
Short-term debt - convertible notes, net
ABS issued - Redwood
ABS issued - Legacy Sequoia
ABS issued - Sequoia Choice
Long-term debt - FHLBC
Long-term debt - Other
Net changes in interest expense
Net changes in interest income and expense
Net Interest Income for the Year Ended
4,765
(4,016)
5,133
(30,370)
31,039
(10,251)
(282)
(2,855)
285
—
1,560
2,697
(4,275)
(111)
9,638
9,794
6,939
1,058
3,884
—
219
(6,104)
(754)
1,647
4,557
(6,013)
(8,836)
—
(4,355)
—
(10,079)
(799)
(30,082)
(25,525)
5,823
(132)
5,133
(30,151)
24,935
(11,005)
1,365
1,702
(5,728)
(8,836)
1,560
(1,658)
(4,275)
(10,190)
8,839
(20,288)
(18,586)
41,848
(6,944)
—
(22,937)
17,516
(32,098)
104
(16,473)
619
1,667
—
6,500
(12,645)
6,652
742
3,396
10,644
(2,359)
—
4,422
4,082
—
(3,458)
1,248
16,938
465
—
(232)
(1,538)
—
(5,273)
(181)
(9,583)
(6,187)
(14,101)
42,467
(5,277)
—
(16,437)
4,871
(25,446)
846
(13,077)
8,285
—
4,190
2,544
—
(8,731)
1,067
7,355
(5,722)
$
139,241
$
157,827
The following table presents the components of net interest income by segment for the years ended December 31, 2017 , 2016 , and 2015 .
Table 7 – Net Interest Income by Segment
(In Thousands)
Net Interest Income by Segment
Investment Portfolio
Residential Mortgage Banking
Corporate/Other
Net Interest Income
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
152,070 $
169,203 $
154,911 $
(17,133) $
21,940
(34,769)
19,470
(30,846)
35,053
(26,415)
2,470
(3,923)
$
139,241 $
157,827 $
163,549 $
(18,586) $
14,292
(15,583)
(4,431)
(5,722)
Additional details regarding the activities impacting net interest income at each segment are included in the “ Results
of
Operations
by
Segment
” section that
follows.
59
The Corporate/Other line item in the table above primarily includes interest expense related to long-term debt not directly allocated to our segments and net
interest income from consolidated Legacy Sequoia entities. The $4 million decrease in net interest income from Corporate/Other during 2017 was primarily due to
a higher average balance of long-term debt, as we issued additional convertible debt in August 2017, and lower net interest income from consolidated Legacy
Sequoia entities, as loans in these securitizations continued to pay down. Details regarding consolidated Legacy Sequoia entities are included in the " Results
of
Consolidated
Legacy
Sequoia
Entities
" section that follows.
Specific Borrowing Costs
The following table presents the net interest rate spread between the yield on unsecuritized loans and securities and the debt yield of the short-term debt used
in part to finance each investment type at December 31, 2017 .
Table 8 – Interest Expense — Specific Borrowing Costs
December 31, 2017
Asset yield
Short-term debt yield
Net Spread
Residential Loans Held-for-
Sale
Residential
Securities
4.12%
3.17%
0.95%
4.88%
2.69%
2.19%
For additional discussion on short-term debt, including information regarding margin requirements and financial covenants, see “ Risks
Relating
to
Debt
Incurred
under
Short-Term
and
Long-Term
Borrowing
Facilities
" in the Liquidity
and
Capital
Resources
section of this MD&A.
Results of Operations by Segment
Redwood operates in two segments: Investment Portfolio and Residential Mortgage Banking. Beginning in the first quarter of 2017, we eliminated our
Commercial segment and renamed our Residential Investments segment as the Investment Portfolio segment. Our segments are based on our organizational and
management structure, which aligns with how our results are monitored and performance is assessed. For additional information on our segments, refer to Note
21
in Part II, Item 8 and Part I, Item 1 of this Annual Report on Form 10-K. The following table presents the segment contribution from our two segments reconciled
to our consolidated net income for the years ended December 31, 2017 , 2016 , and 2015 .
Table 9 – Segment Results Summary
(In Thousands)
Segment Contribution from:
Investment Portfolio
Residential Mortgage Banking
Corporate/Other
Net Income
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
185,671 $
188,077 $
164,483 $
(2,406) $
44,311
(89,576)
35,111
(91,936)
4,308
(66,703)
9,200
2,360
$
140,406 $
131,252 $
102,088 $
9,154 $
23,594
30,803
(25,233)
29,164
The following sections provide a detailed discussion of the results of operations at each of our two business segments for the years ended December 31, 2017 ,
2016 , and 2015 . The $2 million improvement from Corporate/Other in 2017 was primarily due to $10 million of costs incurred in 2016 associated with the
restructuring of our residential conforming and commercial mortgage banking operations in 2016. This improvement was partially offset by an increase in interest
expense from convertible debt we issued in August 2017 as well as a decline in income from our consolidated Legacy Sequoia securitizations.
60
Investment Portfolio Segment
Our Investment Portfolio segment is primarily comprised of our portfolio of residential mortgage loans held-for-investment and financed through the FHLBC
and our real estate securities portfolio. Additionally, beginning in the third quarter of 2017, this segment includes residential loans held-for-investment at our
consolidated Sequoia Choice entities.
For segment reporting purposes, certain of our Sequoia senior trading securities were included in our Residential Mortgage Banking segment in 2016 and
2015. As such, they are excluded from any amounts and tables in this section and may not agree with similarly titled amounts and tables in our consolidated
financial statements and footnotes.
The following table presents the components of segment contribution for the Investment Portfolio segment for the years ended December 31, 2017 , 2016 , and
2015 .
Table 10 – Investment Portfolio Segment Contribution
(In Thousands)
Interest income
Interest expense
Net interest income
Reversal of provision for loan losses
Net Interest Income after Provision
Non-interest income
MSR income (loss), net
Investment fair value changes, net
Other income
Realized gains, net
Total non-interest income, net
Direct operating expenses
Segment contribution before income taxes
(Provision for) benefit from income taxes
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
188,760 $
192,200 $
177,595 $
(3,440) $
(36,690)
152,070
—
152,070
7,860
18,414
4,576
14,107
44,957
(6,028)
190,999
(5,328)
(22,997)
169,203
7,102
176,305
14,353
(24,367)
6,338
27,717
24,041
(10,421)
189,925
(1,848)
(22,684)
154,911
355
155,266
(3,922)
(20,089)
3,192
36,369
15,550
(7,179)
163,637
846
(13,693)
(17,133)
(7,102)
(24,235)
(6,493)
42,781
(1,762)
(13,610)
20,916
4,393
1,074
(3,480)
14,605
(313)
14,292
6,747
21,039
18,275
(4,278)
3,146
(8,652)
8,491
(3,242)
26,288
(2,694)
23,594
Total Segment Contribution
$
185,671 $
188,077 $
164,483 $
(2,406) $
The following table presents our primary portfolios of investment assets in our Investment Portfolio segment at December 31, 2017 and December 31, 2016.
Table 11 – Investment Portfolio
(In Thousands)
Residential loans held-for-investment at Redwood
$
Residential securities
Commercial/Multifamily securities
Residential loans held-for-investment at Sequoia Choice
Mortgage servicing rights
Other assets
December 31, 2017
December 31, 2016
Change
2,434,386 $
1,152,485
324,025
620,062
63,598
149,317
2,261,016 $
926,669
91,770
—
118,526
217,554
173,370
225,816
232,255
620,062
(54,928)
(68,237)
Total Assets at Investment Portfolio
$
4,743,873 $
3,615,535 $
1,196,575
61
Overview
During 2017, the increase in our total investment portfolio was primarily attributable to the deployment of $464 million of capital into new residential and
multifamily securities investments, as well as strong price appreciation of our security investments resulting from tightening credit spreads during the year.
Additionally, we consolidated $620 million of residential Sequoia Choice loans from securitizations we completed during the third and fourth quarters. At
December 31, 2017 , our economic investment in the Sequoia Choice entities was $78 million , representing securities we retained in the securitizations. These
increases were offset by a decrease in our MSR investments as we disposed of nearly all of our conforming MSRs during 2017.
Net
Interest
Income
Net interest income from our Investment Portfolio primarily includes interest income from our residential loans held-for-investment and our securities, as well
as the associated interest expense from short-term debt, FHLBC borrowings, and ABS issued. The following table presents the components of net interest income
for our Investment Portfolio segment for the years ended December 31, 2017 , 2016 , and 2015 .
Table 12 – Net Interest Income ("NII") from Investment Portfolio
(In Thousands)
Net interest income from:
HFI residential loans at Redwood
HFI residential loans at Sequoia Choice
Residential securities
Commercial/Multifamily securities
Commercial mezzanine loans
Other interest income
NII from Investment Portfolio
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
69,201 $
73,560 $
39,703 $
(4,359) $
33,857
858
74,020
6,137
345
1,509
—
67,210
2,255
25,168
1,010
—
84,183
—
858
6,810
3,882
30,720
(24,823)
305
499
—
(16,973)
2,255
(5,552)
705
$
152,070 $
169,203 $
154,911 $
(17,133) $
14,292
The decrease in net interest income from our Investment Portfolio segment during 2017 was primarily due to the sale of our commercial mezzanine loans
during 2016, as well as from higher interest costs on our FHLB borrowings during 2017. These decreases were partially offset by higher net interest income from
real estate securities, primarily resulting from higher average balances of these investments from the redeployment of capital from our commercial mezzanine loan
sales in 2016.
During 2016, the increase in our total investment portfolio net interest income was primarily attributable to the addition of residential loans held-for-
investment and financed through the FHLBC, as our FHLB-member subsidiary fully utilized its borrowing capacity of $2.00 billion. This increase was partially
offset by a decrease in our investments in residential securities, resulting from net sales during 2016.
62
Investment
fair
value
changes,
net
The following table presents the components of investment fair value changes, net for our Investment Portfolio segment, which is comprised of market
valuation gains and losses from our investments and associated hedges, for the years ended December 31, 2017 , 2016 , and 2015 .
Table 13 – Investment Portfolio Fair Value Changes, Net by Investment Type
(In Thousands)
Market valuation changes:
Residential loans held-for-investment at Redwood
Net investments in Sequoia Choice entities (1)
Residential trading securities
Commercial/Multifamily trading securities
Other valuation changes
Investment Fair Value Changes, Net
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
(15,415) $
(32,425) $
1,425 $
17,010 $
(33,850)
(323)
20,450
16,196
(2,494)
—
6,999
2,578
(1,519)
—
(18,312)
—
(3,202)
(323)
13,451
13,618
(975)
—
25,311
2,578
1,683
$
18,414 $
(24,367) $
(20,089) $
42,781 $
(4,278)
(1)
Includes changes in fair value of the residential loans held-for-sale and the ABS issued at the entities, which netted together represent the change in value of our retained
investments (senior and subordinate securities) at the consolidated VIEs.
For 2017, the net positive investment fair value changes primarily resulted from net increases in the fair value of our trading securities and their associated
hedges, which were primarily due to tightening credit spreads on these securities during this period. These increases were partially offset by decreases in the fair
value of our residential loans held-for-investment and their associated hedges, primarily resulting from principal paydowns and hedging costs.
For 2016, the net negative investment fair value changes primarily resulted from decreases in the fair value of our residential loans held-for-investment and
their associated derivatives, which primarily resulted from higher hedging costs due to interest rate volatility, as well as loss of premium from principal
repayments. These decreases were partially offset by net increases in the fair value of our trading securities, which primarily resulted from tightening credit spreads
on these securities during 2016.
MSR
Income
(Loss),
net
The following table presents the components of MSR income (loss), net for the years ended December 31, 2017 , 2016 , and 2015 .
Table 14 – MSR Income (Loss), net
(In Thousands)
Net servicing fee income
Changes in fair value of MSR from the receipt of expected
cash flows
MSR provision for repurchases
MSR income before the effect of changes in interest rates and
other assumptions
Changes in fair value of MSRs from interest rates and other
assumptions (1)
Changes in fair value of associated derivatives
Total net effect of changes in assumptions and rates
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
18,292 $
34,871 $
33,885 $
(16,579) $
986
(9,078)
302
(21,860)
(18,939)
270
(707)
12,782
32
(2,921)
977
9,516
13,281
14,239
(3,765)
(958)
(1,088)
(568)
(1,656)
(14,512)
15,584
1,072
(5,453)
(12,708)
(18,161)
13,424
(16,152)
(2,728)
(9,059)
28,292
19,233
18,275
MSR Income (Loss), Net
$
7,860 $
14,353 $
(3,922) $
(6,493) $
(1) Primarily reflects changes in prepayment assumptions on our MSRs due to changes in benchmark interest rates.
63
MSR income before the effect of changes in interest rates and other assumptions declined in 2017, primarily due to the sale of our conforming MSRs during
the second quarter of 2017. The total net effect of changes in assumptions and rates decreased, primarily due to lower hedging costs in 2016.
The net MSR loss for 2015 primarily resulted from decreases in market interest rates during the first quarter of 2015, as we did not begin to identify specific
derivatives for hedging MSRs until the second quarter of 2015. During the first quarter of 2015, we managed our exposure to market interest rate risk for our
MSRs on an enterprise-wide basis and the associated hedging offset related to changes in market interest rates of positive $12 million during that quarter is
presented as a component of Investment fair value changes, net on our consolidated income statements.
Realized
Gains,
net
During the year s ended December 31, 2017 , 2016, and 2015, we realized gains of $14 million , $28 million , and $36 million , primarily from the sale of $90
million , $253 million , and $366 million of AFS securities, respectively.
Direct
Operating
Expenses
and
Provision
for
Income
Taxes
The increase in operating expenses from 2015 to 2016 was primarily attributable to higher operating costs associated with the management of MSRs during
2016. We began disposing of our conforming MSRs in 2016 and had disposed of substantially all of them by the end of 2017, which primarily drove the decrease
in operating expenses from 2016 to 2017.
The provision for income taxes at our Investment Portfolio segment in 2017 and 2016 resulted from GAAP income earned at our TRS during those periods,
primarily from MSRs and certain non-REIT eligible securities. For 2016, the tax provision at our TRS was reduced as the result of our releasing a valuation
allowance previously maintained on certain net deferred tax assets. For additional detail on income taxes, see the "Taxable
Income"
section that follows.
Residential Loans Held-for-Investment at Redwood Portfolio
The following table provides the activity of residential loans held-for-investment at Redwood during the years ended December 31, 2017 and 2016 .
Table 15 – Residential Loans Held-for-Investment at Redwood - Activity
(In Thousands)
Fair value at beginning of period
Transfers between portfolios (1)
Principal repayments
Changes in fair value, net
Fair Value at End of Period
Years Ended December 31,
2017
2016
$
2,261,016 $
500,887
(322,187)
(5,330)
$
2,434,386 $
1,791,195
1,007,389
(514,466)
(23,102)
2,261,016
(1) Represents the net transfers of loans into our Investment Portfolio segment from our Residential Mortgage Banking segment and their reclassification from held-for-sale to
held-for-investment.
At December 31, 2017 , $2.43 billion of loans were held by our FHLB-member subsidiary and financed with $2.00 billion of borrowings from the FHLBC. In
connection with these borrowings, our FHLB-member subsidiary is required to hold $43 million of FHLB stock.
At December 31, 2017 , the weighted average maturity of these FHLB borrowings was approximately eight years and they had a weighted average cost of
1.38% per annum. This interest cost resets every 13 weeks and we seek to fix the interest cost of these FHLB borrowings over their weighted average maturity by
using a combination of swaps, TBAs and other derivatives.
During 2017 , we had net transfers of $501 million of residential loans from our Residential Mortgage Banking segment to our portfolio of loans held-for-
investment at Redwood. In October 2017, the FHLB increased the capital requirement on our borrowing facility, which effectively increased the portion of loans
we finance with equity relative to what was required previously. This change resulted in additional loans being transferred to our FHLB member subsidiary to
collateralize the FHLB borrowings.
64
Under a final rule published by the Federal Housing Finance Agency in January 2016, our FHLB-member subsidiary will remain an FHLB-member through
the five-year transition period for captive insurance companies. Our FHLB-member subsidiary's existing $2.00 billion of FHLB debt, which matures beyond this
transition period, is permitted to remain outstanding until its stated maturity. As residential loans pledged as collateral for this debt pay down, we are permitted to
pledge additional loans or other eligible assets to collateralize this debt; however, we do not expect to be able to increase our subsidiary's FHLB debt above the
existing $2.00 billion .
The following table presents the unpaid principal balances for residential real estate loans held-for-investment at fair value by product type at December 31,
2017 .
Table 16 – Characteristics of Residential Real Estate Loans Held-for-Investment at Redwood
December 31, 2017
(Dollars in Thousands)
Fixed - 30 year
Fixed - 10, 15, 20, & 25 year
Hybrid
Total Outstanding Principal
Principal Balance
Weighted Average Coupon
$
$
2,131,263
73,268
203,462
2,407,993
4.09%
3.65%
4.07%
The outstanding loans held-for-investment at Redwood at December 31, 2017 were prime-quality, first lien loans, of which 96% were originated between 2013
and 2017 and 4% were originated in 2012 and prior years. The weighted average FICO score of borrowers backing these loans was 770 (at origination) and the
weighted average loan-to-value ("LTV") ratio was 65% (at origination). At December 31, 2017 , none of these loans were greater than 90 days delinquent or in
foreclosure.
Real Estate Securities Portfolio
The following table sets forth our real estate securities activity by collateral type in our Investment Portfolio segment for the years ended December 31, 2017
and 2016 .
Table 17 – Real Estate Securities Activity by Collateral Type
Year Ended December 31, 2017
Senior
Re-REMIC
Subordinate
(In Thousands)
Beginning fair value
Transfers
Acquisitions
Sequoia securities
Third-party securities
Sales
Sequoia securities
Third-party securities
Gains on sales and calls, net
Effect of principal payments (3)
Change in fair value, net
Ending Fair Value
Residential
Residential (1)
Residential
Commercial (2)
Total
$
173,613 $
85,479
$
667,577 $
91,770 $
1,018,439
46,604
(46,604)
—
14,524
32,681
—
(13,635)
5,327
(33,396)
(14,755)
—
—
—
—
—
(3,209)
3,209
65,138
330,974
(42,304)
(156,529)
8,780
(30,094)
59,105
—
—
237,143
—
(15,858)
—
(5,066)
16,036
—
79,662
600,798
(42,304)
(186,022)
14,107
(71,765)
63,595
$
210,963 $
38,875
$
902,647
$
324,025 $
1,476,510
65
Year Ended December 31, 2016
Senior
Re-REMIC
Subordinate
(In Thousands)
Beginning fair value
Transfers
Acquisitions
Sequoia securities
Third-party securities
Sales
Sequoia securities
Third-party securities
Gains on sales and calls, net
Effect of principal payments (3)
Change in fair value, net
Ending Fair Value
Residential
Residential (1)
Residential
Commercial (2)
Total
$
336,595 $
76,947
—
4,943
(21,016)
(186,960)
16,008
(28,200)
(24,704)
165,064 $
(76,947)
526,512 $
8,078 $
1,036,249
—
—
—
—
—
—
—
—
(6,758)
4,120
10,606
227,248
(51,034)
(41,486)
6,507
(32,894)
22,118
—
84,598
—
(1,312)
—
—
406
10,606
316,789
(72,050)
(229,758)
22,515
(67,852)
1,940
$
173,613 $
85,479 $
667,577
$
91,770 $
1,018,439
(1) Re-REMIC securities, as presented herein, were created by third parties through the resecuritization of certain senior RMBS.
(2) Our commercial securities are primarily comprised of Agency multifamily securities.
(3) The effect of principal payments reflects the change in fair value due to principal payments, which is calculated as the cash principal received on a given security during the
period multiplied by the prior quarter ending price or acquisition price for that security.
At December 31, 2017 , our securities consisted of fixed-rate assets ( 79% ), adjustable-rate assets ( 4% ), hybrid assets that reset within the next year ( 7% ),
and hybrid assets that reset between 12 and 36 months ( 10% ).
We directly finance our holdings of real estate securities with a combination of capital and collateralized debt in the form of repurchase (or “repo”) financing.
The following table presents the fair value of our residential securities that were financed with repurchase debt at December 31, 2017 .
Table 18 – Real Estate Securities Financed with Repurchase Debt
December 31, 2017
(Dollars in Thousands, except Weighted Average Price)
Residential Securities
Senior
Subordinate - Mezzanine
Total Residential Securities
Commercial/Multifamily Securities
Total
Real Estate
Securities (1)
Repurchase
Debt
Allocated
Capital
Weighted Average
Price (2)
Financing Haircut
(3)
$
109,910 $
(96,531) $
13,379 $
373,759
483,669
304,335
(312,491)
(409,022)
(239,724)
61,268
74,647
64,611
$
788,004 $
(648,746) $
139,258
99
99
99
97
12%
16%
15%
21%
(1) Amounts represent carrying value of securities, which are held at GAAP fair value.
(2) GAAP fair value per $100 of principal.
(3) Allocated capital divided by GAAP fair value.
At December 31, 2017 , we had short-term debt incurred through repurchase facilities of $649 million , which was secured by $788 million of real estate
securities. The remaining $689 million of our securities were financed with capital. Our repo borrowings were made under facilities with nine different
counterparties, and the weighted average cost of funds for these facilities during the fourth quarter of 2017 was approximately 2.55% per annum.
At December 31, 2017 , the securities we financed through repurchase facilities had no material credit issues. In addition to the allocated capital listed in the
table above that directly supports our repurchase facilities (the "financing haircut”), we continue to hold a designated amount of supplemental risk capital available
for potential margin calls or future obligations relating to these facilities.
66
The majority of the $110 million of senior securities noted in the table above are supported by seasoned residential loans originated prior to 2008. The $374
million of mezzanine securities financed through repurchase facilities at December 31, 2017 , carry investment grade credit ratings and are supported by residential
loans originated between 2012 and 2017. The $304 million of multifamily securities financed through repurchase facilities at December 31, 2017 carry investment
grade credit ratings with 7%-8% of structural credit enhancement.
The following table presents our residential securities at December 31, 2017 and December 31, 2016, categorized by portfolio vintage (the years the securities
were issued), and by priority of cash flows (senior, re-REMIC, and subordinate). We have additionally separated securities issued through our Sequoia platform or
by third parties, including the Agencies.
Table 19 – Real Estate Securities by Vintage and Type
December 31, 2017
(In Thousands)
Senior (1)
Re-REMIC
Subordinate
Mezzanine (2)
Subordinate (1)
Total Subordinate
Total Securities (3)
December 31, 2016
(In Thousands)
Senior
Re-REMIC
Subordinate
Mezzanine (2)
Subordinate
Total Subordinate
Total Securities
Sequoia 2012-
2017
Third Party
2013-2017
Agency CRT
2013-2017
Third Party
<=2008
Total
Residential
Securities
Commercial
2015-2017
Total Real
Estate
Securities
$
33,773 $
33,517 $
— $
143,673 $
210,963 $
—
—
—
38,875
38,875
— $
210,963
—
38,875
147,466
139,442
286,908
183,985
108,455
292,440
—
300,713
300,713
—
22,586
22,586
331,451
571,196
902,647
324,025
—
655,476
571,196
324,025
1,226,672
$
320,681 $
325,957 $
300,713 $
205,134 $
1,152,485 $
324,025 $
1,476,510
Sequoia 2012-
2016
Third Party
2012-2016
Agency CRT
2013-2016
Third Party
<=2008
Total
Residential
Securities
Commercial
2015-2016
Total Real
Estate
Securities
$
26,618 $
5,611 $
— $
141,384 $
173,613 $
—
—
—
85,479
85,479
— $
173,613
—
85,479
136,007
113,310
249,317
179,390
64,450
243,840
—
152,126
152,126
—
22,294
22,294
315,397
352,180
667,577
91,770
—
91,770
407,167
352,180
759,347
$
275,935 $
249,451 $
152,126 $
249,157 $
926,669 $
91,770 $
1,018,439
(1) At December 31, 2017, senior Sequoia and third-party securities included $70 million of IO securities, and subordinate third-party securities included $12 million of IO
securities.
(2) Mezzanine includes securities initially rated AA through BBB- and issued in 2012 or later.
(3) Excludes $78 million of securities retained from our consolidated Sequoia Choice securitizations. For GAAP purposes we consolidated $620 million of residential loans
and $542 million of non-recourse ABS debt associated with these retained securities.
67
(Dollars in Thousands)
Residential
Senior
Re-REMIC
Subordinate
Mezzanine
Subordinate
(Dollars in Thousands)
Residential
Senior
Re-REMIC
Subordinate
Mezzanine
Subordinate
(Dollars in Thousands)
Residential
Senior
Re-REMIC
Subordinate
Mezzanine
Subordinate
The following tables present the components of the interest income we earned on AFS securities for the years ended December 31, 2017 , 2016 , and 2015 .
Table 20 – Interest Income — AFS Securities
Year Ended December 31, 2017
Interest
Income
Discount
(Premium)
Amortization
Total
Interest
Income
Average
Amortized Cost
Interest
Income
Discount (Premium)
Amortization
Total
Interest
Income
Yield as a Result of
$
5,349 $
7,988 $
13,337 $
103,481
3,012
3,188
6,200
50,138
4,860
11,368
2,215
5,404
7,075
16,772
123,571
153,205
5.17%
6.01%
3.93%
7.42%
5.71%
7.72%
6.36%
12.89%
12.37%
1.79%
3.53%
4.37%
5.72%
10.95%
10.08%
Total AFS Securities
$
24,589 $
18,795 $
43,384 $
430,395
Year Ended December 31, 2016
Yield as a Result of
Interest
Income
Discount
(Premium)
Amortization
Total
Interest
Income
Average
Amortized Cost
Interest
Income
Discount (Premium)
Amortization
Total
Interest
Income
$
4,636 $
6,055 $
10,691 $
118,617
6,619
11,765
18,384
103,762
7,260
9,621
2,686
5,747
9,946
15,368
184,602
123,376
3.91%
6.38%
3.93%
7.80%
5.31%
5.10%
11.34%
9.01%
17.72%
1.46%
4.66%
4.95%
5.39%
12.46%
10.26%
Total AFS Securities
$
28,136 $
26,253 $
54,389 $
530,357
Year Ended December 31, 2015
Yield as a Result of
Interest
Income
Discount
(Premium)
Amortization
Total
Interest
Income
Average
Amortized
Cost
Interest
Income
Discount (Premium)
Amortization
Total
Interest
Income
$
13,633 $
17,650 $
31,283 $
385,072
8,648
9,200
17,848
104,414
11,466
9,238
3,519
6,481
14,985
15,719
283,049
114,431
3.54%
8.28%
4.05%
8.07%
4.85%
4.58%
8.81%
8.12%
17.09%
1.24%
5.66%
4.15%
5.29%
13.73%
9.00%
Total AFS Securities
$
42,985 $
36,850 $
79,835 $
886,966
During 2017, several Re-REMIC securities we held were exchanged for the underlying senior securities. Several of these exchanged investments had higher
relative yields and, as such, the balance of our investments in Re-REMICs and their associated yields declined and the yields of our senior securities increased
during the year ended December 31, 2017, as compared to 2016.
68
The following tables present the components of carrying value at December 31, 2017 and December 31, 2016 for our AFS residential securities.
Table 21 – Carrying Value of AFS Securities
December 31, 2017
(In Thousands)
Principal balance
Credit reserve
Unamortized discount, net
Amortized cost
Gross unrealized gains
Gross unrealized losses
Carrying Value
December 31, 2016
(In Thousands)
Principal balance
Credit reserve
Unamortized discount, net
Amortized cost
Gross unrealized gains
Gross unrealized losses
Carrying Value
Senior
Re-REMIC
Subordinate
Total
$
144,512 $
44,613 $
419,020 $
(2,936)
(34,379)
107,197
35,027
(1,235)
(5,820)
(9,662)
29,131
9,744
—
(37,793)
(139,712)
241,515
86,419
(132)
$
140,989 $
38,875 $
327,802 $
608,145
(46,549)
(183,753)
377,843
131,190
(1,367)
507,666
Senior
Re-REMIC
Subordinate
Total
$
148,862 $
95,608 $
456,359 $
(4,814)
(41,877)
102,171
36,304
(1,929)
(6,857)
(19,613)
69,138
16,341
—
(35,802)
(136,622)
283,935
68,032
(1,240)
$
136,546 $
85,479 $
350,727 $
700,829
(47,473)
(198,112)
455,244
120,677
(3,169)
572,752
We designate any amount of unpaid principal balance that we do not expect to receive and thus do not expect to earn or recover as a credit reserve on each
security. Any remaining net unamortized discounts or premiums on the security are amortized into income over time using the effective yield method.
At December 31, 2017 , credit reserves for our AFS securities totaled $47 million , or 7.7% of the principal balance of our residential securities, as compared
to $47 million , or 6.8% , at December 31, 2016 . During the year ended December 31, 2017 , increases resulting from acquisitions and impairments were partially
offset by reductions in the credit reserve from realized losses, sales, and transfers out of credit reserve to accretable discount. During the years ended December 31,
2017 and 2016 , realized credit losses on our residential securities totaled $4 million and $6 million , respectively.
Residential Loans Held-for-Investment at Sequoia Choice Portfolio
During the third and fourth quarters of 2017, we issued our first securitizations primarily comprised of expanded-prime Choice loans. We consolidate the
Sequoia Choice securitization entities for financial reporting purposes in accordance with GAAP. These entities are independent of Redwood and the assets and
liabilities of these entities are not, respectively, owned by us or legal obligations of ours. We record the assets and liabilities of the consolidated Sequoia Choice
entities at fair value, based on the estimated fair value of the debt securities (ABS) issued from the securitizations, in accordance with GAAP provisions for
collateralized financing entities. At December 31, 2017 , the estimated fair value of our economic investments in the consolidated Sequoia Choice entities was $78
million , and was comprised of retained senior and subordinate securities.
69
The following tables present the statements of income for the years ended December 31, 2017 , 2016 , and 2015 and the balance sheets of the consolidated
Sequoia Choice entities at December 31, 2017 and December 31, 2016. All amounts in the statements of income and balance sheets presented below are included
in our consolidated financial statements and are included in our Investment Portfolio segment.
Table 22 – Consolidated Sequoia Choice Entities Statements of Income
(In Thousands)
Interest income
Interest expense
Net interest income
Investment fair value changes, net
Net Income from Consolidated Sequoia Choice
Entities
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
5,133 $
(4,275)
858
(323)
$
535 $
— $
—
—
—
— $
— $
—
—
—
5,133 $
(4,275)
858
(323)
— $
535 $
Table 23 – Consolidated Sequoia Choice Entities Balance Sheets
(In Thousands)
Residential loans, held-for-investment, at fair value
Other assets
Total Assets
Other liabilities
Asset-backed securities issued, at fair value
Total liabilities
Equity (fair value of Redwood's retained investments in entities)
Total Liabilities and Equity
December 31, 2017
December 31, 2016
$
$
$
$
620,062 $
2,528
622,590
$
2,035 $
542,140
544,175
78,415
622,590 $
The following table presents residential loan activity at the consolidated Sequoia Choice entities for the years ended December 31, 2017 and 2016 .
Table 24 – Residential Loans Held-for-Investment at Sequoia Choice - Activity
(In Thousands)
Balance at beginning of period
New securitization issuance
Principal repayments
Changes in fair value, net
Balance at End of Period
Years Ended December 31,
2017
2016
$
$
— $
645,689
(20,600)
(5,027)
620,062 $
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
The outstanding loans held-for-investment at our Sequoia Choice entities at December 31, 2017 were primarily comprised of prime-quality, first lien, 30-year,
fixed-rate loans and were originated in 2012 or later. The gross weighted average coupon of these loans was 4.70% , the weighted average FICO score of
borrowers backing these loans was 742 (at origination) and the weighted average original LTV ratio was 75% (at origination). At December 31, 2017 , none of
these loans were greater than 90 days delinquent or in foreclosure.
70
Mortgage Servicing Rights Portfolio
Our MSRs are held and managed at our taxable REIT subsidiary and typically are acquired together with loans from originators and then separately
recognized under GAAP when the MSR is retained and the associated loan is sold to a third party or transferred to a Sequoia residential securitization sponsored by
us that meets the GAAP criteria for sale. In addition, we have also purchased MSRs on a flow basis from third-parties that sold the associated loans directly to the
Agencies. Although we own the rights to service loans, we contract with sub-servicers to perform these activities. Our receipt of MSR income is not subject to any
covenants other than customary performance obligations associated with servicing residential loans. If a sub-servicer we contract with was to fail to perform these
obligations, our servicing rights could be terminated and we would evaluate our MSR asset for impairment at that time.
The following table provides the activity for MSRs by portfolio for the years ended December 31, 2017 and 2016 .
Table 25 – MSR Activity by Portfolio
(In Thousands)
Jumbo
Conforming
Total MSRs
Jumbo
Conforming
Total MSRs
Balance at beginning of period
$
60,003 $
58,523 $
118,526 $
58,138 $
133,838 $
191,976
Years Ended December 31,
2017
2016
Additions
MSRs retained from Sequoia
securitizations
MSRs retained from third-party loan
sales
Purchased MSRs
Sold MSRs
Market valuation adjustments
7,123
—
7,123
6,451
—
6,451
263
—
—
(4,985)
—
640
(52,788)
(5,181)
263
640
(52,788)
(10,166)
177
—
—
(4,763)
3,380
15,354
(62,440)
(31,609)
3,557
15,354
(62,440)
(36,372)
118,526
Balance at End of Period
$
62,404 $
1,194 $
63,598 $
60,003 $
58,523 $
During the year ended December 31, 2017 , we sold conforming MSRs with a fair value of $53 million . The remaining $64 million of MSRs are primarily
associated with loans transferred to Sequoia securitizations we completed over the past several years.
The following table presents characteristics of our MSR investments and their associated loans at December 31, 2017 .
Table 26 – Characteristics of MSR Investments Portfolio
(Dollars in Thousands)
Unpaid principal balance
Fair value of MSRs
MSR values as percent of unpaid principal balance
Gross cash yield (1)
Number of loans
Average loan size
Average coupon
Average loan age (months)
Average original loan-to-value
Average original FICO score
60+ day delinquencies
$
$
$
December 31, 2017
5,556,655
63,598
1.14%
0.27%
8,687
640
3.96%
41
67%
770
0.20%
(1) Gross cash yield is calculated by dividing the gross servicing fees we received for the year ended December 31, 2017 , by the weighted average notional balance of loans
associated with MSRs we owned during the year.
71
At December 31, 2017 , nearly all of our MSRs were comprised of base MSRs and we did not own any portion of a servicing right related to any loan where
we did not own the entire servicing right. At both December 31, 2017 and December 31, 2016, we had $1 million of servicer advances outstanding related to our
MSRs, which are presented in Other assets on our consolidated balance sheets.
Residential Mortgage Banking Segment
The following table presents the components of segment contribution for the Residential Mortgage Banking segment for the years ended December 31, 2017 ,
2016 , and 2015 .
Table 27 – Residential Mortgage Banking Segment Contribution
(In Thousands)
Interest income
Loans
Sequoia securities
Total interest income
Interest expense
Net interest income
Mortgage banking activities, net
Direct operating expenses
Segment contribution before income taxes
(Provision for) benefit from income taxes
Segment Contribution
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
39,309 $
33,089 $
47,222 $
6,220 $
(14,133)
—
39,309
(17,369)
21,940
53,908
572
33,661
(14,191)
19,470
40,753
5,038
52,260
(17,207)
35,053
8,268
(25,113)
(23,252)
(43,182)
50,735
(6,424)
36,971
(1,860)
139
4,169
(572)
5,648
(3,178)
2,470
13,155
(1,861)
13,764
(4,564)
$
44,311 $
35,111 $
4,308 $
9,200 $
(4,466)
(18,599)
3,016
(15,583)
32,485
19,930
36,832
(6,029)
30,803
The following tables provide the activity of unsecuritized residential loans during the years ended December 31, 2017 and 2016 .
Table 28 – Residential Loans Held-for-Sale — Activity
(In Thousands)
Balance at beginning of period
Acquisitions
Sales
Transfers between portfolios (1)
Principal repayments
Changes in fair value, net
Balance at End of Period
Years Ended December 31,
2017
2016
$
835,399 $
5,741,651
(3,982,683)
(1,146,576)
(53,475)
33,629
$
1,427,945 $
985,919
4,747,564
(3,813,538)
(1,007,389)
(80,838)
3,681
835,399
(1) Represents the net transfers of loans out of our Residential Mortgage Banking segment into our Investment Portfolio segment and their reclassification from held-for-sale to
held-for-investment. Includes $646 million of Choice loans securitized during the second half of 2017, which were not treated as sales for GAAP purposes and continue to
be reported on our consolidated balance sheets within our Investment Portfolio segment.
Overview
During the year ended December 31, 2017 , we purchased $5.74 billion of predominately prime residential jumbo loans, securitized $2.64 billion of jumbo
Select loans that were accounted for as sales, and sold $1.35 billion of jumbo loans to third parties. Additionally, we transferred $646 million of jumbo Choice
loans that did not qualify for sales accounting treatment under GAAP to Sequoia securitization entities and we had net transfers of $501 million of loans to our
Investment Portfolio segment that were financed with borrowings from the FHLBC. Our pipeline of loans identified for purchase at December 31, 2017 included
$1.25 billion of jumbo loans.
72
We utilize a combination of capital and our residential loan warehouse facilities to manage our inventory of residential loans held-for-sale. At December 31,
2017 , we had $1.04 billion of warehouse debt outstanding to fund our residential loans held-for-sale. The weighted average cost of the borrowings outstanding
under these facilities during the fourth quarter of 2017 was 3.04% per annum. Our warehouse capacity at December 31, 2017 totaled $1.58 billion across four
separate counterparties, which should continue to provide sufficient liquidity to fund our residential mortgage banking operations in the near-term.
At December 31, 2017 , we had 451 loan sellers, up from 406 at the end of 2016. This included 185 jumbo sellers and 266 sellers from various FHLB districts
participating in the FHLB's MPF Direct program.
Net
Interest
Income
Net interest income from residential mortgage banking is primarily comprised of interest income earned on residential loans from the time we purchase the
loans to when we sell or securitize them, offset by intere st expense incurred on short-term warehouse debt used in part to finance the loans while we hold them on
our consolidated balance sheets. Prior to their transfer in the second quarter of 2015, net interest income included interest income from Sequoia securities that were
used in part to mitigate certain risks related to interest rate movements on our residential loan pipeline.
In 2017, the $2 million increase in net interest income was primarily due to increased interest income from a higher average balance of loans held-for-sale
during 2017, as compared to 2016. This increase was partially offset by higher interest expense on our residential loan warehouse facilities, resulting from rising
benchmark interest rates during 2017.
In 2016, the $16 million decrease in net interest income was primarily due to lower average balances of conforming loans that year, which resulted from the
wind-down of conforming loan purchases and sales during the first quarter of 2016. In addition, interest income decreased as a result of the transfer of the Sequoia
securities discussed above.
The amount of net interest income we earn on loans held-for-sale is dependent on many variables, including the amount of loans and the time they are
outstanding on our consolidated balance sheet and their interest rates, as well as the amount of leverage we employ through the use of short-term debt to finance
the loans and the interest rates on that debt. These factors will impact net interest income in future periods.
Mortgage
Banking
Activities,
Net
Mortgage banking activities, net, includes the changes in market value of both the loans we hold for sale and commitments for loans we intend to purchase
(collectively, our loan pipeline), as well as the effect of hedges we utilize to manage risks associated with our loan pipeline. Our loan sale profit margins are
measured over the period from when we commit to purchase a loan and subsequently sell or securitize the loan. Accordingly, these profit margins may encompass
positive or negative market valuation adjustments on loans, hedging gains or losses associated with our loan pipeline, and any other related transaction expenses,
and may be realized over the course of one or more quarters for financial reporting purposes.
The following table presents the components of residential mortgage banking activities, net. Amounts presented include both the changes in market values for
loans that were sold and associated derivative positions that were settled during the periods presented, as well as changes in market values of loans, derivatives and
hedges outstanding at the end of each period.
Table 29 – Components of Residential Mortgage Banking Activities, Net
(In Thousands)
Changes in fair value of:
Residential loans, at fair value (1)
Sequoia securities
Risk management derivatives (2)
Other income, net (3)
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
69,373 $
31,399 $
53,946 $
37,974 $
(22,547)
—
(17,529)
2,064
1,455
5,696
2,203
(15,261)
(34,457)
4,040
(1,455)
(23,225)
(139)
16,716
40,153
(1,837)
32,485
Total Residential Mortgage Banking Activities, Net
$
53,908 $
40,753 $
8,268 $
13,155 $
(1)
Includes changes in fair value for loan purchase and forward sale commitments.
(2) Represents market valuation changes of derivatives that are used to manage risks associated with our accumulation of residential loans.
(3) Amounts in this line include other fee income from loan acquisitions and the provision for repurchase expense, presented net.
73
The increase in mortgage banking activities, net in 2017 was primarily due to higher loan purchase volume on similar gross margins primarily due to improved
securitization execution in 2017 as compared to 2016.
At December 31, 2017 , we had a repurchase reserve of $4 million outstanding related to residential loans sold through this segment. For the years ended
December 31, 2017 and 2016 , we recorded $0.1 million and $1 million of reversals of provision for repurchases, respectively, that were included in income from
mortgage banking activities, net, in this segment. We review our loan repurchase reserves each quarter and adjust them as necessary based on current information
available at each reporting date.
The following table details outstanding principal balances for residential loans held-for-sale by product type at December 31, 2017 .
Table 30 – Characteristics of Residential Loans Held-for-Sale
December 31, 2017
(Dollars in Thousands)
First Lien Prime
Fixed - 30 year
Fixed - 15, 20, & 25 year
Hybrid
ARM
Total Outstanding Principal
Operating
Expenses
and
Taxes
Principal Value
Weighted Average
Coupon
$
1,273,850
56,001
78,884
444
$
1,409,179
4.21%
3.62%
3.52%
2.32%
Operating expenses for this segment primarily include costs associated with the underwriting, purchase and sale of residential loans. Operating expenses
increased $2 million during 2017, primarily related to the increase in loan purchase volume in 2017, as compared with 2016.
The $20 million decrease in operating expenses in 2016 at this segment was primarily attributable to the restructuring of our conforming loan mortgage
banking operations during the first quarter of 2016. All severance and related charges from the restructuring of our conforming mortgage banking operations were
included in Corporate/Other for segment reporting purposes.
All residential mortgage banking activities are performed at our taxable REIT subsidiary and the provision for income taxes is generally correlated to the
amount of this segment's contribution before income taxes in relation to the TRS's overall GAAP income and associated tax provision. For 2016, the tax provision
at our TRS was reduced as the result of our releasing valuation allowance previously maintained on certain net deferred tax assets. For additional detail on income
taxes, see the "Taxable
Income"
section that follows.
Results of Consolidated Legacy Sequoia Entities
We sponsored Sequoia securitization entities prior to 2012 that are reported on our consolidated balance sheets for financial reporting purposes in accordance
with GAAP. Each of these entities is independent of Redwood and of each other and the assets and liabilities of these entities are not, respectively, owned by us or
legal obligations of ours. We record the assets and liabilities of the consolidated Legacy Sequoia entities at fair value, based on the estimated fair value of the debt
securities (ABS) issued from the securitizations in accordance with GAAP provisions for collateralized financing entities. At December 31, 2017 , the estimated
fair value of our investments in the consolidated Legacy Sequoia entities was $14 million .
74
The following tables present the statements of income (loss) for the years ended December 31, 2017 , 2016 , and 2015 and the balance sheets of the
consolidated Legacy Sequoia entities at December 31, 2017 and December 31, 2016. All amounts in the statements of income and balance sheets presented below
are included in our consolidated financial statements.
Table 31 – Consolidated Legacy Sequoia Entities Statements of Income (Loss)
(In Thousands)
Interest income
Interest expense
Net interest income
Investment fair value changes, net
Net (Loss) Income from Consolidated Legacy Sequoia
Entities
$
Table 32 – Consolidated Legacy Sequoia Entities Balance Sheets
(In Thousands)
Residential loans held-for-investment, at fair value
Other assets
Total Assets
Other liabilities
Asset-backed securities issued, at fair value
Total liabilities
Equity (fair value of Redwood's retained investments in entities)
Total Liabilities and Equity
Net Interest Income at Consolidated Legacy Sequoia Entities
Years Ended December 31,
Changes
2017
2016
2015
'17/'16
'16/'15
$
19,407 $
19,537 $
24,814 $
(130) $
(14,789)
4,618
(8,027)
(13,103)
6,434
(4,200)
(15,646)
9,168
(1,192)
(1,686)
(1,816)
(3,827)
(5,277)
2,543
(2,734)
(3,008)
(3,409) $
2,234 $
7,976 $
(5,643) $
(5,742)
December 31, 2017
December 31, 2016
632,817 $
4,367
637,184 $
537 $
622,445
622,982
14,202
637,184 $
791,636
6,681
798,317
518
773,462
773,980
24,337
798,317
$
$
$
$
The decreases in net interest income in 2017 and 2016 were primarily attributable to the continued pay down of loans at the consolidated entities.
Investment Fair Value Changes, net at Consolidated Legacy Sequoia Entities
Investment fair value changes, net at consolidated Legacy Sequoia entities includes the change in fair value of the residential loans held-for-investment, REO,
and the ABS issued at the entities, which netted together represent the change in value of our retained investments in the consolidated Legacy Sequoia entities. The
increase in negative investment fair value changes in 2017 was primarily related to the decline in fair value of retained IO securities, as prepayments of the loans
underlying these securities accelerated in 2017.
75
Residential Loans at Consolidated Legacy Sequoia Entities
The following table provides details of residential loan activity at consolidated Legacy Sequoia entities for the years ended December 31, 2017 and 2016 .
Table 33 – Residential Loans at Consolidated Legacy Sequoia Entities — Activity
(In Thousands)
Balance at beginning of period
Principal repayments
Transfers to REO
Deconsolidation adjustments
Changes in fair value, net
Balance at End of Period
Years Ended December 31,
2017
2016
$
791,636 $
(177,353)
(4,219)
—
22,753
$
632,817 $
1,021,870
(197,407)
(11,566)
(6,871)
(14,390)
791,636
First lien adjustable rate mortgage ("ARM") and hybrid loans comprise all of the loans in the consolidated Legacy Sequoia entities and were primarily
originated in 2006 or prior. All of the $15 million of hybrid loans held at consolidated Legacy Sequoia entities at December 31, 2017 had reset in 2010, and now
act as ARM loans. For outstanding loans at consolidated Legacy Sequoia entities at December 31, 2017 , the weighted average FICO score of borrowers backing
these loans was 728 (at origination) and the weighted average original LTV ratio was 66% (at origination). At December 31, 2017 and December 31, 2016 , the
unpaid principal balance of loans at consolidated Legacy Sequoia entities delinquent greater than 90 days was $25 million and $30 million , respectively, of which
the unpaid principal balance of loans in foreclosure was $10 million and $11 million , respectively.
Tax Provision and Taxable Income
Tax Provision under GAAP
For the years ended December 31, 2017 , 2016, and 2015, we recorded tax provision s of $12 million and $4 million , and a tax benefit of $10 million ,
respectively. Our tax provision or benefit is primarily derived from GAAP net income or loss at our TRS as we do not book a material tax provision associated
with income generated at our REIT. Our TRS income is generally earned from our mortgage banking activities, MSRs, and other non-REIT eligible security
investments.
Our tax provision for 2017 includes a benefit of $8 million due to a reduction of our net federal deferred tax liabilities resulting from the Tax Act and the
associated reduction of the federal statutory tax rate from 35% to 21% for tax years beginning after December 31, 2017. Going forward, earnings at our TRS will
be subject to the new lower federal statutory rate.
For 2016, our tax provision included a benefit from the reversal of the valuation allowance recorded against our federal net deferred tax assets (DTAs). For
2015, our benefit from income taxes resulted from GAAP losses generated at our TRS, which was reduced by a valuation allowance we established on certain net
deferred tax assets in that year.
76
Taxable Income
The following table summarizes our taxable income and distributions to shareholders for the years ended December 31, 2017 , 2016 , and 2015 . For each of
these periods, we had no undistributed REIT taxable income, after the application of net operating loss carryforwards.
Table 34 – Taxable Income
(In Thousands except per Share Data)
REIT taxable income
Taxable REIT subsidiary income (loss)
Total Taxable Income
REIT taxable income per share
Total taxable income per share
Distributions to shareholders
Distributions to shareholders per share
Years Ended December 31,
2017 est. (1)
2016
2015
$
$
$
$
$
$
87,994 $
31,660
119,654 $
1.15 $
1.56 $
86,271 $
1.12 $
97,576 $
68,792
166,368 $
1.27 $
2.17 $
86,240 $
1.12 $
85,685
(42,034)
43,651
1.05
0.55
92,493
1.12
(1) Our tax results for the year ended December 31, 2017 are estimates until we file tax returns for 2017 .
Taxable Income Distribution Requirement
As a REIT, we are required to distribute at least 90% of our taxable income, after the application of federal net operating loss carryforwards (NOLs), to our
shareholders. For 2017 , our estimated REIT taxable income of $88 million exceeded our available NOLs by $31 million , and therefore our minimum dividend
distribution requirement was $28 million . The following table details our federal NOLs and capital loss carryforwards available as of December 31, 2017 .
Table 35 - Federal Net Operating and Capital Loss Carryforwards
(In Thousands)
REIT Loss Carryforwards
Net operating loss
Capital loss
Total REIT Loss Carryforwards
TRS Loss Carryforwards
Net operating loss
Capital loss
Total TRS Loss Carryforwards
1 to 3
Years
Loss Carryforward Expiration by Period
3 to 5
Years
5 to 15
Years
After 15
Years
Total
$
— $
— $
— $
(56,761) $
(56,761)
—
—
$
—
—
$
—
—
$
—
—
$
(56,761)
$
(56,761)
$
— $
— $
— $
$
$
(2,548)
(2,548)
$
$
—
—
$
$
—
—
$
$
—
—
—
$
$
$
—
(2,548)
(2,548)
At December 31, 2016, we maintained $58 million of NOLs at the REIT level. In order to utilize these carryforwards, taxable income must exceed our
dividend distributions. During 2017 , we distributed $86 million to shareholders, which was less than our estimated taxable income of $88 million . We therefore
expect to report REIT taxable income on our 2017 federal income tax return after the application of a dividends paid deduction. As a result, we expect $2 million
of our federal NOLs at the REIT level to be utilized in 2017 . Federal NOLs at the REIT level do not expire until 2029.
The Tax Act created a limitation on the annual usage of REIT NOLs to 80% of REIT taxable income before the dividends paid deduction, effective with
respect to NOLs arising in taxable years beginning after December 31, 2017. We do not expect this to materially impact our REIT.
77
Federal capital loss carryforwards of $3 million at our TRS will expire in 2020. In order to utilize these carryforwards, our TRS must recognize capital gains
in excess of capital losses before the expiration dates.
Tax Characteristics of Distributions to Shareholders
For the year ended December 31, 2017 , we declared and distributed four regular quarterly dividends totaling $86 million ( $1.12 per share). Under the federal
income tax rules applicable to REITs, the taxable portion of any distribution to shareholders is determined by (i) taxable income of the REIT, exclusive of the
dividends paid deduction and NOLs; and (ii) net capital gains recognized by the REIT, exclusive of capital loss carryforwards. The income or loss generated at our
TRS does not directly affect the tax characterization of our dividends.
Our 2017 dividend distributions are expected to be characterized for federal income tax purposes as 71% ordinary dividend income and 29% qualified
dividend income (generated from $25 million of qualified dividends from our TRS to our REIT). Under the federal income tax rules applicable to REITs, none of
the 2017 dividend distributions are expected to be characterized as long-term capital gains due to capital loss carryforwards being used to offset our 2017 net
capital gains.
Beginning in 2018, the Tax Act provides that individual taxpayers may deduct 20% of their ordinary REIT dividends from taxable income. This results in a
maximum federal effective tax rate of 29.6% on an individual taxpayer’s ordinary REIT dividends, compared to the highest marginal rate of 37%. This deduction
does not apply to REIT dividends classified as qualified dividends or long-term capital gains dividends, as those dividends are taxed at a maximum rate of 20% for
individuals.
In December 2017 , our board of directors announced its intention to pay a regular dividend of $0.28 per share each quarter in 2018 .
Differences between Estimated Total Taxable Income and GAAP Income
Differences between estimated taxable income and GAAP income are largely due to the following: (i) we cannot establish loss reserves for future anticipated
events for tax but we can for GAAP, as realized credit losses are expensed when incurred for tax and these losses are anticipated through lower yields on assets or
through loss provisions for GAAP; (ii) the timing, and possibly the amount, of some expenses (e.g., certain compensation expenses) are different for tax than for
GAAP; (iii) 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; (iv) at the REIT and certain TRS entities, unrealized gains and losses on market valuation adjustments of securities and derivatives are not
recognized for tax until the instrument is sold or extinguished; (v) for tax, basis may not be assigned to mortgage servicing rights retained when whole loans are
sold resulting in lower tax gain on sale; (vi) for tax, we do not consolidate securitization entities as we do under GAAP; and, (vii) dividend distributions to our
REIT from our TRS are included in REIT taxable income, but not GAAP income. As a result of these differences in accounting, our estimated taxable income can
vary significantly from our GAAP income during certain reporting periods.
For tax years beginning after December 31, 2017 (and after December 31, 2018 for debt-instruments with original issue discount), the Tax Act requires
acceleration of certain types of revenue for federal income tax purposes. We are evaluating the effects of this change, and currently do not believe these provisions
will have a material income tax effect for us.
The tax basis in assets and liabilities at the REIT was $4.39 billion and $3.31 billion , respectively, at December 31, 2017 . The GAAP basis in assets and
liabilities at the REIT was $5.55 billion and $4.40 billion , respectively, at December 31, 2017 . The primary difference in both the tax and GAAP assets and
liabilities is attributable to securitization entities that are consolidated for GAAP reporting purposes but not for tax purposes.
78
The tables below reconcile our estimated total taxable income to our GAAP income for the years ended December 31, 2017 , 2016 , and 2015 .
Table 36 – Differences between Estimated Total Taxable Income and GAAP Net Income
(In Thousands, except per Share Data)
REIT (Est.)
TRS (Est.)
Total Tax (Est.)
GAAP
Differences
Year Ended December 31, 2017
$
185,820 $
38,824 $
224,644 $
248,057 $
1.15 $
0.41 $
1.56 $
1.60 $
(0.04)
(In Thousands, except per Share Data)
REIT
TRS
Total Tax
GAAP
Differences
Year Ended December 31, 2016
$
199,969 $
33,289 $
233,258 $
246,355 $
Interest income
Interest expense
Net interest income
Realized credit losses
Mortgage banking activities, net
MSR income, net
Investment fair value changes, net
Operating expenses
Other income (1)
Realized gains, net
Provision for income taxes
Net Income
Income per basic common share
Interest income
Interest expense
Net interest income
Reversal of provision for loan losses
Realized credit losses
Mortgage banking activities, net
MSR income, net
Investment fair value changes, net
Operating expenses
Other income
Realized gains, net
Provision for income taxes
Net Income
Income per basic common share
$
$
$
$
(59,875)
125,945
(3,442)
—
—
(16,483)
(43,323)
26,382
(735)
(350)
(29,787)
9,037
—
44,162
3,930
5,292
(31,609)
1,013
—
(165)
(89,662)
134,982
(3,442)
44,162
3,930
(11,191)
(74,932)
27,395
(735)
(515)
(108,816)
139,241
—
53,908
7,860
10,374
(77,156)
4,576
13,355
(11,752)
87,994 $
31,660 $
119,654 $
140,406 $
(48,534)
151,435
—
(7,989)
—
—
(2,277)
(44,950)
1,386
—
(29)
(27,862)
5,427
—
—
26,477
86,955
(8,133)
(43,466)
1,374
284
(126)
(76,396)
156,862
—
(7,989)
26,477
86,955
(10,410)
(88,416)
2,760
284
(155)
(88,528)
157,827
7,102
—
38,691
14,353
(28,574)
(88,786)
6,338
28,009
(3,708)
97,576 $
68,792 $
166,368 $
131,252 $
1.27 $
0.90 $
2.17 $
1.54 $
0.63
(23,413)
19,154
(4,259)
(3,442)
(9,746)
(3,930)
(21,565)
2,224
22,819
(14,090)
11,237
(20,752)
(13,097)
12,132
(965)
(7,102)
(7,989)
(12,214)
72,602
18,164
370
(3,578)
(27,725)
3,553
35,116
(1) For 2017, other income at the REIT is primarily comprised of dividend income from our TRS.
79
(In Thousands, except per Share Data)
REIT
TRS
Total Tax
GAAP
Differences
Year Ended December 31, 2015
$
187,146 $
39,987 $
227,133 $
259,432 $
Interest income
Interest expense
Net interest income
Reversal of provision for loan losses
Realized credit losses
Mortgage banking activities, net
MSR income (loss), net
Investment fair value changes, net
Operating expenses
Other income
Realized gains, net
(Provision for) benefit from income taxes
Net Income (Loss)
Income (loss) per basic common share
Potential Taxable Income Volatility
(43,485)
143,661
—
(8,645)
—
—
(390)
(49,304)
403
—
(40)
(36,345)
3,642
—
—
(24,637)
33,669
(2,437)
(53,932)
1,771
—
(110)
(79,830)
147,303
—
(8,645)
(24,637)
33,669
(2,827)
(103,236)
2,174
—
(150)
$
$
85,685 $
(42,034) $
43,651
1.05 $
(0.50) $
0.55
$
$
(95,883)
163,549
355
—
10,972
(3,922)
(21,357)
(97,416)
3,192
36,369
10,346
102,088 $
(32,299)
16,053
(16,246)
(355)
(8,645)
(35,609)
37,591
18,530
(5,820)
(1,018)
(36,369)
(10,496)
(58,437)
1.18 $
(0.63)
We expect period-to-period volatility in our estimated taxable income. A description of the factors that can cause this volatility is provided below.
Recognition of Gains and Losses on Sale
Since the computation of amortization and impairments on assets may differ for tax and GAAP and many of our assets held for investment purposes are
marked-to-market for GAAP, but not for tax, the tax and GAAP basis on assets sold or called may differ, resulting in differences in gains and losses on sale or call.
In addition, gains realized for tax may be offset by prior capital losses and, thus, not affect taxable income. At December 31, 2017 , we had an estimated $3 million
in federal capital loss carryforwards at the TRS level. We anticipate selling appreciated securities within the capital loss carryforward period, and it is likely that
the TRS will benefit from all of the capital loss carryforwards. As such, no valuation allowance was recorded against any portion of the corresponding deferred tax
asset. However, our estimate could change in future periods and, to the extent we expect to utilize the capital loss carryforwards, we could record additional tax
expense or benefit for GAAP.
Prepayments on Securities
We have retained certain IO securities since the time they were issued from Sequoia securitizations we sponsored and purchased additional third-party IO
securities. Our tax basis in these securities was $104 million at December 31, 2017 . The return on IOs is sensitive to prepayments and, to the extent prepayments
vary period to period, income from these IOs will vary. 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. Currently, our tax basis is above the fair values for these IOs in the aggregate. If a
securitization is called, the remaining tax basis in the IO is expensed, creating an ordinary loss at the call date.
Prepayments also affect the taxable income recognition on other securities we own. For tax purposes, we are required to use particular prepayment
assumptions for the remaining lives of each security. As actual prepayment speeds vary, the yield we recognize for tax purposes will be adjusted accordingly. Thus,
to the extent actual prepayments differ from our long-term assumptions or vary from period to period, the yield recognized will also vary and this difference could
be material.
80
Credit Losses on Securities and Loans
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 accrue 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. 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 create significant taxable income volatility to the extent the level of credit losses
fluctuates during reporting periods. Credit losses are based on our tax basis, which differs from our basis for GAAP purposes. We anticipate an additional $20
million of credit losses for tax on securities, based on our projection of principal balance losses and assuming a similar tax basis as we have recently experienced,
although the timing of actual losses is difficult to accurately project.
Our estimated total taxable income for the years ended December 31, 2017 , 2016, and 2015 included $3 million , $8 million , and $9 million , respectively, in
realized credit losses on investments.
Compensation Expense
The total tax expense for equity award compensation is dependent upon varying factors such as the timing of payments of dividend equivalent rights, the
distribution of deferred stock units and performance stock units, and the cash deferrals to and withdrawals from our Executive Deferred Compensation Plan. For
GAAP purposes, 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. An exception may apply to performance-based compensation that is paid pursuant to a written and binding contract in effect before November 2, 2017.
Thus, the total amount of compensation expense, as well as the timing, could be significantly different for tax than for GAAP.
As an example, for GAAP we expense the grant date fair value of performance stock units (PSUs) granted over the vesting term of those PSUs (regardless of
the degree to which the performance conditions for vesting are ultimately satisfied, if at all), whereas for tax the value of the PSUs that actually vest in accordance
with the performance conditions of those awards and are subsequently distributed to the award recipient is recorded as an expense on the date of distribution. For
example, if no PSUs under a particular grant ultimately vest, due to the failure to satisfy the performance conditions, no tax expense will be recorded for those
PSUs, even though we would have already recorded expense for GAAP equal to the grant date fair value of the PSU awards. Conversely, for example, if
performance is such that a number of shares of common stock equal to 200% of the PSU award ultimately vest and are delivered to the award recipient, expense
for tax will equal the common stock value on the date of distribution of 200% of the number of PSUs originally granted. This expense for tax could significantly
exceed the recorded expense for GAAP.
In addition, since the timing of distributions of deferred stock units, performance stock units, or cash out of the Executive Deferred Compensation Plan is
based on employees' deferral elections, it can be difficult to project when the tax expense will occur.
Mortgage Servicing Rights
For GAAP purposes, we recognize MSRs through the direct acquisition of servicing rights from third parties or through the retention of MSRs associated with
residential loans that we have acquired and subsequently sold to non-consolidated securitization entities or to third parties. For tax purposes, basis in our MSR
assets is recognized through the direct acquisition of servicing rights from third parties, or to the extent that a retained MSR entitles us to receive a servicing fee in
excess of so-called normal servicing (or the right to receive reasonable compensation for services to be performed under the mortgage serving contract). Tax basis
in our normal MSR assets is not recognized when MSRs are retained from sales of loans to non-consolidated securitization entities or to third parties, thereby
creating a favorable temporary GAAP to tax difference from sale of the loans. For the year ended December 31, 2017 , we retained $9 million of MSRs from
jumbo and conforming loan sales for which no tax basis was recognized. Additionally, in 2017 , we purchased $1 million of MSRs associated with conforming
loans where the initial tax basis was equal to the purchase price. No other tax basis in our MSR assets was recognized in 2017 .
For GAAP purposes, mortgage servicing fee income, net of servicing expense, as well as changes in the estimated fair value of our MSRs, is recognized on
our consolidated statements of income over the life of the MSR asset. For tax purposes, only mortgage servicing fee income, net of servicing expense is recognized
as taxable income. Any MSR where basis is recognized for tax purposes through acquisition is amortized as a tax expense over a finite life.
81
Periodic changes in the market values of MSRs are recorded through the income statement for GAAP purposes, but not for tax purposes. Only when MSRs are
sold will a tax gain or loss be recognized. As tax basis is not recognized for retained MSRs and the rules for writing-off tax basis of purchased MSRs are
restrictive, the tax gain from the sale of MSRs can be substantial. For the year ended December 31, 2017, we recognized a tax loss of $16 million from the sale of
MSRs as we were able to write-off nearly all the tax basis of our purchased MSRs. Future sales of MSRs could result in significant tax gains.
LIQUIDITY AND CAPITAL RESOURCES
Summary
Our principal sources of cash consist of borrowings under mortgage loan warehouse facilities, securities repurchase agreements, payments of principal and
interest we receive from our investment portfolios, and cash generated from our operating activities. Our most significant uses of cash are to purchase mortgage
loans for our mortgage banking operations, to fund investments in residential loans, to purchase investment securities, to repay principal and interest on our
warehouse facilities, repurchase agreements, and long-term debt, to make dividend payments on our capital stock, and to fund our operations.
Our total capital was $1.79 billion at December 31, 2017 , and included $1.21 billion of equity capital and $575 million of the total $2.58 billion of long-term
debt on our consolidated balance sheet. This portion of debt included $201 million of exchangeable debt due in 2019, $245 million of convertible debt due in 2023,
and $140 million of trust-preferred securities due in 2037.
As of December 31, 2017 , we estimate that our capital available for investment was approximately $280 million . Subsequent to year-end, we have continued
to optimize our portfolio and have sufficient capital to repay our maturing convertible debt due in April 2018.
In February 2016, our Board of Directors approved an authorization for the repurchase of up to $100 million of our common stock and also authorized the
repurchase of outstanding debt securities, including convertible and exchangeable debt. This authorization replaced all previous share repurchase plans and has no
expiration date. During the year ended December 31, 2017 , we repurchased 610,342 shares of our common stock pursuant to this authorization for $9 million . At
December 31, 2017 , approximately $77 million of this current authorization remained available for repurchases of shares of our common stock. During the period
between December 31, 2017 and February 26, 2018, we repurchased 1,040,829 shares of our common stock pursuant to this authorization for $16 million .
In February 2018, our Board of Directors approved an authorization for the repurchase of an additional $39 million of our common stock, increasing the total
amount authorized for repurchases of common stock to $100 million, and also authorized the repurchase of outstanding debt securities, including convertible and
exchangeable debt. As noted above, this authorization increased the previous share repurchase authorization approved in February 2016 and has no expiration date.
This repurchase authorization does not obligate us to acquire any specific number of shares or securities. Under this authorization, shares or securities may be
repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of
1934, as amended. At February 26, 2018, approximately $100 million of this current authorization remained available for repurchases of shares of our common
stock. Like other investments we may make, any repurchases of our common stock or debt securities under this authorization would reduce our available capital
described above.
While we believe our available capital is sufficient to fund our currently contemplated investment activities and repay existing debt, we may raise capital from
time to time to make long-term investments or for other purposes. To the extent we seek additional capital to fund our operations and investment activities, our
approach to raising capital will continue to be based on what we believe to be in the best long-term interests of shareholders.
We are subject to risks relating to our liquidity and capital resources, including risks relating to incurring debt under residential loan warehouse facilities,
securities repurchase facilities, and other short- and long-term debt facilities and other risks relating to our use of derivatives. A further discussion of these risks is
set forth below under the heading “ Risks
Relating
to
Debt
Incurred
under
Short-
and
Long-Term
Borrowing
Facilities
" and in Part I, Item 1A - Risk Factors of
this Annual Report on Form 10-K.
Cash Flows and Liquidity for the Year Ended December 31, 2017
Cash flows from our mortgage banking activities and our investments can be volatile from quarter to quarter depending on many factors, including the timing
and amount of loan and securities acquisitions and sales and repayments, the profitability of mortgage banking activities, as well as changes in interest rates,
prepayments, and credit losses. Therefore, cash flows generated in the current period are not necessarily reflective of the long-term cash flows we will receive from
these investments or activities.
82
Cash Flows from Operating Activities
Cash flows from operating activities were negative $1.71 billion in 2017 . This amount includes the net cash utilized during the period from the purchase and
sale of residential mortgage loans associated with our mortgage banking activities. Purchases of loans are financed to a large extent with short-term debt, for which
changes in cash are included as a component of financing activities. Excluding cash flows from the purchase, sale, and principal payments of loans classified as
held-for-sale, cash flows from operating activities were positive $37 million in 2017 , positive $135 million in 2016, and negative $46 million in 2015.
Cash Flows from Investing Activities
During 2017 , our net cash provided by investing activities was $287 million and primarily resulted from principal payments on loans held-for-investment at
Redwood and at our consolidated Sequoia entities, principal payments from, and proceeds from net sales of, real estate securities and proceeds from sales of MSRs.
Although we generally intend to hold our investment securities as long-term investments, we may sell certain of these securities in order to manage our interest rate
risk and liquidity needs, to meet other operating objectives, and to adapt to market conditions. We cannot predict the timing and impact of future sales of
investment securities, if any.
Because many of our investment securities are financed through repurchase agreements, a significant portion of the proceeds from any sales or principal
payments of our investment securities could be used to repay balances under these financing sources. Similarly, all or a significant portion of cash flows from
principal payments of loans at consolidated Sequoia entities would generally be used to repay ABS issued by those entities.
As presented in the " Supplemental
Noncash
Information
" subsection of our consolidated statements of cash flows, during 2017 , 2016, and 2015, we had
significant transfers of residential loans from held-for-sale to held-for-investment classification, and also retained MSRs and securities from Sequoia securitizations
we sponsored, which represent non-cash transactions that were not included in cash flows from investing activities.
Cash Flows from Financing Activities
During 2017 , our net cash provided by financing activities was $1.36 billion . This primarily resulted from $859 million of net borrowings of short-term debt,
the issuance of asset-backed securities from our Sequoia Choice securitizations in the second half of 2017, and the issuance of convertible debt in August 2017,
which were partially offset by $205 million of repayments of ABS issued and the distribution of $88 million of dividends.
In December 2017 , our Board of Directors announced its intention to pay a regular dividend of $0.28 per share per quarter in 2018 . In February 2018 , the
Board of Directors declared a regular dividend of $0.28 per share for the first quarter of 2018 , which is payable on March 29, 2018 to shareholders of record on
March 15, 2018 .
In accordance with the terms of our outstanding deferred stock units, which are stock-based compensation awards, each time we declare and pay a dividend on
our common stock, we are required to make a dividend equivalent payment in that same per share amount on each outstanding deferred stock unit.
Short-Term Debt
In the ordinary course of our business, we use recourse debt through several different types of borrowing facilities and use cash borrowings under these
facilities to, among other things, fund the acquisition of residential loans (including those we acquire and originate in anticipation of securitization), finance
investments in securities and other investments, and otherwise fund our business and operations.
At December 31, 2017 , we had four short-term residential loan warehouse facilities with a total outstanding debt balance of $1.04 billion (secured by
residential loans with an aggregate fair value of $1.15 billion ) and a total uncommitted borrowing limit of $1.58 billion . In addition, at December 31, 2017 , we
had an aggregate outstanding short-term debt balance of $649 million under nine securities repurchase facilities, which were secured by securities with a fair
market value of $788 million . We also had a secured line of credit with no outstanding debt balance and a total borrowing limit of $10 million (secured by
securities with a fair market value of $5 million ) at December 31, 2017 .
83
During the second quarter of 2017, $288 million principal amount of our convertible notes due in 2018 and $2 million of associated unamortized deferred
issuance costs were reclassified from long-term debt to short-term debt, as the maturity of the notes was less than one year as of April 2017. Additionally, during
the second quarter of 2017, we repurchased $37 million par value of these notes at a premium and recorded a loss on extinguishment of debt of $1 million in
Realized gains, net on our consolidated statements of income. At December 31, 2017 , the outstanding principal amount of these notes was $250 million .
During 2017 , the highest balance of our short-term debt outstanding was $2.11 billion .
Long-Term Debt
FHLBC Borrowings
In July 2014, our FHLB-member subsidiary entered into a borrowing agreement with the Federal Home Loan Bank of Chicago. At December 31, 2017 , under
this agreement, our subsidiary could incur borrowings up to $2.00 billion , also referred to as “advances,” from the FHLBC secured by eligible collateral,
including, but not limited to residential mortgage loans. During the year ended December 31, 2017 , our FHLB-member subsidiary made no additional borrowings
under this agreement. Under a final rule published by the Federal Housing Finance Agency in January 2016, our FHLB-member subsidiary will remain an FHLB
member through a five-year transition period for captive insurance companies. Our FHLB-member subsidiary's existing $2.00 billion of FHLB debt, which
matures beyond this transition period, is permitted to remain outstanding until stated maturity. As residential loans pledged as collateral for this debt pay down, we
are permitted to pledge additional loans or other eligible assets to collateralize this debt; however, we do not expect to be able to increase our subsidiary's FHLB
debt above the existing $2.00 billion maximum.
At December 31, 2017 , $2.00 billion of advances were outstanding under this agreement, which were classified as long-term debt, with a weighted average
interest rate of 1.38% per annum and a weighted average maturity of eight years . At December 31, 2017 , accrued interest payable on these borrowings was $4
million . Advances under this agreement are charged interest based on a specified margin over the FHLBC’s 13-week discount note rate, which resets every 13
weeks. Our total advances under this agreement were secured by residential mortgage loans with a fair value of $2.43 billion at December 31, 2017 . This
agreement also requires our subsidiary to purchase and hold stock in the FHLBC in an amount equal to a specified percentage of outstanding advances. At
December 31, 2017 , our subsidiary held $43 million of FHLBC stock that is included in Other assets on our consolidated balance sheets.
Convertible Notes
In August 2017, we issued $245 million principal amount of 4.75% convertible senior notes due 2023 . After deducting the underwriting discount and issuance
costs, we received approximately $238 million of net proceeds. Including amortization of deferred debt issuance costs, the weighted average interest expense yield
on these convertible notes is approximately 5.3% per annum. At December 31, 2017 , the outstanding principal amount of these notes was $245 million . At
December 31, 2017, the accrued interest payable balance on this debt was $4 million .
In November 2014, one of our taxable subsidiaries issued $205 million principal amount of 5.625% exchangeable senior notes due 2019 . After deducting the
underwriting discount and issuance costs, we received approximately $198 million of net proceeds. Including amortization of deferred debt issuance costs, the
weighted average interest expense yield on these exchangeable notes is approximately 6.3% per annum. During the year ended December 31, 2016, we
repurchased $4 million par value of these notes at a discount and recorded a gain on extinguishment of debt of $0.3 million in Realized gains, net on our
consolidated statements of income. At December 31, 2017 , the outstanding principal amount of these notes was $201 million . At December 31, 2017 , the accrued
interest payable balance on this debt was $1 million .
In March 2013, we issued $288 million principal amount of 4.625% convertible senior notes due 2018. After deducting the underwriting discount and issuance
costs, we received approximately $279 million of net proceeds. Including amortization of deferred debt issuance costs, the weighted average interest expense yield
on these convertible notes was approximately 4.8% per annum. During the three months ended June 30, 2017, $288 million principal amount of these convertible
notes and $2 million of unamortized deferred issuance costs were reclassified from long-term debt to short-term debt, as the maturity of the notes was less than one
year as of April 2017. Additionally, during the second quarter of 2017, we repurchased $37 million par value of these notes at a premium and recorded a loss on
extinguishment of debt of $1 million in Realized gains, net on our consolidated statements of income. At December 31, 2017 , the outstanding principal amount of
these notes was $250 million . At December 31, 2017 , the accrued interest payable balance on this debt was $2 million .
84
Trust Preferred Securities and Subordinated Notes
At December 31, 2017 , we had trust preferred securities and subordinated notes outstanding of $100 million and $40 million , respectively, issued by us in
2006 and 2007. This debt requires quarterly interest payments at a floating rate equal to three-month LIBOR plus 2.25% and must be redeemed no later than 2037.
Prior to 2014, we entered into interest rate swaps with aggregate notional values totaling $140 million to hedge the variability in this long-term debt interest
expense. Including hedging costs and amortization of deferred debt issuance costs, the weighted average interest expense yield on our trust preferred securities and
subordinated notes is approximately 6.75% per annum. These swaps are accounted for as cash flow hedges with all interest recorded as a component of net interest
income and other valuation changes recorded as a component of equity.
Asset-Backed Securities
At December 31, 2017 , there were $698 million (principal balance) of loans owned at consolidated Legacy Sequoia securitization entities, which were funded
with $691 million (principal balance) of ABS issued at these entities. In addition, at December 31, 2017 , there were $605 million (principal balance) of loans
owned at consolidated Sequoia Choice securitization entities, which was funded with $527 million (principal balance) of ABS issued at these entities. The loans
and ABS issued from these entities are reported at estimated fair value. See the subsections titled " Residential
Loans
Held-for-Investment
at
Sequoia
Choice
Portfolio"
and " Results
of
Consolidated
Legacy
Sequoia
Entities
" in the Results
of
Operations
section of this MD&A for additional details on these entities.
Ratio of Earnings to Fixed Charges
The ratio of earnings to fixed charges represents the number of times “fixed charges” are covered by “earnings.” “Fixed charges” consist of interest on
outstanding long-term debt, convertible notes with a maturity of less than one year, and asset-backed securities issued, as well as associated amortization of debt
discount and deferred issuance costs. The proportion deemed representative of the interest factor of operating lease expense has not been deducted as the total
operating lease expense in itself was de minimis and did not affect the ratios in a material way. “Earnings” consist of consolidated income before income taxes and
fixed charges.
The following table presents our ratio of earnings to fixed charges for the each of the years ended December 31, 2017 , 2016 , 2015 , 2014 , and 2013 .
Table 37 – Ratio of Earnings to Fixed Charges
Ratio of earnings to fixed charges
Years Ended December 31,
2017
2016
2015
2014
2013
2.88 x
3.04 x
2.40 x
2.65 x
3.90 x
85
Risks Relating to Debt Incurred under Short- and Long-Term Borrowing Facilities
As described above under the heading “ Results
of
Operations
,” in the ordinary course of our business, we use debt financing obtained through several
different types of borrowing facilities to, among other things, finance the acquisition of residential mortgage loans (including those we acquire in anticipation of
sale or securitization), and finance investments in securities and other investments. We may also use short- and long-term borrowings to fund other aspects of our
business and operations, including the repurchase of shares of our common stock. Debt incurred under these facilities is generally either the direct obligation of
Redwood Trust, Inc., or the direct obligation of subsidiaries of Redwood Trust, Inc. and guaranteed by Redwood Trust, Inc.
Residential
Loan
Warehouse
Facilities
.
One source of our short-term debt financing is secured borrowings under residential loan warehouse facilities that, as
of December 31, 2017 , were in place with four different financial institution counterparties. Under these four warehouse facilities, we had an aggregate borrowing
limit of $1.58 billion at December 31, 2017 ; however, these facilities are uncommitted, which means that any request we make to borrow funds under these
facilities may be declined for any reason, even if at the time of the borrowing request we have then-outstanding borrowings that are less than the borrowing limits
under these facilities. Short-term financing for residential mortgage loans is obtained under these facilities by our transfer of mortgage loans to the counterparty in
exchange for cash proceeds (in an amount less than 100% of the principal amount of the transferred mortgage loans), and our covenant to reacquire those loans
from the counterparty for the same amount plus a financing charge.
In order to obtain financing for a residential loan under these facilities, the loan must initially (and continuously while the financing remains outstanding) meet
certain eligibility criteria, including, without limitation, that the loan is not in a delinquent status. In addition, under these warehouse facilities, residential loans can
only be financed for a maximum period, which period would not generally exceed 364 days. We generally intend to repay the short-term financing of a loan under
one of these facilities at or prior to the expiration of that financing with the proceeds of a securitization or other sale of that loan, through the proceeds of other
short-term borrowings, or with other equity or long-term debt capital. While a residential loan is financed under a warehouse facility, to the extent the market value
of the loan declines (which market value is generally determined by the counterparty under the facility), we are required to either immediately reacquire the loan or
meet a margin requirement to pledge additional collateral, such as cash or additional residential loans, in an amount at least equal to the decline in value. See
further discussion below under the heading “ Margin
Call
Provisions
Associated
with
Short-Term
Debt
and
Other
Debt
Financing
.”
Because these warehouse facilities are uncommitted, at any given time we may not be able to obtain additional financing under them when we need it,
exposing us to, among other things, liquidity risks of the types described in Part I, Item 1A of this Annual Report on Form 10-K under the heading “ Risk
Factors
,” and in Part II, Item 7A of this Annual Report on Form 10-K under the heading “ Market
Risks
.” In addition, with respect to residential loans that at any given
time are already being financed through these warehouse facilities, we are exposed to market, credit, liquidity, and other risks of the types described in Part I,
Item 1A of this Annual Report on Form 10-K under the heading “ Risk
Factors
,” and in Part II, Item 7A of this Annual Report on Form 10-K under the heading “
Market
Risks
,” if and when those loans become ineligible to be financed, decline in value, or have been financed for the maximum term permitted under the
applicable facility.
Under our residential loan warehouse facilities, we also make various representations and warranties and have agreed to certain covenants, events of default,
and other terms that if breached or triggered can result in our being required to immediately repay all outstanding amounts borrowed under these facilities and
these facilities being unavailable to use for future financing needs. In particular, the terms of these facilities include financial covenants, cross-default provisions,
judgment default provisions, and other events of default (such as, for example, events of default triggered by one of the following: a change in control over
Redwood, regulatory investigation or enforcement action against Redwood, Redwood’s failure to continue to qualify as a REIT for tax purposes, or Redwood’s
failure to maintain the listing of its common stock on the New York Stock Exchange). Under a cross-default provision, an event of default is triggered (and the
warehouse facility becomes unavailable and outstanding amounts borrowed thereunder become due and payable) if an event of default or similar event occurs
under another borrowing or credit facility we maintain in excess of a specified amount. Under a judgment default provision, an event of default is triggered (and
the warehouse facility becomes unavailable and outstanding amounts borrowed thereunder become due and payable) if a judgment for damages in excess of a
specified amount is entered against us in any litigation and we are unable to promptly satisfy the judgment. Financial covenants included in these warehouse
facilities are further described below under the heading “ Financial
Covenants
Associated
with
Short-Term
Debt
and
Other
Debt
Financing
.”
These residential loan warehouse facilities could also become unavailable and outstanding amounts borrowed thereunder could become immediately due and
payable if there is a material adverse change in our business. If we breach or trigger the representations and warranties, covenants, events of default, or other terms
of our warehouse facilities, we are exposed to liquidity and other risks, including of the type described in Part I, Item 1A of this Annual Report on Form 10-K
under the heading “ Risk
Factors
,” and in Part II, Item 7A of this Annual Report on Form 10-K under the heading “ Market
Risks
.”
86
In addition to the four residential loan warehouse facilities described above, in the ordinary course of business we may seek to establish additional warehouse
facilities that may be of a similar or greater size and may have similar or more restrictive terms. In the event a counterparty to one or more of our warehouse
facilities becomes insolvent or unable or unwilling to perform its obligations under the facility, we may be unable to access short-term financing we need or fail to
recover the full value of our residential mortgage loans financed.
Securities
Repurchase
Facilities
. Another source of short-term debt financing is through securities repurchase facilities we have established with various
different financial institution counterparties. Under these facilities we do not have an aggregate borrowing limit; however, these facilities are uncommitted, which
means that any request we make to borrow funds under these facilities may be declined for any reason. Short-term financing for securities is obtained under these
facilities by our transfer of securities to the counterparty in exchange for cash proceeds (in an amount less than 100% of the fair value of the transferred securities),
and our covenant to reacquire those securities from the counterparty for the same amount plus a financing charge.
Under these securities repurchase facilities, securities are financed for a fixed period, which would not generally exceed 90 days. We generally intend to repay
the short-term financing of a security under one of these facilities through a renewal of that financing with the same counterparty, through a sale of the security, or
with other equity or long-term debt capital. While a security is financed under a securities repurchase facility, to the extent the value of the security declines (which
value is generally determined by the counterparty under the facility), we are required to either immediately reacquire the security or meet a margin requirement to
pledge additional collateral, such as cash or U.S. Treasury securities, in an amount at least equal to the decline in value. See further discussion below under the
heading “ Margin
Call
Provisions
Associated
with
Short-Term
Debt
and
Other
Debt
Financing
.”
At the end of the fixed period applicable to the financing of a security under a securities repurchase facility, if we intend to continue to obtain financing for
that security we would typically request the same counterparty to renew the financing for an additional fixed period. If the same counterparty does not renew the
financing, it may be difficult for us to obtain financing for that security under one of our other securities repurchase facilities, due to the fact that the financial
institution counterparties to our securities repurchase facilities generally only provide financing for securities that we purchased from them or one of their affiliates.
Because our securities repurchase facilities are uncommitted, at any given time we may not be able to obtain additional financing under them when we need it,
exposing us to, among other things, liquidity risks of the types described in Part I, Item 1A of this Annual Report on Form 10-K under the heading “ Risk
Factors
,” and in Part II, Item 7A of this Annual Report on Form 10-K under the heading “ Market
Risks
.” In addition, with respect to securities that at any given time are
already being financed through our securities repurchase facilities, we are exposed to market, credit, liquidity, and other risks of the types described in Part I,
Item 1A of this Annual Report on Form 10-K under the heading “ Risk
Factors
,” and in Part II, Item 7A of this Annual Report on Form 10-K under the heading “
Market
Risks
,” if and when those securities decline in value, or have been financed for the maximum term permitted under the applicable facility.
Under our securities repurchase facilities, we also make various representations and warranties and have agreed to certain covenants, events of default, and
other terms (including of the type described above under the heading “ Residential
Loan
Warehouse
Facilities
”) that if breached or triggered can result in our
being required to immediately repay all outstanding amounts borrowed under these facilities and these facilities being unavailable to use for future financing needs.
In particular, the terms of these facilities include financial covenants, cross-default provisions, judgment default provisions, and other events of default (including
of the type described above under the heading “ Residential
Loan
Warehouse
Facilities
”). Financial covenants included in our repurchase facilities are further
described below under the heading “ Financial
Covenants
Associated
with
Short-Term
Debt
and
Other
Debt
Financing
.”
Our securities repurchase facilities could also become unavailable and outstanding amounts borrowed thereunder could become immediately due and payable
if there is a material adverse change in our business. If we breach or trigger the representations and warranties, covenants, events of default, or other terms of our
securities repurchase facilities, we are exposed to liquidity and other risks, including of the type described in Part I, Item 1A of this Annual Report on Form 10-K
under the heading “ Risk
Factors
,” and in Part II, Item 7A of this Annual Report on Form 10-K under the heading “ Market
Risks
.”
In the ordinary course of business we may seek to establish additional securities repurchase facilities that may have similar or more restrictive terms. In the
event a counterparty to one or more of our securities repurchase facilities becomes insolvent or unable or unwilling to perform its obligations under the facility, we
may be unable to access the short-term financing we need or fail to recover the full value of our securities financed.
87
Other
Short-Term
Debt
Facilities
. We also maintain a $10 million committed line of short-term credit from a bank, which is secured by our pledge of certain
mortgage-backed securities we own. This bank line of credit is an additional source of short-term financing for us. Similar to the uncommitted warehouse and
securities repurchase facilities described herein, under this committed line we make various representations and warranties and have agreed to certain covenants,
events of default, and other terms that if breached or triggered can result in our being required to immediately repay all outstanding amounts borrowed under this
facility and this facility being unavailable to use for future financing needs. The margin call provisions and financial covenants included in this committed line are
further described below under the headings “ Margin
Call
Provisions
Associated
with
Short-Term
Debt
and
Other
Debt
Financing
” and “ Financial
Covenants
Associated
with
Short-Term
Debt
and
Other
Debt
Financing
.” When we use this committed line to incur short-term debt we are exposed to the market, credit,
liquidity, and other types of risks described above with respect to residential loan warehouse and securities repurchase facilities.
FHLB
Borrowing
Facility
. Our wholly-owned subsidiary, RWT Financial, LLC, is a party to a secured borrowing facility with the Federal Home Loan Bank
of Chicago (FHLBC) that was put into place in July 2014. Borrowings under this facility, also referred to as “advances,” are required to be secured by eligible
collateral including, but not limited to, residential mortgage loans and residential mortgage-backed securities. Under a final rule published by the Federal Housing
Finance Agency in January 2016, our FHLB-member subsidiary will remain an FHLB member through the five-year transition period for captive insurance
companies. Our FHLB-member subsidiary's existing $2.00 billion of FHLB debt, which matures beyond this transition period, is permitted to remain outstanding
until stated maturity. As residential loans pledged as collateral for this debt pay down, we are permitted to pledge additional loans or other eligible assets to
collateralize this debt; however, we do not expect to be able to increase our subsidiary's FHLB debt above the existing $2.00 billion maximum. At December 31,
2017, $2.00 billion of advances were outstanding under this facility.
Similar to the uncommitted warehouse and securities repurchase facilities described herein, under this facility we make various representations and
warranties and have agreed to certain covenants, events of default, and other terms that if breached or triggered can result in our being required to immediately
repay all outstanding amounts borrowed under this facility. In particular, the terms of this facility permit the acceleration of the amortization of amounts borrowed
through the facility if the FHLBC determines, in its sole discretion, that our creditworthiness or the creditworthiness of our FHLB-member subsidiary does not
meet the minimum requirements of the FHLBC. Outstanding amounts borrowed under this facility could become immediately due and payable if the FHLBC
determines there has been a material adverse change in our financial condition, or that we have breached or otherwise not complied with the terms of the FHLBC’s
credit policy. Additionally, the FHLBC may increase the required amount of collateral at any time as a result of a change in its credit policy or as a result of our
credit deterioration, in which case we may be required to deliver additional collateral in the form of cash or other eligible collateral. Factors that may affect the
FHLB’s judgment of our or our FHLB member subsidiary’s creditworthiness, financial condition, or compliance with its credit policy include, among other things,
increases in levels of indebtedness, increases in debt-to-capital ratios, or decreases in stockholders’ equity. The margin call provisions and financial covenants
included in this facility are further described below under the headings “ Margin
Call
Provisions
Associated
with
Short-Term
Debt
and
Other
Debt
Financing
”
and “ Financial
Covenants
Associated
with
Short-Term
Debt
and
Other
Debt
Financing
.” When we use this facility to incur debt we are exposed to the market,
credit, liquidity, and other types of risks described above with respect to residential loan warehouse and securities repurchase facilities.
Our access to financing under this facility is also subject to the risks described under the heading “ Risk
Factors
-
Federal
regulations
may
limit,
eliminate,
or
reduce
the
attractiveness
of
our
subsidiary’s
ability
to
use
borrowings
from
the
Federal
Home
Loan
Bank
of
Chicago
to
finance
the
mortgage
loans
and
securities
it
holds
and
acquires,
which
could
negatively
impact
our
business
and
operating
results”
in Part I, Item 1A of this Annual Report on Form 10-K.
Financial
Covenants
Associated
With
Short-Term
Debt
and
Other
Debt
Financing
Set forth below is a summary of the financial covenants associated with our short-term debt and other debt financing facilities.
•
Residential Loan Warehouse Facilities . As noted above, one source of our short-term debt financing is secured borrowings under residential loan
warehouse facilities we have established and, as of December 31, 2017 , were in place with four different financial institution counterparties. Financial
covenants included in these warehouse facilities are as follows and at December 31, 2017 , and through the date of this Annual Report on Form 10-K, we
were in compliance with each of these financial covenants:
• Maintenance of a minimum dollar amount of stockholders’ equity/tangible net worth at Redwood.
•
• Maintenance of a minimum dollar amount of cash and cash equivalents at Redwood or maintenance of an amount of cash and cash equivalents in
excess of a specified percentage of outstanding short-term recourse indebtedness.
• Maintenance of a minimum ratio of consolidated recourse indebtedness to stockholders’ equity and tangible net worth at Redwood.
88
•
•
•
• Maintenance of uncommitted residential loan warehouse facilities with a specified level of unused borrowing capacity.
Securities Repurchase Facilities . As noted above, another source of our short-term debt financing is through secured borrowings under securities
repurchase facilities we have established with various financial institution counterparties. Financial covenants included in these securities repurchase
facilities are as follows and at December 31, 2017 , and through the date of this Annual Report on Form 10-K, we were in compliance with each of these
financial covenants:
• Maintenance of a minimum dollar amount of stockholders’ equity/tangible net worth at Redwood.
• Maintenance of a minimum dollar amount of cash and cash equivalents at Redwood.
• Maintenance of a minimum ratio of consolidated recourse indebtedness to consolidated adjusted tangible net worth at Redwood.
Committed Line of Credit . As noted above, we also maintain a $10 million committed line of short-term credit from a bank, which is secured by our
pledge of certain mortgage-backed securities we own. The types of financial covenants included in this bank line of credit are a subset of the covenants
summarized above.
FHLB Borrowing Facility . As noted above, a wholly-owned subsidiary of ours, RWT Financial, also maintains a borrowing facility with the FHLBC,
borrowings under which are required to be secured by eligible collateral including, but not limited to, residential mortgage loans and residential mortgage-
backed securities. Financial covenants included in this facility are as follows and at December 31, 2017 , and through the date of this Annual Report on
Form 10-K, we were in compliance with each of these financial covenants:
• Maintenance by RWT Financial of a minimum ratio of total liabilities (excluding debt subordinated to the FHLBC and non-recourse debt) to
stockholders’ equity and debt subordinated to the FHLBC.
• Maintenance by RWT Financial of a minimum level of unencumbered assets based on the level of indebtedness to the FHLBC.
• Maintenance of a minimum ratio of total liabilities (excluding non-recourse debt) to stockholders’ equity at Redwood.
• Maintenance of a minimum dollar amount of cash and cash equivalents, excess qualifying collateral, or undrawn borrowing capacity by RWT
Financial.
As noted above, at December 31, 2017 , and through the date of this Annual Report on Form 10-K, we were in compliance with the financial covenants
associated with our short-term debt and other debt financing facilities. In particular, with respect to: (i) financial covenants that require us to maintain a minimum
dollar amount of stockholders’ equity or tangible net worth, at December 31, 2017 our level of stockholders’ equity and tangible net worth resulted in our being in
compliance with these covenants by more than $200 million; and (ii) financial covenants that require us to maintain recourse indebtedness below a specified ratio,
at December 31, 2017 our level of recourse indebtedness resulted in our being in compliance with these covenants at a level such that we could incur at least $600
million in additional recourse indebtedness.
Margin
Call
Provisions
Associated
With
Short-Term
Debt
and
Other
Debt
Financing
•
Residential Loan Warehouse Facilities . As noted above, one source of our short-term debt financing is secured borrowings under residential loan
warehouse facilities we have established and, as of December 31, 2017 , were in place with four different financial institution counterparties. These
warehouse facilities include the margin call provisions described below and during the twelve months ended December 31, 2017 , and through the date of
this Annual Report on Form 10-K, we complied with any margin calls received from creditors under these warehouse facilities:
•
If at any time the market value (as determined by the creditor) of any residential mortgage loan financed under a facility declines, then the creditor
may demand that we transfer additional collateral to the creditor (in the form of cash, U.S. Treasury obligations (in certain cases), or additional
residential mortgage loans) with a value equal to the amount of the decline. If we receive any such demand, (i) under two of our residential loan
warehouse facilities, we would generally be required to transfer the additional collateral on the same day (although demands received after a certain
time would only require the transfer of additional collateral on the following business day) and (ii) under two of our residential loan warehouse
facilities, we would generally be required to transfer the additional collateral on the following business day. The value of additional residential
mortgage loans transferred as additional collateral is determined by the creditor.
89
•
•
•
Securities Repurchase Facilities . Another source of our short-term debt financing is through secured borrowings under securities repurchase facilities we
have established with various financial institution counterparties. These repurchase facilities include the margin call provisions described below and
during the twelve months ended December 31, 2017 , and through the date of this Annual Report on Form 10-K, we complied with any margin calls
received from creditors under these repurchase facilities:
•
If at any time the market value (as determined by the creditor) of any securities financed under a facility declines, then the creditor may demand that
we transfer additional collateral to the creditor (in the form of cash, U.S. Treasury obligations, or additional securities) with a value equal to the
amount of the decline. If we receive any such demand, we would generally be required to transfer the additional collateral on the same day. The value
of additional securities transferred as additional collateral is determined by the creditor.
Committed Line of Credit . As noted above, we also maintain a $10 million committed line of short-term credit from a bank, which is secured by our
pledge of certain mortgage-backed securities we own. Margin call provisions included in this bank line of credit are as follows and during the twelve
months ended December 31, 2017 , and through the date of this Annual Report on Form 10-K, we complied with any margin calls received from this
creditor under this line of credit:
•
If at any time the total market value (as determined by two broker-dealers) of the securities that are pledged as collateral under this facility declines to
a value less than the outstanding amount of borrowings under this facility, then the creditor may demand that we transfer additional collateral to the
creditor (in the form of cash, U.S. Treasury obligations, or additional securities) with a value equal to the amount of the difference. If we receive any
such demand, we would generally be required to transfer the additional collateral within two business days. The value of additional collateral pledged
is determined by the creditor.
FHLB Borrowing Facility . As noted above, a wholly-owned subsidiary of ours, RWT Financial, also maintains a borrowing facility with the FHLBC,
borrowings under which are required to be secured by eligible collateral including, but not limited to, residential mortgage loans and residential mortgage-
backed securities. This facility includes the margin call provisions described below during the twelve months ended December 31, 2017 , and through the
date of this Annual Report on Form 10-K, we complied with any margin calls received from the creditor under this facility.
•
If at any time the aggregate market value (as determined by the FHLBC) of the residential mortgage loans and residential mortgage-backed securities
pledged as collateral under this facility declines to a value less than the required collateral level, or if any collateral ceases to be qualifying collateral
under the terms of this facility, we would be required to promptly deliver additional collateral sufficient to maintain the required collateral level. The
value of additional loans or securities transferred as additional collateral is determined by the FHLBC.
90
OFF BALANCE SHEET ARRANGEMENTS AND CONTRACTUAL OBLIGATIONS
Off Balance Sheet Arrangements
We do not have any material off balance sheet arrangements.
Contractual Obligations
The following table presents our contractual obligations and commitments at December 31, 2017 , as well as the obligations of the securitization entities that
we consolidate for financial reporting purposes.
Table 38 – Contractual Obligations and Commitments
December 31, 2017
(In Millions)
Obligations of Redwood
Short-term debt
Convertible notes
Anticipated interest payments on convertible notes
FHLBC borrowings
Anticipated interest payments on FHLBC borrowings
Other long-term debt
Anticipated interest payments on other long-term debt (1)
Accrued interest payable
Operating leases
Total Redwood Obligations and Commitments
$
2,037
Obligations of Consolidated Entities for Financial Reporting
Purposes
Consolidated ABS (2)
Anticipated interest payments on ABS (3)
$
Accrued interest payable
Total Obligations of Entities Consolidated for Financial Reporting
Purposes
—
41
3
44
$
$
Payments Due or Commitment Expiration by Period
Less Than
1 Year
1 to 3
Years
3 to 5
Years
After 5
Years
Total
$
1,688 $
— $
— $
— $
1,688
250
29
—
43
—
9
16
2
201
35
—
100
—
19
—
4
359
—
82
—
82
$
$
—
23
—
102
—
19
—
3
147
—
76
—
76
245
12
2,000
142
140
133
—
9
696
99
2,000
387
140
180
16
18
$
$
2,681 $
5,224
1,218 $
1,218
391
—
1,609
590
3
1,811
7,035
Total Consolidated Obligations and Commitments
$
2,081
$
441
$
223
$
4,290 $
(1)
Includes anticipated interest payments related to hedges.
(2) All consolidated ABS issued are collateralized by real estate loans. Although the stated maturity is as shown, the ABS obligations will pay down as the principal balances of
these real estate loans or securities pay down. The amount shown is the principal balance of the ABS issued and not necessarily the value reported in our consolidated
financial statements.
(3) The anticipated interest payments on consolidated ABS issued is calculated based on the contractual maturity of the ABS and therefore assumes no prepayments of the
principal outstanding at December 31, 2017 .
91
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reported periods. Actual results could
differ from those estimates. A discussion of critical accounting policies and the possible effects of changes in estimates on our consolidated financial statements is
included in Note
2
—
Basis
of
Presentation
and
Note
3
—
Summary
of
Significant
Accounting
Policies
included in Part II, Item 8 of this Annual Report on Form
10-K. Management discusses the ongoing development and selection of these critical accounting policies with the audit committee of the board of directors.
We expect quarter-to-quarter GAAP earnings volatility from our business activities. 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, increases or decreases in
earnings from mortgage banking activities, and certain non-recurring events. In addition, the amount or timing of our reported earnings may be impacted by
technical accounting issues and estimates, some of which are described below.
Changes in the Fair Value of Loans Held at Fair Value
Our loans held-for-sale on our consolidated balance sheet at December 31, 2017 , were being held-for-sale or future securitization and were expected to be
sold to third parties or securitization entities. At the time of purchase or origination, we typically elect the fair value option for these loans. Additionally, we have
elected the fair value option for most of our residential loans held-for-investment. For residential loans for which we have elected the fair value option, changes in
fair values are recorded in Mortgage banking activities, net or Investment fair value changes, net on our consolidated statements of income in the period in which
the valuation change occurs. Periodic fluctuations in the values of these investments are inherently volatile and thus can lead to significant period-to-period GAAP
earnings volatility.
The fair value of loans is affected by, among other things, changes in interest rates, credit performance, prepayments, and market liquidity. To the extent
interest rates change or market liquidity and or credit conditions materially change, the value of these loans could decline, which could have a material effect on
reported earnings.
Changes in Fair Values of Securities
Our securities are classified as either trading or 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 Investment fair value changes, net on our consolidated statements of income in the period in which the
valuation change occurs. Periodic fluctuations in the values of these investments are inherently volatile and thus can lead to significant period-to-period GAAP
earnings volatility.
For AFS securities, cumulative unrealized gains and losses are recorded as a component of Accumulated other comprehensive income in our consolidated
balance sheets. Unrealized gains are not credited to current earnings and unrealized losses are not charged against current earnings to the extent they are temporary
in nature. Certain factors may require us, however, to recognize declines in the values of AFS securities 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 AFS securities, 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 on AFS securities can lead to significant period-to-period GAAP earnings volatility. In addition, sales of securities in large unrealized gain or
loss positions that are not impaired can lead to significant period-to-period GAAP earnings volatility.
Changes in Fair Values of Mortgage Servicing Rights
Mortgage servicing rights are carried on our consolidated balance sheets at their estimated fair values, with changes in fair values recorded in the consolidated
statements of income as a component of MSR income (loss), net. Periodic fluctuations in the values of our mortgage servicing rights can be caused by actual
prepayments on the underlying loans, changes in assumptions regarding future projected prepayments on the underlying loans, or changes in the discount rate
assumptions used to value mortgage servicing rights. Periodic fluctuations in the values of these investments are inherently volatile and can lead to significant
period-to-period GAAP earnings volatility.
92
Changes in Fair Values of Derivative Financial Instruments
We generally use derivatives as part of our mortgage banking activities (e.g., to manage risks associated with loans we plan to acquire and subsequently sell or
securitize), in relation to our residential investments (to manage risks associated with our securities, MSRs, and held-for-investment loans), and to manage
variability in debt interest expense indexed to adjustable rates, and 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 therefore lead to volatility in our periodic earnings, even when we are meeting our hedging objectives.
Some of our derivatives are accounted for as trading instruments with all associated changes in value recorded through our consolidated statements of income.
Changes in value of the assets and liabilities we manage by using derivatives may not be accounted for similarly. This could lead to reported income and book
values in specific periods that do not necessarily reflect the economics of our risk management strategy. Even when the assets and liabilities are similarly
accounted for as trading instruments, periodic changes in their values 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 Mortgage Banking Income
The amount of income that can be earned from mortgage banking activities is primarily dependent on the volume of loans we are able to acquire and any
potential profit we earn upon the sale or securitization of these loans. Our ability to acquire loans and the volume of loans we acquire is dependent on many factors
that are beyond our control, including general economic conditions and changes in interest rates, loan origination volumes industry-wide and at the sellers we
purchase our loans from, increased regulation, and competition from other financial institutions. Our profitability from mortgage banking activities is also
dependent on many factors, including our ability to effectively hedge certain risks related to changes in interest rates and other factors that are beyond our control,
including changes in market credit risk pricing. Additionally, our income from mortgage banking activities is generally generated over the period from when we
identify a loan for purchase until we subsequently sell or securitize the loan. This income may encompass positive or negative market valuation adjustments on
loans, hedging gains or losses associated with related risk management activities, and any other related transaction expenses, and may be realized unevenly over
the course of one or more quarters for financial reporting purposes. Additional factors that could impact our profitability are discussed in Part I, Item 1A - Risk
Factors
of this Annual Report on Form 10-K and above, under the headings “ Changes
in
the
Fair
Value
of
Loans
Held
at
Fair
Value
” and “ Changes
in
Fair
Values
of
Derivative
Financial
Instruments
.” Changes in the volumes of loans acquired or originated in connection with our mortgage banking activities and our
profitability on these activities can lead to significant period-to-period GAAP earnings volatility.
Changes in Yields for Securities
The yields we project on available-for-sale real estate securities can have a significant 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 principal balance), 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 principal balance), 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 10 years. There is 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 any change could be material.
93
Changes in Loss Contingency Reserves
We may be exposed to various loss contingencies, including, without limitation, those described in Note
14
to the consolidated financial statements included in
Part II, Item 8 of this Annual Report on Form 10-K. In accordance with FASB guidance on accounting for contingencies, we review the need for any loss
contingency reserves and establish them when, in the opinion of management, it is probable that a matter would result in a liability, and the amount of loss, if any,
can be reasonably estimated. The establishment of a loss contingency reserve, the subsequent increase in a reserve or release of reserves previously established, or
the recognition of a loss in excess of previously established reserves, can occur as a result of various factors and events that affect management’s opinion of
whether the standard for establishing, increasing, or continuing to maintain, a reserve has been met. Changes in the loss contingency reserves can lead to significant
period-to-period GAAP earnings volatility.
Changes in Provision for Taxes
Our provision for income taxes is primarily the result of GAAP income or losses generated at our TRS. Deferred tax assets/liabilities are generated by
temporary differences in GAAP income and taxable income at our taxable subsidiaries and are a significant component of our GAAP provision for income taxes.
In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be
realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary
differences become deductible. We consider historical and projected future taxable income and capital gains as well as tax planning strategies in making this
assessment. We determine the extent to which realization of this deferred asset is not assured and establish a valuation allowance accordingly. The estimate of net
deferred tax assets and associated valuation allowances could change in future periods to the extent that actual or revised estimates of future taxable income during
the carry-forward periods change from current expectations, causing significant period-to-period GAAP earnings volatility.
Market Risks
We seek to manage 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. Information concerning the risks we are
managing, how these risks are changing over time, and potential GAAP earnings and taxable income volatility we may experience as a result of these risks is
discussed under the caption “ Risk
Factors
” of this Annual Report on Form 10-K, under the caption " Risks
Relating
to
Debt
Incurred
under
Short-
and
Long-Term
Borrowing
Facilities
" within this MD&A, and under the caption " Quantitative
and
Qualitative
Disclosures
About
Market
Risk"
of this Annual Report on Form
10-K .
Other Risks
In addition to the market and other risks described above, our business and results of operations are subject to a variety of types of risks and uncertainties,
including, among other things, those described under the caption “ Risk
Factors
” of this Annual Report on Form 10-K.
NEW ACCOUNTING STANDARDS
A discussion of new accounting standards and the possible effects of these standards on our consolidated financial statements is included in Note
3
—
Summary
of
Significant
Accounting
Policies
included in Part II, Item 8 of this Annual Report on Form 10-K.
94
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market Risks
We seek to manage risks inherent in our business - including but not limited to credit risk, interest rate risk, prepayment risk, inflation risk, and fair value and
liquidity 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. This section presents a general
overview of these risks. Additional information concerning the risks we are managing, how these risks are changing over time, and potential GAAP earnings and
taxable income volatility we may experience as a result of these risks is further discussed in Part I, Item 1A and Part II, Item 7 of this Annual Report on Form 10-
K.
Credit Risk
Integral to our business is assuming credit risk through our ownership of real estate loans, securities and other investments as well as through our reliance on
the creditworthiness of business counterparties. We believe the securities and loans we purchase are priced to generate an expected return that compensates us for
the underlying credit risk associated with these investments. Nevertheless, there may be significant credit losses associated with these investments should they
perform worse than we expect on a credit basis. For additional details, refer to Part I, Item 1A of this Annual Report on Form 10-K and see the risk factor titled
“The
nature
of
the
assets
we
hold
and
the
investments
we
make
expose
us
to
credit
risk
that
could
negatively
impact
the
value
of
those
assets
and
investments,
our
earnings,
dividends,
cash
flows,
and
access
to
liquidity,
or
otherwise
negatively
affect
our
business.”
We manage our credit risks by analyzing the extent of the risk we are taking and reviewing whether we believe the appropriate underwriting criteria are met,
and we utilize systems and staff to monitor the ongoing credit performance of our loans and securities. To the extent we find the credit risks on specific assets are
changing adversely, we may be able to take actions, such as selling the affected investments, to mitigate potential losses. However, we may not always be
successful in analyzing risks, reviewing underwriting criteria, 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.
Residential
Loans
and
Securities
Our residential loans and securities backed by residential loans are generally secured by real property. Credit losses on real estate loans and securities can
occur for many reasons, including: poor origination practices; fraud; poor underwriting; poor servicing practices; weak economic conditions; increases in payments
required to be made by borrowers; declines in the value of real estate; natural disasters, the effects of climate change (including flooding, drought, and severe
weather) and other natural events; uninsured property loss; over-leveraging of the borrower; costs of remediation of environmental conditions, such as indoor
mold; acts of war or terrorism; changes in legal protections for lenders and other changes in law or regulation; and personal events affecting borrowers, such as
reduction in income, job loss, divorce, or health problems. In addition, if the U.S. economy or the housing market were to weaken (and that weakening was in
excess of what we anticipated), credit losses could increase beyond levels that we have anticipated.
With respect to most of the legacy Sequoia securitization entities sponsored by us that we consolidate 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 that can lead to
additional credit losses.
We may also own some securities backed by loans that are not prime quality such as re-performing loans, Alt-A quality loans (and, to a lesser degree, some
backed by subprime loans) that have substantially higher credit risk characteristics than prime-quality loans. Consequently, we can expect these lower credit-
quality loans to have higher rates of delinquency and loss, and if such losses differ from our assumptions, we could incur credit losses. In addition, we may invest
in riskier loan types with the potential for 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.
Additionally, we own residential mortgage credit risk transfer (or "CRT") securities issued by Fannie Mae and Freddie Mac ("the Agencies"), for which we
assume credit risk both on the residential loans that the securities reference, as well as corporate credit risk from the Agencies, as our investments in the securities
are not secured by the reference loans.
95
Commercial/Multifamily
Securities
The commercial/multifamily securities we invest in are primarily subordinate positions in securitizations sponsored by Freddie Mac that are comprised of
loans collateralized by multifamily properties. We may also invest in other third-party sponsored commercial mortgage backed securities. Credit losses on
commercial/multifamily securities 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 properties; declining rents on single and multifamily
residential rental 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; and changes in legal protections for lenders. In addition, if the U.S. economy or were to weaken (and
that weakening was in excess of what we anticipated), credit losses could increase beyond levels that we have anticipated.
Counterparties
We are also exposed to credit risk with respect to our business and lender counterparties. For example, counterparties we acquire loans from, lend to, or invest
in, make representations and warranties and covenants to us, and may also indemnify us against certain losses. To the extent we have suffered a loss and are
entitled to enforce those agreements to recover damages, if our counterparties are insolvent or unable or unwilling to comply with these agreements we would
suffer a loss due to the credit risk associated with our counterparties. As an example, under short-term borrowing facilities and certain swap and other derivative
agreements, we sometimes transfer assets as collateral to our counterparties. To the extent a counterparty is not able to return this collateral to us if and when we
are entitled to its return, we could suffer a loss due to the credit risk associated with that counterparty.
In addition, because we rely on the availability of credit under committed and uncommitted borrowing facilities to fund our business and investments, our
counterparties’ willingness and ability to extend credit to us under these facilities is a significant counterparty risk (and is discussed further below under the
heading “Fair Value and Liquidity Risks”).
Interest Rate Risk
Changes in interest rates and the shape of the yield curve can affect the cash flows and fair values of our assets, liabilities, and derivative financial instruments
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) that assumes some interest rate risks but not to such a degree that the achievement of our long-term goals would likely be adversely 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. For additional details, refer to Part I, Item 1A of this Annual Report on Form 10-K and see the risk factor titled “Interest
rate
fluctuations
can
have
various
negative
effects
on
us
and
could
lead
to
reduced
earnings
and
increased
volatility
in
our
earnings.”
We invest in securities, residential loans, and MSRs, which all expose us to interest rate risk. Additionally, we purchase residential loans from third parties,
then sell or securitize these assets. We are exposed to interest rate risk during the “accumulation” period - the period from when we enter into agreements to
purchase the loans with the intention of selling or securitizing them at a future date.
To mitigate this interest rate risk, we use derivative financial instruments for risk management purposes. We may also use derivative financial instruments in
an effort to maintain a close match between pledged assets and debt. 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.
Prepayment Risk
Prepayment risks exist in many of the assets on our consolidated balance sheets. In general, discount securities benefit from faster prepayment rates on the
underlying real estate loans while premium securities (such as IOs), and MSRs benefit from slower prepayments on the underlying loans. In addition, loans held
for investment at premiums also benefit from slower prepayments. For additional details, refer to Part I, Item 1A of this Annual Report on Form 10-K and see the
risk factor titled “Changes
in
prepayment
rates
of
mortgage
loans
could
reduce
our
earnings,
dividends,
cash
flows,
and
access
to
liquidity.”
When we make investments that are subject to prepayment risk, we apply a reasonable baseline prepayment range in determining expected returns. If actual
prepayment rates deviate from our baseline expectations, it could have an adverse change to our expected returns. In order to mitigate this risk, we may use
derivative financial instruments. We caution that prepayment rates are difficult to predict or anticipate, and adverse changes in the rate of prepayment could reduce
our cash flows, earnings, and dividends.
96
Inflation Risk
Virtually all of our consolidated assets and liabilities are financial in nature. As a result, changes in interest rates and other factors drive our performance more
directly than does inflation. That said, changes in interest rates generally correlate with inflation rates or changes in inflation rates, and therefore adverse changes in
inflation or changes in inflation expectations can lead to lower returns on our investments than originally anticipated.
Our consolidated 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.
Fair Value and Liquidity Risks
To fund our assets we may use a variety of debt alternatives in addition to equity capital that present us with fair value and liquidity risks. We seek to manage
these risks, including by maintaining what we believe to be adequate cash and capital levels.
We acquire residential loans and then sell or securitize them as part of our mortgage banking operations. Changes in the fair value of the loans, once sold or
securitized, do not have an impact on our liquidity. However, changes in fair values during the accumulation period (while these loans are typically funded with
short-term debt before they are sold or securitized) may impact our liquidity. We also own residential loans that are held-for-investment and may be financed with
borrowings from the FHLBC or funded with short-term debt. We would be exposed to liquidity risk to the extent the values of these loans decline and/or the
counterparties we use to finance these investments adversely change our borrowing requirements. We attempt to mitigate our liquidity risk from FHLBC
borrowings and short-term financing facilities by setting aside adequate capital, in addition to amounts required by our financing counterparties.
Many of the securities we acquire are funded with a combination of our capital and short-term debt facilities. For the securities we acquire with a combination
of capital and short-term debt, we would be exposed to liquidity risk to the extent the values of these investments decline and/or the counterparties we use to
finance these investments adversely change our borrowing requirements. We attempt to mitigate our liquidity risk from short-term financing facilities by setting
aside adequate capital.
Under our borrowing facilities, interest rate swaps and other derivatives agreements, we pledge assets as security for our payment obligations and make
various representations and warranties and agree to certain covenants, events of default, and other terms. In addition, our borrowing facilities are generally
uncommitted, meaning that each time we request a new borrowing under a facility the lender has the option to decline to extend credit to us. The terms of these
facilities and agreements typically include financial covenants (such as covenants to maintain a minimum amount of tangible net worth or stockholders’ equity
and/or a minimum amount of liquid assets and/or a maximum amount of recourse debt to equity), margin requirements (which typically require us to pledge
additional collateral if and when the value of previously pledged collateral declines), operating covenants (such as covenants to conduct our business in accordance
with applicable laws and regulations and covenants to provide notice of certain events to creditors), representations and warranties (such as representations and
warranties relating to characteristics of pledged collateral, our exposure to litigation and/or regulatory enforcement actions and the absence of material adverse
changes to our financial condition, our operations, or our business prospects), and events of default (such as a breach of covenant or representation/warranty and
cross-defaults, under which an event of default is triggered under a credit facility if an event of default or similar event occurs under another credit facility). For
additional details, refer to Part II, Item 7 of this Annual Report on Form 10-K and see the discussion titled “Risks
Relating
to
Debt
Incurred
under
Short-
and
Long-Term
Borrowing
Facilities.”
Quantitative Information on Market Risk
Our future earnings are sensitive to a number of market risk factors and changes in these factors may have a variety of secondary effects that, in turn, will also
impact our earnings and equity. To supplement the discussion above of the market risks we face, the following table incorporates information that may be useful in
analyzing certain market risks that may affect our consolidated balance sheet at December 31, 2017 . The table presents principal cash flows and related average
interest rates by year of repayment. The forward curve (future interest rates as implied by the yield structure of debt markets) at December 31, 2017 , was used to
project the average coupon rates for each year presented. The timing of principal cash flows includes assumptions on the prepayment speeds of assets based on
their recent prepayment performance and future prepayment performance consistent with the forward curve. Our future results depend greatly on the credit
performance of the underlying loans (this table assumes no credit losses), future interest rates, prepayments, and our ability to invest our existing cash and future
cash flow.
97
Quantitative Information on Market Risk
Principal Amounts Maturing and Effective Rates During Period
(Dollars in Thousands)
2018
2019
2020
2021
2022
Thereafter
December 31, 2017
Principal
Balance
Fair
Value
Interest rate sensitive assets
Residential loans - HFI at
Redwood
Fixed Rate
Principal
$
251,301
$
236,809
$
223,153
$
210,285
$
198,159
$
1,084,825
$ 2,204,532 $ 2,229,615
Interest Rate
4.08%
4.08%
4.08%
4.08%
4.08%
4.08%
Hybrid
Principal
32,341
28,978
25,965
23,265
20,846
72,066
203,461
204,771
Interest Rate
4.07%
4.07%
4.07%
4.07%
4.07%
4.07%
209,625
159,484
121,856
92,861
70,443
43,653
697,922
632,817
3.18%
3.65%
3.79%
3.83%
3.86%
3.88%
128,529
101,600
80,262
63,355
49,967
181,034
604,747
620,062
4.97%
4.98%
4.98%
4.98%
4.98%
4.98%
Residential loans - HFI at
Sequoia
Adjustable Rate Principal
Fixed Rate
Interest Rate
Principal
Interest Rate
Residential loans - HFS (1)
Adjustable Rate Principal
Interest Rate
444
2.32%
Fixed Rate
Principal
1,329,851
Interest Rate
Hybrid
Principal
Interest Rate
Residential Senior Securities
Adjustable Rate Principal
Interest Rate
Fixed Rate (2)
Principal
Interest Rate
Hybrid
Principal
Interest Rate
Residential Re-
REMIC Securities
Fixed Rate
Principal
Interest Rate
Hybrid
Principal
Interest Rate
Residential Subordinate
Securities
Adjustable Rate Principal
Interest Rate
4.18%
78,884
3.52%
7,954
3.58%
3,470
1.99%
8,135
3.34%
108
5.60%
555
3.93%
49
3.81%
—
N/A
—
N/A
—
N/A
6,666
3.99%
3,045
1.94%
7,665
3.51%
860
5.62%
2,464
4.39%
—
N/A
—
N/A
—
N/A
5,695
4.13%
2,708
1.93%
7,263
3.55%
711
5.62%
2,593
4.52%
—
N/A
—
N/A
—
N/A
4,868
4.31%
2,443
1.94%
7,057
3.57%
1,259
5.64%
2,181
4.68%
—
N/A
—
N/A
—
N/A
4,173
4.38%
2,244
1.94%
6,829
3.59%
1,299
5.64%
1,843
4.75%
—
N/A
444
298
—
1,329,851
1,348,300
N/A
—
78,884
79,347
N/A
20,295
49,651
48,444
4.45%
9,955
23,865
92,949
1.94%
34,047
70,996
69,570
3.61%
23,202
27,439
22,474
5.65%
7,538
17,174
16,401
4.83%
41
3.82%
35
3.83%
29
3.84%
25
3.84%
3,505
3.84%
3,684
2,708
Fixed Rate
Principal
24,826
28,180
31,893
31,849
35,837
786,179
938,764
845,717
Interest Rate
Hybrid
Principal
Interest Rate
4.89%
4,620
3.37%
4.98%
4,192
3.52%
5.01%
3,912
3.66%
4.97%
3,219
3.90%
5.00%
3,391
4.14%
5.02%
57,225
76,559
54,222
4.39%
98
Quantitative Information on Market Risk
Principal Amounts Maturing and Effective Rates During Period
(Dollars in Thousands)
2018
2019
2020
2021
2022
Thereafter
December 31, 2017
Principal
Balance
Fair
Value
Interest rate sensitive assets (continued)
Multifamily Securities
Adjustable Rate
Principal
$
14,460
$
10,124
$
6,473
$
3,692
$
3,803
$
79,480
$
118,032 $
119,801
Interest Rate
Fixed Rate
Principal
Interest Rate
Interest rate sensitive liabilities
Asset-backed securities issued
Sequoia Entities
5.20%
—
3.89%
5.51%
—
3.89%
5.62%
—
3.89%
5.65%
—
3.89%
5.71%
—
3.89%
5.77%
221,300
221,300
204,224
3.89%
Adjustable Rate
Principal
175,607
133,512
101,571
77,037
58,112
145,286
691,125
622,445
Interest Rate
2.40%
2.80%
2.96%
3.01%
3.05%
3.05%
Fixed Rate
Principal
123,867
97,669
76,898
60,427
46,757
121,039
526,657
542,140
Interest Rate
Short-term Debt
Principal
Long-term Debt
FHLBC
Borrowings
Interest Rate
Principal
Interest Rate
Convertible Notes
Principal
Other long-
term debt
Interest Rate
Principal
Interest Rate
Interest rate agreements
Interest Rate Swaps
(Purchased)
(Sold)
Notional
Amount
Receive Strike Rate
Pay Strike Rate
Notional
Amount
Receive Strike Rate
Pay Strike Rate
3.96%
1,938,853
3.60%
3.96%
—
N/A
—
2.14%
—
2.45%
—
200,765
5.48%
5.48%
—
6.75%
—
6.75%
3.97%
—
N/A
—
2.54%
—
5.33%
—
6.75%
3.97%
—
N/A
—
2.53%
—
5.33%
—
6.75%
3.98%
—
N/A
—
2.58%
—
5.33%
—
6.75%
3.98%
—
1,938,853
1,939,056
N/A
1,999,999
1,999,999
1,999,999
2.66%
245,000
445,765
441,724
5.33%
139,500
139,500
101,138
6.75%
—
453,000
560,000
232,000
556,000
956,500
2,757,500
(37,175)
1.94%
2.04%
—
1.78%
1.94%
2.25%
2.13%
—
1.78%
2.25%
2.34%
2.17%
60,000
1.78%
2.34%
2.33%
2.19%
—
1.84%
2.33%
2.38%
2.29%
2.65%
2.30%
100,000
235,000
395,000
(8,270)
1.84%
2.38%
1.95%
2.65%
(1) As we generally expect our residential loans held-for-sale to be sold within one year, we have only presented principal amounts and effective rates through 2018.
(2) The fair value of fixed-rate senior securities includes $69 million of interest-only securities, for which there is no principal at December 31, 2017.
99
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements of Redwood Trust, Inc. and Notes thereto, together with the Reports of Independent Registered Public Accounting
Firm thereon, are set forth on pages F-1 through F-82 of this Annual Report on Form 10-K and incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A. CONTROLS AND PROCEDURES
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 evaluating 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 fourth quarter of 2017 that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting.
Management of Redwood Trust, Inc., together with its consolidated subsidiaries (the company, or Redwood), is responsible for establishing and maintaining
adequate internal control over financial reporting. Our internal control over financial reporting is a process designed under the supervision of our chief executive
officer and chief financial officer to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our consolidated financial
statements for external reporting purposes in accordance with U.S. generally accepted accounting principles (GAAP).
As of the end of our 2017 fiscal year, management conducted an assessment of the effectiveness of our internal control over financial reporting based on the
framework established in Internal Control - Integrated Framework released by the Committee of Sponsoring Organizations of the Treadway Commission (COSO)
in 2013. Based on this assessment, management has determined that the company’s internal control over financial reporting as of December 31, 2017 , was
effective.
Our internal control over financial reporting includes policies and procedures that pertain to the maintenance of records that, in reasonable detail, accurately
and fairly reflect transactions and dispositions of assets; provide reasonable assurances that transactions are recorded as necessary to permit preparation of financial
statements in accordance with GAAP, and that receipts and expenditures are being made only in accordance with authorizations of management and the board of
directors of Redwood; and provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that
could have a material effect on our consolidated financial statements.
The company’s internal control over financial reporting as of December 31, 2017 , has been audited by Grant Thornton LLP, an independent registered public
accounting firm, as stated in their report appearing on page F-4, which expresses an unqualified opinion on the effectiveness of the company’s internal control over
financial reporting as of December 31, 2017 .
ITEM 9B. OTHER INFORMATION
There is no information required to be disclosed in a report on Form 8-K during the fourth quarter of the year covered by this Annual Report on Form 10-K
that has not been so reported.
100
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
The information required by Item 10 is incorporated herein by reference to the definitive Proxy Statement to be filed with the SEC pursuant to Regulation 14A
within 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K.
ITEM 11. EXECUTIVE COMPENSATION
Under SEC regulations, Redwood had six Named Executive Officers (NEOs) for 2017 , which are listed below with their current titles:
• Martin S. Hughes, Chief Executive Officer
•
•
•
•
•
Christopher J. Abate, President
Dashiell I. Robinson, Executive Vice President
Andrew P. Stone, Executive Vice President, General Counsel, and Secretary
Collin L. Cochrane, Chief Financial Officer
Garnet Kanouse, Managing Director, Head of Residential
2017 Performance-Based Annual Bonus Compensation
Redwood’s compensation program is designed to reward NEOs based on Redwood’s financial performance and each NEO’s individual performance,
including each NEO’s contribution to Redwood’s performance.
During the first quarter of 2017 , after a review of Redwood's compensation program, and with input and guidance from its independent compensation
consultant, Frederic W. Cook & Co., Inc. (Cook & Co.), the Compensation Committee of the Board of Directors determined to continue to use in 2017 a formula
for performance-based annual bonus compensation based on a non-GAAP ROE-based performance metric, as in prior years. The non-GAAP ROE-based financial
performance measure reflects GAAP earnings on average equity capital adjusted to exclude accumulated other comprehensive income, which is referred to as
"Adjusted ROE."
101
Performance-Based Annual Bonuses Earned for 2017 . Annual performance-based bonuses earned by NEOs for 2017 consisted of both a company
performance component and an individual performance component. With respect to 2017 company performance bonuses for NEOs, target bonus amounts would
be earned if Adjusted ROE equaled 9.00%, which represented a level of financial performance commensurate with earnings exceeding the Board of Directors'
annual dividend policy for 2017. For 2017, based on the performance-based annual bonus formula approved by the Compensation Committee, Redwood's actual
financial performance exceeded the target level of performance. The total performance-based annual bonuses earned by the NEOs for 2017 are set forth in the table
below.
NEO
Mr. Hughes, (1)
Chief Executive Officer
Mr. Abate, (2)
President
Mr. Robinson, (3)
Executive Vice President
Mr. Stone, (2)
Executive Vice President and General Counsel
Mr. Cochrane, (2)
Chief Financial Officer
Mr. Kanouse, (2)
Managing Director, Head of Residential
2017 Company
Performance
Component of Annual
Bonus Earned
($)
2017 Individual
Performance
Component of Annual
Bonus Earned
($)
2017 Performance-
Based Annual Bonuses
Earned ($)
$
$
$
$
$
$
2,303,481 $
656,250 $
2,959,731
1,447,903 $
206,250 $
1,654,153
— $
— $
1,000,000
772,215 $
110,000 $
882,215
607,315 $
86,510 $
693,825
877,517 $
187,500 $
1,065,017
——————
(1) For 2017, it was determined that any portion of the CEO's performance-based annual bonus which exceeded his target annual bonus would not be fully paid in cash, but
would instead be paid 50% in cash and 50% in the form of vested deferred stock units ("DSUs") with a mandatory three-year holding period. Accordingly, in 2017, Mr.
Hughes earned $2,136,115 in cash, and $823,616 in the form of vested DSUs for his performance-based annual bonus.
(2) For 2017, it was determined that any portion of an NEO’s performance-based annual bonus which exceeded two times the target annual bonus would not be fully paid in
cash, but would instead be paid 50% in cash and 50% in the form of vested deferred stock units with a mandatory three-year holding period, except with respect to the CEO,
who is subject to further limitations as described above in Footnote (1), and with respect to Mr. Robinson, as described below in Footnote (3). Accordingly, in 2017, Mr.
Abate, Mr. Stone, and Mr. Cochrane each earned a portion (less than $2,500 each) of the performance-based annual bonus amounts indicated in the table above in the form
of vested DSUs, and Mr. Kanouse earned $1,032,509 in cash and $32,508 in the form of vested DSUs for his performance-based annual bonus.
(3)
In connection with Mr. Robinson's commencement of employment with Redwood in September 2017, he entered into an employment agreement with the Company that
provided for a pre-negotiated total 2017 year-end cash bonus in the amount of $1 million as an inducement to join Redwood.
Other Information . Other information required by Item 11 is incorporated herein by reference to the definitive Proxy Statement to be filed with the SEC
pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K.
102
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by Item 12 is incorporated herein by reference to the definitive Proxy Statement to be filed with the SEC pursuant to Regulation 14A
within 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required by Item 13 is incorporated herein by reference to the definitive Proxy Statement to be filed with the SEC pursuant to Regulation 14A
within 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by Item 14 is incorporated herein by reference to the definitive Proxy Statement to be filed with the SEC pursuant to Regulation 14A
within 120 days after the end of the fiscal year covered by this Annual Report on Form 10-K.
103
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES
Documents filed as part of this report:
(1)
(2)
Consolidated Financial Statements and Notes thereto
Schedules to Consolidated Financial Statements: Schedule IV - Mortgage Loans on Real Estate
PART IV
All other Consolidated Financial Statements schedules not included have been omitted because they are either inapplicable or the information required is
provided in the Company’s Consolidated Financial Statements and Notes thereto, included in Part II, Item 8, of this Annual Report on Form 10-K.
(3)
Exhibits:
Exhibit
Number
3.1
3.1.1
3.1.2
3.1.3
3.1.4
3.1.5
3.1.6
3.1.7
3.1.8
3.1.9
3.1.10
3.2.1
3.2.2
4.1
4.2
4.3
Exhibit
Articles of Amendment and Restatement of the Registrant, effective July 6, 1994 (incorporated by reference to the Registrant’s Quarterly
Report on Form 10-Q, Exhibit 3.1, filed on August 6, 2008)
Articles Supplementary of the Registrant, effective August 10, 1994 (incorporated by reference to the Registrant’s Quarterly Report on Form
10-Q, Exhibit 3.1.1, filed on August 6, 2008)
Articles Supplementary of the Registrant, effective August 11, 1995 (incorporated by reference to the Registrant’s Quarterly Report on Form
10-Q, Exhibit 3.1.2, filed on August 6, 2008)
Articles Supplementary of the Registrant, effective August 9, 1996 (incorporated by reference to the Registrant’s Quarterly Report on Form
10-Q, Exhibit 3.1.3, filed on August 6, 2008)
Certificate of Amendment of the Registrant, effective June 30, 1998 (incorporated by reference to the Registrant’s Quarterly Report on Form
10-Q, Exhibit 3.1.4, filed on August 6, 2008)
Articles Supplementary of the Registrant, effective April 7, 2003 (incorporated by reference to the Registrant’s Quarterly Report on Form 10-
Q, Exhibit 3.1.5, filed on August 6, 2008)
Articles of Amendment of the Registrant, effective June 12, 2008 (incorporated by reference to the Registrant’s Quarterly Report on Form 10-
Q, Exhibit 3.1.6, filed on August 6, 2008)
Articles of Amendment of the Registrant, effective May 19, 2009 (incorporated by reference to the Registrant’s Current Report on Form 8-K,
Exhibit 3.1, filed on May 21, 2009)
Articles of Amendment of the Registrant, effective May 24, 2011 (incorporated by reference to the Registrant’s Current Report on Form 8-K,
Exhibit 3.1, filed on May 20, 2011)
Articles of Amendment of the Registrant, effective May 18, 2012 (incorporated by reference to the Registrant’s Current Report on Form 8-K,
Exhibit 3.1, filed on May 21, 2012)
Articles of Amendment of the Registrant, effective May 16, 2013 (incorporated by reference to the Registrant’s Current Report on Form 8-K,
Exhibit 3.1, filed on May 21, 2013)
Amended and Restated Bylaws of the Registrant, as adopted on March 5, 2008 (incorporated by reference to the Registrant’s Current Report
on Form 8-K, Exhibit 3.1, filed on March 11, 2008)
First Amendment to Amended and Restated Bylaws of the Registrant, as adopted on May 17, 2012 (incorporated by reference to the
Registrant’s Current Report on Form 8-K, Exhibit 3.2, filed on May 21, 2012)
Form of Common Stock Certificate (incorporated by reference to the Registrant’s Registration Statement on Form S-11 (No. 333-08363),
Exhibit 4.3, filed on August 6, 1996)
Indenture dated as of October 1, 2001 between Sequoia Mortgage Trust 5 and Bankers Trust Company of California, N.A., as Trustee
(incorporated by reference to Sequoia Mortgage Funding Corporation’s Current Report on Form 8-K, Exhibit 99.1, filed on November 15,
2001)
Indenture dated as April 1, 2002 between Sequoia Mortgage Trust 6 and Deutsche Bank National Trust Company, as Trustee (incorporated by
reference to Sequoia Mortgage Funding Corporation’s Current Report on Form 8-K, Exhibit 99.1, filed on May 13, 2002)
104
Exhibit
Number
Exhibit
4.4
4.5
4.6
4.7
4.8
4.9
4.10
4.11
4.12
4.13
4.14
9.1
9.2
10.1*
10.2*
10.3*
10.4*
10.5*
Junior Subordinated Indenture dated as of December 12, 2006 between the Registrant and The Bank of New York Trust Company, National
Association, as Trustee (incorporated by reference to the Registrant’s Current Report on Form 8-K, Exhibit 1.4, filed on December 12, 2006)
Amended and Restated Trust Agreement dated December 12, 2006 among the Registrant, The Bank of New York Trust Company, National
Association, The Bank of New York (Delaware), the Administrative Trustees (as named therein) and the several holders of the Preferred
Securities from time to time (incorporated by reference to the Registrant’s Current Report on Form 8-K, Exhibit 1.3, filed on December 12,
2006)
Purchase Agreement dated December 12, 2006 among the Registrant, Redwood Capital Trust I and Merrill Lynch International (incorporated
by reference to the Registrant’s Current Report on Form 8-K, Exhibit 1.1, filed on December 12, 2006)
Purchase Agreement dated December 12, 2006 among the Registrant, Redwood Capital Trust I and Bear, Stearns & Co. Inc. (incorporated by
reference to the Registrant’s Current Report on Form 8-K, Exhibit 1.2, filed on December 12, 2006)
Subordinated Indenture dated as of May 23, 2007 between the Registrant and Wilmington Trust Company (incorporated by reference to the
Registrant’s Current Report on Form 8-K, Exhibit 1.2, filed on May 23, 2007)
Purchase Agreement dated May 23, 2007 between the Registrant and Obsidian CDO Warehouse, LLC (incorporated by reference to the
Registrant’s Current Report on Form 8-K, Exhibit 1.1, filed on May 23, 2007)
Indenture, dated as of November 28, 2012, among RCMC 2012-CREL1, LLC, as Issuer, KeyCorp Real Estate Capital Markets, Inc., as
Advancing Agent, and Wells Fargo Bank, National Association, as Trustee, Paying Agent, Transfer Agent, Custodian, Backup Advancing
Agent and Notes Registrar (incorporated by reference to the Registrant’s Current Report on Form 8-K, Exhibit 10.1, filed on December 4,
2012)
Indenture, dated March 6, 2013, between Redwood Trust, Inc. and Wilmington Trust, National Association, as Trustee (incorporated by
reference to the Registrant’s Current Report on Form 8-K/A, Exhibit 4.1, filed on March 6, 2013)
First Supplemental Indenture, dated March 6, 2013, between Redwood Trust, Inc. and Wilmington Trust, National Association, as Trustee
(including the form of 4.625% Convertible Senior Note due 2018) (incorporated by reference to the Registrant’s Current Report on Form 8-
K/A, Exhibit 4.2, filed on March 6, 2013)
Second Supplemental Indenture, dated August 18, 2017, between Redwood Trust, Inc. and Wilmington Trust, National Association, as Trustee
(including the form of 4.75% Convertible Senior Note due 2023) (incorporated by reference to the Registrant’s Current Report on Form 8-K,
Exhibit 4.2, filed on August 18, 2017)
Indenture, by and among Redwood Trust, Inc., RWT Holdings, Inc. and Wilmington Trust, National Association, as Trustee, dated as of
November 24, 2014 (including the form of 5.625% Exchangeable Senior Note due 2019) (incorporated by reference to the Registrant’s
Current Report on Form 8-K, Exhibit 4.1, filed on November 25, 2014)
Waiver Agreement dated as of November 15, 2007 between the Registrant and Davis Selected Advisors, L.P. (incorporated by reference to the
Registrant’s Annual Report on Form 10-K, Exhibit 9.1, filed on March 5, 2008)
Amendment of Waiver Agreement dated as of January 16, 2008 between Registrant and Davis Selected Advisors, L.P. (incorporated by
reference to the Registrant’s Annual Report on Form 10-K, Exhibit 9.2, filed on March 5, 2008)
2014 Incentive Award Plan (incorporated by reference to the Registrant’s Current Report on Form 8-K, Exhibit 10.1, filed on May 23, 2014)
Form of Redwood Trust, Inc. Deferred Stock Unit Award Agreement under 2014 Incentive Award Plan (2014) (incorporated by reference to
the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.2, filed on August 8, 2014)
Form of Redwood Trust, Inc. Performance Stock Unit Award Agreement under 2014 Incentive Award Plan (2014) (incorporated by reference
to the Registrant’s Current Report on Form 8-K, Exhibit 10.1, filed on December 19, 2016)
Form of Redwood Trust, Inc. Restricted Stock Award Agreement under 2014 Incentive Award Plan (2014) (incorporated by reference to the
Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.4, filed on August 8, 2014)
Amended and Restated 1994 Executive and Non-Employee Director Stock Option Plan, as last amended January 24, 2002 (incorporated by
reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.14.5, filed on May 15, 2002)
105
Exhibit
Number
10.6*
10.7*
10.8*
10.9*
10.10*
10.11*
10.12*
10.13*
10.14*
10.15*
10.16*
10.17*
10.18*
10.19*
10.20*
10.21*
10.22*
10.23*
10.24*
10.25
10.26
10.27
Exhibit
2002 Incentive Plan, as amended through May 16, 2013 (incorporated by reference to the Registrant’s Current Report on Form 8-K, Exhibit
10.1, filed on May 21, 2013)
Form of Employee Incentive Stock Option Grant Agreement under 2002 Incentive Plan (incorporated by reference to the Registrant’s Annual
Report on Form 10-K, Exhibit 10.8.1, filed on March 16, 2005)
Form of Employee Non-Qualified Stock Option Grant Agreement under 2002 Incentive Plan (incorporated by reference to the Registrant’s
Annual Report on Form 10-K, Exhibit 10.8.2, filed on filed on March 16, 2005)
Form of Amendment to Employee Non-Qualified Stock Option Grant Agreement under 2002 Incentive Plan (incorporated by reference to the
Registrant’s Current Report on Form 8-K, Exhibit 10.2, filed on November 17, 2005)
Form of Restricted Stock Award Agreement under 2002 Incentive Plan – Pre-December 2011 (incorporated by reference to the Registrant’s
Annual Report on Form 10-K, Exhibit 10.8.3, filed on March 16, 2005)
Form of Deferred Stock Unit Award Agreement under 2002 Incentive Plan – Pre-December 2011 (incorporated by reference to the
Registrant’s Current Report on Form 8-K, Exhibit 10.1, filed on December 2, 2010)
Form of Performance Stock Unit Award Agreement under 2002 Incentive Plan – Pre-December 2011 (incorporated by reference to the
Registrant’s Current Report on Form 8-K, Exhibit 10.2, filed on December 2, 2010)
Form of Restricted Stock Award Agreement under 2002 Incentive Plan (incorporated by reference to the Registrant’s Current Report on Form
8-K, Exhibit 10.3, filed on December 8, 2011)
Form of Deferred Stock Unit Award Agreement under 2002 Incentive Plan (incorporated by reference to the Registrant’s Current Report on
Form 8-K, Exhibit 10.1, filed on December 8, 2011)
Form of Performance Stock Unit Award Agreement under 2002 Incentive Plan – December 2011 (incorporated by reference to the
Registrant’s Current Report on Form 8-K, Exhibit 10.2, filed on December 8, 2011)
Form of Performance Stock Unit Award Agreement under 2002 Incentive Plan – December 2012 (incorporated by reference to the
Registrant’s Current Report on Form 8-K, Exhibit 10.1, filed on December 11, 2012)
Form of Performance Stock Unit Award Agreement under 2014 Incentive Plan (2016 Form) (incorporated by reference to the Registrant’s
Current Report on Form 8-K, Exhibit 10.1, filed on December 14, 2016)
Form of Performance Stock Unit Award Agreement under 2014 Incentive Plan (2017 Form) (incorporated by reference to the Registrant’s
Current Report on Form 8-K, Exhibit 10.1, filed on December 14, 2017)
2002 Employee Stock Purchase Plan, as amended through May 16, 2013 (incorporated by reference to the Registrant’s Current Report on
Form 8-K, Exhibit 10.2, filed on May 21, 2013)
Executive Deferred Compensation Plan, as amended and restated on December 10, 2008 (incorporated by reference to the Registrant’s Current
Report on Form 8-K, Exhibit 10.1, filed on January 14, 2009)
First Amendment to Amended and Restated Executive Deferred Compensation Plan, effective as of November 23, 2013 (incorporated by
reference to the Registrant’s Annual Report on Form 10-K, Exhibit 10.15, filed on February 26, 2014)
Direct Stock Purchase and Dividend Reinvestment Plan (incorporated by reference to the Plan text included in the Registrant’s Prospectus
Supplement filed on September 5, 2012)
Summary of the Registrant’s Compensation Arrangements for Non-Employee Directors (incorporated by reference to the “Director
Compensation” section of the Registrant’s Definitive Proxy Statement filed on March 21, 2017)
Revised Form of Indemnification Agreement for Directors and Executive Officers (incorporated by reference to the Registrant’s Current
Report on Form 8-K, Exhibit 99.3, filed on November 16, 2009)
Office Building Lease, dated February 27, 2003 (incorporated by reference to the Registrant’s Annual Report on Form 10-K, Exhibit 10.30.2,
filed on March 12, 2004)
Office Building Lease (second floor), dated July 31, 2006 (incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q,
Exhibit 10.1, filed November 2, 2006)
Second Amendment to Lease, dated July 31, 2006 (incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.3,
filed November 2, 2006)
106
Exhibit
Number
10.28
10.29
10.30
10.31
10.32
10.33
10.34*
10.35*
10.36*
10.37*
10.40*
10.43*
10.46*
10.48*
10.49*
10.50*
10.51*
Office Building Lease, effective as of and dated as of June 1, 2012 (incorporated by reference to the Registrant’s Quarterly Report on Form
10-Q, Exhibit 10.1, filed November 3, 2011)
First Amendment to Lease, effective as of May 25, 2017, between AG-SKB Belvedere Owner, L.P. and the Registrant (incorporated by
reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.1, filed on August 4, 2017)
Exhibit
Second Amendment to Lease, effective as of December 27, 2017, between AG-SKB Belvedere Owner, L.P. and the Registrant (filed herewith)
Lease Agreement, dated as of January 11, 2013, between MG-Point, LLC, as Landlord, and the Registrant, as Tenant (incorporated by
reference to the Registrant’s Annual Report on Form 10-K, Exhibit 10.22, filed on February 26, 2013)
First Amendment to Lease, effective as of June 27, 2013, between MG-Point, LLC, as Landlord, and the Registrant, as Tenant (incorporated
by reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.4, filed August 8, 2013)
Second Amendment to Lease, effective as of June 23, 2014, between MG-Point, LLC, as Landlord, and the Registrant, as Tenant (incorporated
by reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.7, filed August 8, 2014)
Amended and Restated Employment Agreement, dated as of February 22, 2017, by and between Martin S. Hughes and the Registrant
(incorporated by reference to the Registrant's Annual Report on Form 10-K, Exhibit 10.31, filed February 24, 2017)
Amended and Restated Employment Agreement, dated as of March 31, 2009, by and between Brett D. Nicholas and the Registrant
(incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.3, filed on May 5, 2009)
First Amendment to Amended and Restated Employment Agreement, by and between Brett D. Nicholas and the Registrant, dated as of March
17, 2010 (incorporated by reference to the Registrant’s Current Report on Form 8-K, Exhibit 10.2, filed on March 18, 2010)
Second Amendment to Amended and Restated Employment Agreement, by and between Brett D. Nicholas and the Registrant, dated as of
February 24, 2011 (incorporated by reference to the Registrant’s Annual Report on Form 10-K, Exhibit 10.24, filed on February 24, 2011)
Third Amendment to Amended and Restated Employment Agreement, by and between Brett D. Nicholas and the Registrant, dated as of May
17, 2012 (incorporated by reference to the Registrant’s Current Report on Form 8-K, Exhibit 10.4, filed on May 21, 2012)
Fourth Amendment to Amended and Restated Employment Agreement, by and between Brett D. Nicholas and the Registrant, dated as of
December 14, 2012 (incorporated by reference to the Registrant’s Annual Report on Form 10-K, Exhibit 10.36, filed on February 26, 2013)
Fifth Amendment to Amended and Restated Employment Agreement, by and between Brett D. Nicholas and the Registrant, dated as of
August 6, 2014 (incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.6, filed on August 8, 2014)
Sixth Amendment to Amended and Restated Employment Agreement, by and between Brett D. Nicholas and the Registrant, dated as of
August 5, 2015 (incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.1, filed on November 6, 2015)
Amended and Restated Employment Agreement, by and between Christopher J. Abate and the Registrant, dated as of February 22, 2017
(incorporated by reference to the Registrant's Annual Report on Form 10-K, Exhibit 10.49, filed on February 24, 2017)
Employment Agreement, by and between Fred J. Matera and the Registrant, dated as of January 1, 2016 (incorporated by reference to the
Registrant’s Current Report on Form 8-K, Exhibit 10.2, filed on January 4, 2016)
Amended and Restated Employment Agreement, by and between Andrew P. Stone and the Registrant, dated as of February 22, 2017
(incorporated by reference to the Registrant's Annual Report on Form 10-K, Exhibit 10.51, filed on February 24, 2017)
107
Exhibit
Number
10.52
10.53
10.55
10.56
10.57
10.58
10.59
12
21
23
31.1
31.2
32.1
32.2
101
Exhibit
Employment Agreement, by and between Dashiell I. Robinson and the Registrant, dated as of August 8, 2017 (incorporated by reference to the
Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.1, filed on November 7, 2017)
Side Letter Agreement, by and between Dashiell I. Robinson and the Registrant, dated as of August 8, 2017 (incorporated by reference to the
Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.2, filed on November 7, 2017)
Advances, Collateral Pledge, and Security Agreement between the Federal Home Loan Bank of Chicago and RWT Financial, LLC, dated as of
July 16, 2014 (incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.8, filed on August 8, 2014)
Financial Covenant Supplement to Advances, Collateral Pledge, and Security Agreement between the Federal Home Loan Bank of Chicago
and RWT Financial, LLC, dated as of July 16, 2014 (incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit
10.9, filed on August 8, 2014)
Guaranty, dated July 16, 2014, given by Redwood Trust, Inc. in favor of the Federal Home Loan Bank of Chicago (incorporated by reference
to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.10, filed on August 8, 2014)
Second Supplement to Advances, Collateral Pledge and Security Agreement between the Federal Home Loan Bank of Chicago and RWT
Financial, LLC, dated as of February 19, 2015 (incorporated by reference to the Registrant’s Annual Report on Form 10-K, Exhibit 10.53,
filed on February 25, 2015)
Amendment to Advances, Collateral Pledge, and Security Agreement between the Federal Home Loan Bank of Chicago and RWT Financial,
LLC, dated as of October 31, 2017 (incorporated by reference to the Registrant’s Quarterly Report on Form 10-Q, Exhibit 10.3, filed on
November 7, 2017)
Computation of Ratio of Earnings to Fixed Charges (filed herewith)
List of Subsidiaries (filed herewith)
Consent of Grant Thornton LLP (filed herewith)
Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)
Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith)
Certification of the Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith)
Certification of the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed herewith)
Pursuant to Rule 405 of Regulation S-T, the following financial information from the Registrant’s Annual Report on Form 10-K for the period
ended December 31, 2017, is filed in XBRL-formatted interactive data files:
(i) Consolidated Balance Sheets at December 31, 2017 and 2016;
(ii) Consolidated Statements of Income for the years ended December 31, 2017, 2016, and 2015;
(iii) Statements of Consolidated Comprehensive (Loss) Income for the years ended December 31, 2017, 2016, and 2015;
(iv) Consolidated Statements of Changes in Equity for the years ended December 31, 2017, 2016, and 2015;
(v) Consolidated Statements of Cash Flows for the years ended December 31, 2017, 2016, and 2015; and
(vi) Notes to Consolidated Financial Statements.
* Indicates exhibits that include management contracts or compensatory plan or arrangements.
108
ITEM 16. FORM 10-K SUMMARY
Not applicable.
109
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf
by the undersigned, hereunto duly authorized.
SIGNATURES
Date: February 28, 2018
REDWOOD TRUST, INC.
By:
/s/ MARTIN S. HUGHES
Martin S. Hughes
Chief Executive Officer
Pursuant to the requirements the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in
the capacities and on the dates indicated.
Signature
/s/ MARTIN S. HUGHES
Martin S. Hughes
/s/ CHRISTOPHER J. ABATE
Christopher J. Abate
/s/ COLLIN L. COCHRANE
Collin L. Cochrane
/s/ RICHARD D. BAUM
Richard D. Baum
/s/ DOUGLAS B. HANSEN
Douglas B. Hansen
/s/ MARIANN BYERWALTER
Mariann Byerwalter
/s/ DEBORA D. HORVATH
Debora D. Horvath
/s/ GREG H. KUBICEK
Greg H. Kubicek
/s/ KAREN R. PALLOTTA
Karen R. Pallotta
/s/ JEFFREY T. PERO
Jeffrey T. Pero
/s/ GEORGANNE C. PROCTOR
Georganne C. Proctor
Title
Director and Chief Executive Officer
(Principal Executive Officer)
Date
February 28, 2018
Director and President
February 28, 2018
Chief Financial Officer
February 28, 2018
(Principal Financial and Accounting Officer)
Director, Chairman of the Board
February 28, 2018
Director, Vice-Chairman of the Board
February 28, 2018
Director
Director
Director
Director
Director
Director
110
February 28, 2018
February 28, 2018
February 28, 2018
February 28, 2018
February 28, 2018
February 28, 2018
REDWOOD TRUST, INC.
CONSOLIDATED FINANCIAL STATEMENTS,
REPORTS OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
For Inclusion in Annual Report on Form 10-K Filed With
Securities and Exchange Commission
December 31, 2017
F- 1
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULES
REDWOOD TRUST, INC.
Report of Independent Registered Public Accounting Firm
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets at December 31, 2017 and 2016
Consolidated Statements of Income for the Years Ended December 31, 2017, 2016, and 2015
Statements of Consolidated Comprehensive Income for the Years Ended December 31, 2017, 2016, and 2015
Consolidated Statements of Changes in Stockholders’ Equity for the Years Ended December 31, 2017, 2016, and 2015
Consolidated Statements of Cash Flows for the Years Ended December 31, 2017, 2016, and 2015
Notes to Consolidated Financial Statements
Note 1. Organization
Note 2. Basis of Presentation
Note 3. Summary of Significant Accounting Policies
Note 4. Principles of Consolidation
Note 5. Fair Value of Financial Instruments
Note 6. Residential Loans
Note 7. Real Estate Securities
Note 8. Mortgage Servicing Rights
Note 9. Derivative Financial Instruments
Note 10. Other Assets and Liabilities
Note 11. Short-Term Debt
Note 12. Asset-Backed Securities Issued
Note 13. Long-Term Debt
Note 14. Commitments and Contingencies
Note 15. Equity
Note 16. Equity Compensation Plans
Note 17. Mortgage Banking Activities
Note 18. Investment Fair Value Changes, Net
Note 19. Operating Expenses
Note 20. Taxes
Note 21. Segment Information
Note 22. Quarterly Financial Data
Note 23. Subsequent Events
Schedule IV - Mortgage Loans on Real Estate
F- 2
Page
F-3
F-4
F-5
F-6
F-7
F-8
F-9
F-10
F- 10
F- 10
F- 11
F- 24
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F- 41
F- 47
F- 52
F- 54
F- 56
F- 59
F- 60
F- 62
F- 63
F- 67
F- 69
F- 73
F- 74
F- 75
F- 76
F- 78
F- 81
F- 82
F- 83
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Redwood Trust, Inc.
Opinion on the financial statements
We have audited the accompanying consolidated balance sheets of Redwood Trust, Inc. (a Maryland corporation) and subsidiaries (the “Company”) as of
December 31, 2017 and 2016 , the related consolidated statements of income, comprehensive income, changes in stockholders' equity, and cash flows for each of
the three years in the period ended December 31, 2017 and the related notes and schedule (collectively referred to as the "financial statements"). In our opinion, the
financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017 and 2016 and the results of its
operations and its cash flows for each of the three years in the period ended December 31, 2017 , in conformity with accounting principles generally accepted in
the United States of America.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the Company’s
internal control over financial reporting as of December 31, 2017 , based on criteria established in the 2013 Internal
Control—Integrated
Framework
issued by the
Committee of Sponsoring Organizations of the Treadway Commission ("COSO"), and our report dated February 28, 2018 expressed an unqualified opinion.
Basis for opinion
These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company's financial
statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in
accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to
assess the risks of material misstatement of the financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such
procedures included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. Our audits also included evaluating
the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the financial statements. We
believe that our audits provide a reasonable basis for our opinion.
/s/ GRANT THORNTON LLP
We have served as the Company's auditor since 2005.
Newport Beach, CA
February 28, 2018
F- 3
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and Shareholders
Redwood Trust, Inc.
Opinion on internal control over financial reporting
We have audited the internal control over financial reporting of Redwood Trust, Inc. (a Maryland corporation) and subsidiaries (the “Company”) as of
December 31, 2017 , based on criteria established in the 2013 Internal
Control—Integrated
Framework
issued by the Committee of Sponsoring Organizations of
the Treadway Commission (COSO). In our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of
December 31, 2017 , based on criteria established in the 2013 Internal
Control—Integrated
Framework
issued by COSO.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) ("PCAOB"), the consolidated
financial statements of the Company as of and for the year ended December 31, 2017 , and our report dated February 28, 2018 expressed an unqualified opinion on
those financial statements.
Basis for opinion
The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of
internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to
express an opinion on the Company’s internal control over financial reporting based on our audit. We are a public accounting firm registered with the PCAOB and
are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the
Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding
of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of
internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit
provides a reasonable basis for our opinion.
Definition and limitations of internal control over financial reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and
the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over
financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of
financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with
the policies or procedures may deteriorate.
/s/ GRANT THORNTON LLP
Newport Beach, CA
February 28, 2018
F- 4
(In Thousands, except Share Data)
December 31, 2017
December 31, 2016
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
ASSETS (1)
Residential loans, held-for-sale, at fair value
Residential loans, held-for-investment, at fair value
Real estate securities, at fair value
Mortgage servicing rights, at fair value
Cash and cash equivalents
Total earning assets
Restricted cash
Accrued interest receivable
Derivative assets
Other assets
Total Assets
Liabilities
Short-term debt (2)
Accrued interest payable
Derivative liabilities
LIABILITIES AND EQUITY (1)
Accrued expenses and other liabilities
Asset-backed securities issued, at fair value
Long-term debt, net
Total liabilities
Equity
Common stock, par value $0.01 per share, 180,000,000 shares authorized; 76,599,972 and 76,834,663
issued and outstanding
Additional paid-in capital
Accumulated other comprehensive income
Cumulative earnings
Cumulative distributions to stockholders
Total equity
Total Liabilities and Equity
$
1,427,945 $
3,687,265
1,476,510
63,598
144,663
6,799,981
2,144
27,013
15,718
194,966
$
7,039,822 $
$
1,938,682 $
18,435
63,081
67,729
1,164,585
2,575,023
5,827,535
766
1,673,845
85,248
1,290,341
(1,837,913)
1,212,287
$
7,039,822 $
835,399
3,052,652
1,018,439
118,526
212,844
5,237,860
8,623
18,454
36,595
181,945
5,483,477
791,539
9,608
66,329
72,428
773,462
2,620,683
4,334,049
768
1,676,486
71,853
1,149,935
(1,749,614)
1,149,428
5,483,477
——————
(1) Our consolidated balance sheets include assets of consolidated variable interest entities (“VIEs”) that can only be used to settle obligations of these VIEs and liabilities of
consolidated VIEs for which creditors do not have recourse to Redwood Trust, Inc. or its affiliates. At December 31, 2017 and December 31, 2016 , assets of consolidated
VIEs totaled $1,259,774 and $798,317 , respectively. At December 31, 2017 and December 31, 2016 , liabilities of consolidated VIEs totaled $1,167,157 and $773,980 ,
respectively. See Note
4
for further discussion.
Includes $250 million of convertible notes, which were reclassified from Long-term debt, net to Short-term debt as the maturity of the notes was less than one year as of
December 31, 2017. See Note
11
for further discussion.
(2)
The
accompanying
notes
are
an
integral
part
of
these
consolidated
financial
statements.
F- 5
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In Thousands, except Share Data)
2017
2016
2015
Years Ended December 31,
$
154,362 $
137,804 $
Interest Income
Residential loans
Commercial loans
Real estate securities
Other interest income
Total interest income
Interest Expense
Short-term debt
Asset-backed securities issued
Long-term debt
Total interest expense
Net Interest Income
Reversal of provision for loan losses
Net Interest Income after Provision
Non-interest Income
Mortgage banking activities, net
Mortgage servicing rights income (loss), net
Investment fair value changes, net
Other income
Realized gains, net
Total non-interest income, net
Operating expenses
Net Income before Provision for Income Taxes
(Provision for) benefit from income taxes
Net Income
Basic earnings per common share
Diluted earnings per common share
Regular dividends declared per common share
Basic weighted average shares outstanding
Diluted weighted average shares outstanding
345
90,803
2,547
248,057
(36,851)
(19,108)
(52,857)
(108,816)
139,241
—
139,241
53,908
7,860
10,374
4,576
13,355
90,073
(77,156)
152,158
(11,752)
30,496
76,873
1,182
246,355
(22,287)
(14,735)
(51,506)
(88,528)
157,827
7,102
164,929
38,691
14,353
(28,574)
6,338
28,009
58,817
(88,786)
134,960
(3,708)
140,406 $
131,252 $
114,715
46,933
97,448
336
259,432
(30,572)
(21,469)
(43,842)
(95,883)
163,549
355
163,904
10,972
(3,922)
(21,357)
3,192
36,369
25,254
(97,416)
91,742
10,346
102,088
$
$
$
$
1.78 $
1.60 $
1.12 $
76,792,957
101,975,008
1.66 $
1.54 $
1.12 $
76,747,047
97,909,090
1.20
1.18
1.12
82,945,103
84,518,395
The
accompanying
notes
are
an
integral
part
of
these
consolidated
financial
statements.
F- 6
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In Thousands)
Net Income
Other comprehensive income (loss):
Net unrealized gain (loss) on available-for-sale securities (1)
Reclassification of unrealized gain on available-for-sale securities to net income
Net unrealized gain (loss) on interest rate agreements
Reclassification of unrealized loss on interest rate agreements to net income
Total other comprehensive income (loss)
Years Ended December 31,
2017
2016
2015
$
140,406 $
131,252 $
102,088
22,864
(10,536)
1,022
45
13,395
(2,316)
(21,167)
3,271
72
(20,140)
(17,955)
(29,426)
(1,409)
95
(48,695)
Total Comprehensive Income
——————
(1) Amounts are presented net of tax benefit (provision) of zero , $1 million , and $(0.4) million for the years ended December 31, 2017 , 2016 , and 2015 , respectively.
153,801 $
111,112 $
$
53,393
The
accompanying
notes
are
an
integral
part
of
these
consolidated
financial
statements.
F- 7
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
For the Year Ended December 31, 2017
(In Thousands, except Share
Data)
December 31, 2016
Net income
Other comprehensive income
Employee stock purchase and
incentive plans
Non-cash equity award
compensation
Share repurchases
Common dividends declared
December 31, 2017
Common Stock
Shares
76,834,663 $
—
—
375,651
—
(610,342)
—
Amount
$
768
—
—
4
—
(6)
—
Additional
Paid-In
Capital
1,676,486 $
—
—
(3,838)
10,378
(9,181)
—
76,599,972 $
766
$
1,673,845 $
Accumulated
Other
Comprehensive
Income
71,853 $
—
13,395
—
—
—
—
85,248 $
Cumulative
Earnings
1,149,935 $
140,406
—
—
—
—
—
1,290,341 $
Cumulative
Distributions
to Stockholders
Total
(1,749,614) $
1,149,428
—
—
—
—
—
(88,299)
(1,837,913) $
140,406
13,395
(3,834)
10,378
(9,187)
(88,299)
1,212,287
For the Year Ended December 31, 2016
(In Thousands, except Share
Data)
December 31, 2015
Net income
Other comprehensive loss
Employee stock purchase and
incentive plans
Non-cash equity award
compensation
Share repurchases
Common dividends declared
December 31, 2016
Common Stock
Shares
78,162,765 $
—
—
614,952
—
(1,943,054)
—
Amount
$
782
—
—
5
—
(19)
—
Additional
Paid-In
Capital
1,695,956 $
—
—
(7,030)
12,648
(25,088)
—
Accumulated
Other
Comprehensive
Income
Cumulative
Earnings
Cumulative
Distributions
to Stockholders
Total
91,993
$
—
(20,140)
1,018,683 $
131,252
—
—
—
—
—
—
—
—
—
(1,661,149) $
1,146,265
—
—
—
—
—
(88,465)
(1,749,614) $
131,252
(20,140)
(7,025)
12,648
(25,107)
(88,465)
1,149,428
76,834,663 $
768
$
1,676,486 $
71,853
$
1,149,935 $
For the Year Ended December 31, 2015
Common Stock
(In Thousands, except Share
Data)
December 31, 2014
Cumulative effect adjustment -
adoption of ASU 2014-13 (1)
January 1, 2015
Net income
Other comprehensive loss
Dividend reinvestment & stock
purchase plans
Employee stock purchase and
incentive plans
Non-cash equity award
compensation
Share repurchases
Common dividends declared
December 31, 2015
Shares
83,443,141 $
—
83,443,141
—
—
418,508
753,429
—
(6,452,313)
—
78,162,765 $
Additional
Paid-In
Capital
Accumulated
Other
Comprehensive
Income
Cumulative
Earnings
Cumulative
Distributions
to Stockholders
Total
Amount
834 $
1,774,030 $
140,688
$
906,867 $
(1,566,278) $
1,256,141
—
834
—
—
4
7
—
(63)
—
782 $
—
1,774,030
—
—
6,830
(7,988)
11,806
(88,722)
—
—
140,688
—
(48,695)
9,728
916,595
102,088
—
—
—
—
—
—
—
—
—
—
—
1,695,956 $
91,993
$
1,018,683 $
—
9,728
(1,566,278)
1,265,869
—
—
—
—
—
—
(94,871)
(1,661,149) $
102,088
(48,695)
6,834
(7,981)
11,806
(88,785)
(94,871)
1,146,265
——————
(1) Upon the adoption of ASU 2014-13 on January 1, 2015, we reclassified all residential loans held at amortized cost to fair value and eliminated our allowance for loan losses
for residential loans.
The
accompanying
notes
are
an
integral
part
of
these
consolidated
financial
statements.
F- 8
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
Cash Flows From Operating Activities:
Net income
Adjustments to reconcile net income to net cash used in operating activities:
Amortization of premiums, discounts, and debt issuance costs, net
Depreciation and amortization of non-financial assets
Purchases of held-for-sale loans
Proceeds from sales of held-for-sale loans
Principal payments on held-for-sale loans
Net settlements of derivatives
Reversal of provision for loan losses
Non-cash equity award compensation expense
Market valuation adjustments
Realized gains, net
Net change in:
Accrued interest receivable and other assets
Accrued interest payable, deferred tax liabilities, and accrued expenses and other liabilities
Net cash used in operating activities
Cash Flows From Investing Activities:
Purchases of loans held-for-investment
Proceeds from sales of loans held-for-investment
Principal payments on loans held-for-investment
Purchases of real estate securities
Proceeds from sales of real estate securities
Principal payments on real estate securities
Purchase of mortgage servicing rights
Proceeds from sales of mortgage servicing rights
Net change in restricted cash
Net cash provided by investing activities
Cash Flows From Financing Activities:
Proceeds from borrowings on short-term debt
Repayments on short-term debt
Proceeds from issuance of asset-backed securities
Repayments on asset-backed securities issued
Deferred debt issuance costs
Proceeds from issuance of long-term debt
Repayments on long-term debt
Net settlements of derivatives
Net proceeds from issuance of common stock
Net payments on repurchase of common stock
Taxes paid on equity award distributions
Dividends paid
Net cash provided by (used in) financing activities
Net decrease in cash and cash equivalents
Cash and cash equivalents at beginning of period
Cash and cash equivalents at end of period
Supplemental Cash Flow Information:
Cash paid during the period for:
Interest
Taxes
Supplemental Noncash Information:
Years Ended December 31,
2017
2016
2015
$
140,406 $
131,252 $
102,088
(18,250)
1,213
(26,487)
1,140
(34,089)
824
(5,705,842)
(4,953,619)
(11,045,813)
3,903,147
4,192,671
9,761,010
52,956
(9,950)
—
10,378
(51,484)
(13,355)
(17,562)
(4,820)
80,033
(7,301)
(7,102)
12,648
12,917
(28,009)
42,572
3,632
80,299
(59,406)
(355)
11,806
51,975
(36,369)
(88,173)
5,993
(1,713,163)
(545,653)
(1,250,210)
—
—
523,561
(600,875)
228,420
77,778
(643)
52,137
6,479
—
235,604
798,831
(318,268)
497,191
80,055
(15,338)
58,642
(3,056)
286,857
1,333,661
(22,219)
6,459
500,239
(179,265)
439,493
138,630
(32,388)
17,235
(4,939)
863,245
4,895,889
3,918,083
8,570,291
(4,036,634)
(4,981,547)
(8,534,802)
—
—
(261,351)
(388,962)
567,100
(205,163)
(7,380)
245,000
—
(137)
302
(8,417)
(4,136)
(88,299)
1,358,125
(68,181)
212,844
—
771,287
(118,146)
(156)
304
(28,073)
(7,329)
(88,465)
(795,393)
(7,385)
220,229
(33)
1,400,222
(527,371)
(43)
7,301
(85,820)
(8,448)
(94,871)
337,464
(49,501)
269,730
220,229
$
144,663 $
212,844 $
$
103,279 $
87,164 $
2,746
1,303
86,849
165
Real estate securities retained from loan securitizations
Retention of mortgage servicing rights from loan securitizations and sales
Transfers from loans held-for-sale to loans held-for-investment
Transfers from loans held-for-investment to loans held-for-sale
Transfers from residential loans to real estate owned
$
79,662 $
7,387
9,127 $
10,060
244,177
64,725
1,245,430
1,063,860
1,555,814
98,854
4,220
359,005
11,632
154,012
8,500
The
accompanying
notes
are
an
integral
part
of
these
consolidated
financial
statements.
F- 9
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 1. Organization
Redwood Trust, Inc., together with its subsidiaries, focuses on investing in mortgages and other real estate-related assets and engaging in mortgage banking
activities. We seek to invest in real estate-related assets that have the potential to generate attractive cash flow returns over time and to generate income through
our mortgage banking activities. We operate our business in two segments: Investment Portfolio and Residential Mortgage Banking.
Our primary sources of income are net interest income from our investment portfolios and non-interest income from our mortgage banking activities. Net
interest income consists of the interest income we earn on investments less the interest expense we incur on borrowed funds and other liabilities. Income from
mortgage banking activities consists of the profit we seek to generate through the acquisition of loans and their subsequent sale or securitization.
Redwood Trust, Inc. has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Internal
Revenue Code”), beginning with its taxable year ended December 31, 1994. We generally refer, collectively, to Redwood Trust, Inc. and those of its subsidiaries
that are not subject to subsidiary-level corporate income tax as “the REIT” or “our REIT.” We generally refer to subsidiaries of Redwood Trust, Inc. that are
subject to subsidiary-level corporate income tax as “our operating subsidiaries” or “our taxable REIT subsidiaries” or “TRS.”
Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. References herein to “Redwood,” the
“company,” “we,” “us,” and “our” include Redwood Trust, Inc. and its consolidated subsidiaries, unless the context otherwise requires. Refer to Item 1 - Business
in this Annual Report on Form 10-K for additional information on our business.
Note 2. Basis of Presentation
The consolidated financial statements presented herein are at December 31, 2017 and December 31, 2016 , and for the years ended December 31, 2017 , 2016 ,
and 2015 . These consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles ("GAAP") — as
prescribed by the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) — and the rules and regulations of the Securities
and Exchange Commission ("SEC"). In the opinion of management, all normal and recurring adjustments to present fairly the financial condition of the company
at December 31, 2017 and 2016 and results of operations for all periods presented have been made.
Principles of Consolidation
In accordance with GAAP, we determine whether we must consolidate transferred financial assets and variable interest entities (“VIEs”) for financial
reporting purposes. We currently consolidate the assets and liabilities of certain Sequoia securitization entities issued prior to 2012 where we maintain an ongoing
involvement ("Legacy Sequoia"), as well as entities formed in connection with the securitization of Redwood Choice expanded-prime loans beginning in the third
quarter of 2017 ("Sequoia Choice"). Each securitization entity is independent of Redwood and of each other and the assets and liabilities are not owned by and are
not legal obligations of Redwood Trust, Inc. Our exposure to these entities is primarily through the financial interests we have retained, although we are exposed to
certain financial risks associated with our role as a sponsor, servicing administrator, or depositor of these entities or as a result of our having sold assets directly or
indirectly to these entities.
For financial reporting purposes, the underlying loans owned at the consolidated Sequoia entities are shown under Residential loans held-for-investment at fair
value on our consolidated balance sheets. The asset-backed securities (“ABS”) issued to third parties by these entities are shown under ABS issued. In our
consolidated statements of income, we recorded interest income on the loans owned at these entities and interest expense on the ABS issued by these entities as
well as other income and expenses associated with these entities' activities. See Note
12
for further discussion on ABS issued.
See Note
4
for further discussion on principles of consolidation.
F- 10
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 2. Basis of Presentation - (continued)
Use of Estimates
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, amounts 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 periods. 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.
Note 3. Summary of Significant Accounting Policies
Significant Accounting Policies
Fair
Value
Measurements
Our consolidated 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. 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 assets 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 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 for assets 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.
Fair
Value
Option
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 our consolidated statements of income.
We elect the fair value option for certain residential loans, interest-only (“IO”) and certain subordinate securities, and MSRs. We generally elect the fair value
option for residential loans that are held-for-sale, due to our intent to sell or securitize the loans in the near-term. We elect the fair value option for our IO and
certain subordinate securities, and MSRs, for which we generally hedge market interest rate risk. As such, we seek to offset interest rate related changes in the
values of these investments with changes in the values of their associated hedges through our consolidated statements of income. In addition, we elect the fair value
option for the assets and liabilities of our consolidated Sequoia entities in accordance with GAAP accounting for collateralized financing entities ("CFEs").
See Note
5
for further discussion on the fair value option.
F- 11
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
Real
Estate
Loans
Residential
Loans
-
Held-for-Sale
at
Fair
Value
Residential loans held-for-sale include loans that we are marketing for sale to third parties, including transfers to securitization entities that we plan to sponsor
and expect to be accounted for as sales for financial reporting purposes. We generally elect the fair value option for residential loans that we purchase with the
intent to sell to third parties or transfer to Sequoia securitizations. Coupon interest is recognized as revenue when earned and deemed collectible or until a loan
becomes more than 90 days past due, at which point the loan is placed on nonaccrual status. Changes in fair value are recurring and are reported through our
consolidated statements of income in Mortgage banking activities, net.
Residential
Loans
-
Held-for-Sale
at
Lower
of
Cost
or
Market
Loans held-for-sale at lower of cost or market include certain residential loans. These loans are recorded and subsequently reported at the lower of their initial
carrying amount or current fair value. Coupon interest is recognized as revenue when earned and deemed collectible or until a loan becomes more than 90 days
past due, at which point the loan is placed on nonaccrual status. Loans delinquent more than 90 days or in foreclosure are characterized as a serious delinquency.
Cash principal and interest that is advanced from servicers subsequent to a residential loan becoming greater than 90 days past due is accounted for as a reduction
in the outstanding loan principal balance. When a seriously delinquent loan previously placed on nonaccrual status has cured, meaning all delinquent principal and
interest have been remitted by the borrower, the loan is placed back on accrual status. Changes in fair value are non-recurring and are reported through our
consolidated statements of income in Mortgage banking activities, net.
Residential
Loans
Held-for-Investment
-
At
Fair
Value
Certain loans that were originally purchased with the intent to sell as part of our residential mortgage banking operations, and for which we elected the fair
value option at acquisition, were subsequently reclassified to held-for-investment ("HFI") when the loans were transferred to our FHLBC member subsidiary and
pledged as collateral for borrowings made from the Federal Home Loan Bank of Chicago (“FHLBC”). As of December 31, 2017 , our current intent is to hold
these loans for longer-term investment while they are financed by the FHLBC.
In addition, we record loans held at consolidated Sequoia entities at fair value. In accordance with accounting guidance for CFEs, we use the fair value of the
ABS issued by the Sequoia entities (which we determined to be more observable) to determine the fair value of the loans held at these entities.
Coupon interest for these loans is recognized as revenue when earned and deemed collectible or until a loan becomes more than 90 days past due, at which
point the loan is placed on nonaccrual status. When a seriously delinquent loan previously placed on nonaccrual status has cured, meaning all delinquent principal
and interest have been remitted by the borrower, the loan is placed back on accrual status. Changes in fair value are recurring and are reported through our
consolidated statements of income in Investment fair value changes, net.
Repurchase
Reserves
We sell and have sold residential mortgage loans to various parties, including (1) securitization trusts, (2) Fannie Mae and Freddie Mac (“the Agencies”), and
(3) banks and other financial institutions that purchase mortgage loans for investment or private label securitization. We may be required to repurchase residential
mortgage loans we have sold, or loans associated with MSRs we have purchased, in the event of a breach of specified contractual representations and warranties
made in connection with these sales and purchases. With respect to MSRs we purchased, if the associated residential loan was sold to one of the Agencies (which
was typically the case), that Agency can require us, as the owner of the MSR, to repurchase the residential loan in the event of such a breach of representations and
warranties even though we were not the party that sold the associated loan to that Agency. In January 2016, we discontinued the acquisition and aggregation of
conforming loans for resale to the Agencies.
F- 12
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
We do not originate residential mortgage loans and believe the initial risk of loss due to loan repurchases (i.e., due to a breach of representations and
warranties) would generally be a contingency to the companies from whom we acquired the loans or MSRs. However, in some cases, such as where loans or MSRs
were acquired from companies that have since become insolvent, we may have to bear the loss associated with a loan repurchase. Furthermore, even if we do not
have to ultimately bear such a loss because we can recover from the company that sold us the loan or the MSR, there could be a delay in making that recovery.
We establish reserves for mortgage repurchase liabilities related to various representations and warranties that reflect management’s estimate of losses for
loans for which we could have a repurchase obligation, based on a combination of factors. Such factors can include estimated future defaults and loan repurchase
rates, the potential severity of loss in the event of defaults, and the probability of our being liable for a repurchase obligation. We establish a reserve at the time
loans are sold and MSRs are purchased and continually update our reserve estimate during its life. The reserve for mortgage loan repurchase losses is included in
other liabilities on our consolidated balance sheets and the related expense is included as a component of Mortgage banking activities, net and MSR income (loss),
net on our consolidated statements of income.
See Note
14
for further discussion on the residential repurchase reserves.
Real
Estate
Securities,
at
Fair
Value
Our securities primarily consist of residential mortgage backed securities (“RMBS”) and may include other residential and commercial securities. We classify
our real estate securities as trading or available-for-sale securities. Nearly all of our securities are supported by collateral designated as prime at the time of
issuance. Prime residential loans are generally characterized by lower loan-to-value (“LTV”) ratios at the time the loans were originated, and are made to
borrowers with higher Fair Isaac Corporation (“FICO”) scores.
Trading
Securities
We primarily denote trading securities as those securities where we have adopted the fair value option. Trading securities are carried at their estimated fair
values. Coupon interest is recognized as interest income when earned and deemed collectible. Changes in the fair value of securities designated as trading
securities are reported in Investment fair value changes, net on our consolidated statements of income.
Available-for-Sale
Securities
AFS securities are carried at their estimated fair value with unrealized gains and losses excluded from earnings (except when an other-than-temporary
impairment (“OTTI”) is recognized, as discussed below) and reported in Accumulated other comprehensive income (“AOCI”), a component of stockholders’
equity.
Interest income on AFS securities is accrued based on their outstanding principal balance and contractual terms and interest income is recognized based on the
security’s effective interest rate. In order to calculate the effective interest rate, we must 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. On at least a quarterly basis, we review and,
if appropriate, make adjustments to our cash flow projections based on input and analysis received from external sources, internal models, and our own judgments
about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. Changes in cash flows from those originally projected, or from
those estimated at the last evaluation, may result in a prospective change in the yield and interest income recognized on these securities or in the recognition of
OTTI as discussed below.
For AFS securities purchased and held at a discount, a portion of the discount may be designated as non-accretable purchase discount (“credit reserve”), based
on the cash flows we have projected for the security. The amount designated as credit reserve may be adjusted over time, based on our periodic evaluation of
projected cash flows. If the performance of a security with a credit reserve is more favorable than previously forecasted, a portion of the credit reserve may be
reallocated to accretable discount and recognized into interest income over time. Conversely, if the performance of a security with a credit reserve is less favorable
than forecasted, the amount designated as credit reserve may be increased, or impairment charges and write-downs of such securities to a new cost basis could
result.
F- 13
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
When the fair value of an AFS security is less than its amortized cost at the reporting date, the security is considered impaired. We assess our impaired
securities at least quarterly to determine if the impairment is temporary or other-than-temporary (resulting in an OTTI). If we either - (i) intend to sell the impaired
security; (ii) will more likely than not be required to sell the impaired security before it recovers in value; or (iii) if there has been an adverse change in cash flows -
the impairment is deemed an OTTI. In the case of criteria (i) and (ii), we record the entire difference between the security’s estimated fair value and its amortized
cost at the reporting date as an impairment through market valuation adjustments on our consolidated statements of income. If there has been an adverse change in
cash flows, only the portion of the OTTI related to “credit” losses is recognized through other market valuation adjustments on our consolidated statements of
income, with the remaining “non-credit” portion recognized through AOCI on our consolidated balance sheets. If the first two criteria are not met and there has not
been an adverse change in cash flows, the impairment is considered temporary and the entire unrealized loss is recognized through AOCI on our consolidated
balance sheets.
For impaired AFS securities, to determine if there has been an adverse change in cash flows and if any portion of a resulting OTTI is related to credit losses,
we compare the present value of the cash flows expected to be collected as of the current financial reporting date to the amortized cost basis of the security. The
discount rate used to calculate the present value of expected future cash flows is the current yield used for income recognition purposes. If the present value of the
current expected cash flows is less than the amortized cost basis, there has been an adverse change and the security is considered OTTI with the difference between
these two amounts representing the credit loss. The determination as to whether an OTTI exists and, if so, the amount of credit impairment recognized in earnings
is subjective, and based on information available at the time of the assessment as well as our estimates of future performance and cash flows. As a result, the timing
and amount of OTTI constitute a material estimate that is susceptible to significant change.
See Note
7
for further discussion on real estate securities.
MSRs
We recognize MSRs through the retention of servicing rights associated with residential mortgage loans that we acquired and subsequently transferred to
third parties when the transfer meets the GAAP criteria for sale accounting, or through the direct acquisition of MSRs sold by third parties.
We contract with licensed sub-servicers to perform servicing functions for loans associated with our MSRs. We have elected the fair value option for all of
our MSRs, and they are initially recognized and subsequently carried at their estimated fair values. Servicing fee income from MSRs is recorded on a cash basis
when received. Net servicing income and changes in the estimated fair value of MSRs are reported in MSR income (loss), net on our consolidated statements of
income.
See Note
8
for further discussion on MSRs.
Cash
and
Cash
Equivalents
Cash and cash equivalents include non-restricted cash and highly liquid investments with original maturities of three months or less. The Company maintains
its cash and cash equivalents with major financial institutions. Accounts at these institutions are guaranteed by the Federal Deposit Insurance Corporation (“FDIC”)
up to $250,000 for each bank. The Company is exposed to credit risk for amounts held in excess of the FDIC limit. The Company does not anticipate
nonperformance by these institutions.
Restricted
Cash
Restricted cash primarily includes cash held in association with borrowings from the Federal Home Loan Bank of Chicago, and cash associated with our risk-
sharing transactions with the Agencies, as well as principal and interest payments that are collateral for, or payable to, owners of ABS issued by consolidated
securitization entities.
F- 14
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
Accrued
Interest
Receivable
Accrued interest receivable includes interest that is due and payable to us and deemed collectible. 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 receivable 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
Derivative financial instruments we typically utilize include swaps, swaptions, financial futures contracts, CMBX credit default index swaps, and “To Be
Announced” (“TBA”) contracts. These derivatives are primarily used to manage interest rate risk associated with our operations. In addition, we enter into certain
residential loan purchase commitments (“LPCs”) and residential loan forward sale commitments (“FSCs”) that are treated as derivatives for financial reporting
purposes. All derivative financial instruments are recorded at their estimated fair value on our consolidated balance sheets. Derivatives with positive fair values to
us are reported as assets and derivatives with negative fair values to us are reported as liabilities. We classify each derivative as either (i) a trading instrument (no
specific hedging designation for financial reporting purposes) or (ii) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid
related to a recognized asset or liability (cash flow hedge).
Changes in the fair values of derivatives accounted for as trading instruments, including any associated interest income or expense, are recorded in our
consolidated statements of income through MSR income (loss), net if they are used to manage risks associated with our MSR investments, through Mortgage
banking activities , net if they are used to manage risks associated with our mortgage banking activities, or through Investment fair value changes, net if they are
used to manage risks associated with our investments. Valuation changes related to residential LPCs and FSCs are included in Mortgage banking activities, net on
our consolidated statements of income.
Changes in the fair values of derivatives accounted for as cash flow hedges, to the extent they are effective, are recorded in Accumulated other comprehensive
income, a component of equity on our consolidated balance sheets. Interest income or expense, and any ineffectiveness associated with these derivatives, are
recorded as a component of net interest income in our consolidated statements of income. We measure the effective portion of cash flow hedges by comparing the
change in fair value of the expected future variable cash flows of the derivative hedging instruments with the change in fair value of the expected future variable
cash flows of the hedged item.
We will discontinue a designated cash flow hedge relationship if (i) we determine that the hedging derivative is no longer expected to be effective in offsetting
changes in the cash flows of the designated hedged item; (ii) the derivative expires or is sold, terminated, or exercised; (iii) the derivative is de-designated as a cash
flow hedge; or (iv) it is probable that a forecasted transaction associated with the hedged item will not occur by the end of the originally specified time period. To
the extent we de-designate or terminate a cash flow hedging relationship and the associated hedged item continues to exist, any unrealized gain or loss of the cash
flow hedge 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 life of the hedged item.
Swaps
and
Swaptions
Interest rate swaps are agreements in which (i) one counterparty exchanges a stream of fixed interest payments for another counterparty’s stream of variable
interest cash flows; or (ii) each counterparty exchanges variable interest cash flows that are referenced to different indices. Interest rate swaptions are agreements
that provide the owner the right but not the obligation to enter into an underlying interest rate swap with a counterparty in the future. We enter into swap and
swaptions primarily to reduce significant changes in our income or equity caused by interest rate volatility. Certain of these interest rate agreements may be
designated as cash flow hedges.
Eurodollar
Futures
and
Financial
Futures
Eurodollar futures are futures contracts on time deposits denominated in U.S. dollars at banks outside the United States. Eurodollar futures, unlike our other
derivatives, have maturities of only three months. Therefore, in order to achieve the desired interest rate offset necessary to manage our risk, consecutively
maturing contracts are required, resulting in a stated notional amount that is typically higher than our other derivatives. Financial futures are futures contracts on
benchmark U.S. Treasury rates.
F- 15
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
TBA
Agreements
TBA agreements are forward contracts to purchase mortgage-backed securities that will be issued by a U.S. government sponsored enterprise in the future. We
purchase or sell these derivatives to offset - to varying degrees - changes in the values of mortgage products for which we have exposure to interest rate volatility.
Loan
Purchase
and
Forward
Sale
Commitments
We use the term LPCs to refer to agreements with third-party residential loan originators to purchase residential loans at a future date that qualify as a
derivative under GAAP and we use the term FSCs to refer to agreements with third-parties to sell residential loans at a future date that also qualify as derivatives
under GAAP. LPCs and FSCs are recorded at their estimated fair values on our consolidated balance sheets and changes in fair value are recurring and are reported
through our consolidated statements of income in Mortgage banking activities, net.
See Note
9
for further discussion on derivative financial instruments.
Deferred
Tax
Assets
and
Liabilities
Our deferred tax assets/liabilities are generated by temporary differences in GAAP and taxable income at our taxable subsidiaries. These differences generally
reflect differing accounting treatments for GAAP and tax, such as accounting for mortgage servicing rights, discount and premium amortization, credit losses, 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 as required and establish a deferred tax asset. As the income is subsequently realized in future periods under
GAAP, the deferred tax asset is reduced. We may also recognize GAAP income in periods prior to when we recognize income for tax. When this occurs, we
establish a deferred tax liability for GAAP. As the income is subsequently realized in future periods for tax, the deferred tax liability is reduced.
In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be
realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary
differences become deductible. We consider historical and projected future taxable income and capital gains as well as tax planning strategies in making this
assessment. We determine the extent to which realization of this deferred asset is not assured and establish a valuation allowance accordingly. The estimate of net
deferred tax assets could change in future periods to the extent that actual or revised estimates of future taxable income during the carryforward periods change
from current expectations.
Other
Assets
and
Other
Liabilities
Other assets primarily consists of margin receivable, FHLBC stock, MSR holdback receivable, pledged collateral, guarantee asset, and REO. Other liabilities
primarily consists of accrued compensation, guarantee obligations, deferred tax liabilities, margin payable, and residential loan and MSR repurchase reserves.
FHLBC
Stock
In accordance with its borrowing agreement with the FHLBC, our FHLB-member subsidiary is required to purchase and hold stock in the FHLBC in an
amount equal to a specified percentage of outstanding advances. FHLBC stock is considered a non-marketable, long-term investment, and is carried at cost.
Because this stock can only be redeemed or sold at its par value, and only to the FHLBC, carrying value, or cost, approximates fair value. Dividends received from
FHLBC stock are recorded in other income, net in our consolidated statements of income.
Margin
Receivable
and
Payable
Margin receivable and payable result from margin calls between us and our derivatives, master repurchase agreements, and warehouse facilities
counterparties, whereby we or the counterparty were required to post collateral.
F- 16
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
Agency
Risk-Sharing
-
Other
Assets
and
Liabilities
During 2014 and 2015, we entered into various risk-sharing arrangements with Fannie Mae and Freddie Mac. Under these arrangements, we committed to
assume the first 1.00% or 2.25% (depending on the arrangement) of losses realized on reference pools of conforming residential mortgage loans that we acquired
and then sold to the Agencies. As part of these risk-sharing arrangements, during the 10 -year term of our first Fannie Mae arrangement, we receive monthly cash
payments from Fannie Mae based on the monthly outstanding unpaid principal balance of the reference pool of loans, and for our Freddie Mac and our subsequent
Fannie Mae arrangements, the Agencies charged us a reduced guarantee fee for the reference loans we delivered to them in exchange for mortgage backed
securities, which we then sold.
Under these arrangements we are required to pledge assets to the Agencies to collateralize our risk-sharing commitments to them throughout the terms of the
arrangements. These pledged assets are held by a third-party custodian for the benefit of the Agencies. To the extent approved losses are incurred, the custodian
will transfer collateral to the Agencies. As a result of these transactions, we recorded “pledged collateral” in the other assets line item, and “guarantee obligations”
in the other liabilities line item, on our consolidated balance sheets. In addition, for the first Fannie Mae transaction, we recorded a “guarantee asset” in the other
assets line item on our consolidated balance sheets.
The guarantee obligations represent our commitments to assume losses under these arrangements. We amortize the guarantee obligations over the 10 -year
terms of the arrangements based primarily on changes in the outstanding unpaid principal balance of loans in the reference pools, with a portion of the liabilities
treated as a credit reserve that is not amortized into income. In addition, each period we assess the need for a separate loss allowance related to these arrangements,
based on our estimate of credit losses inherent in the reference pools of loans.
Income from cash payments received under the first Fannie Mae risk-sharing arrangement and income related to the amortization of the guarantee obligations
of all three arrangements are recorded in other income, and market valuation changes of the guarantee asset are recorded in Investment fair value changes, net on
our consolidated statements of income.
Our consolidated balance sheets include assets of the special purpose entities ("SPEs") associated with these risk-sharing arrangements (i.e., the "pledged
collateral" referred to above) that can only be used to settle obligations of these SPEs and liabilities of these SPEs for which the creditors of these SPEs (the
Agencies) do not have recourse to Redwood Trust, Inc. or its affiliates. At December 31, 2017 and December 31, 2016 , assets of such SPEs totaled $48 million
and $49 million , respectively, and liabilities of such SPEs totaled $19 million and $22 million , respectively.
See Note
14
for further discussion on loss contingencies — risk-sharing.
MSR
Holdback
Receivable
MSR holdback receivable represents amounts due from third parties related to the sale of MSRs that will be received upon the final transfer of the related
servicing documentation at the end of the holdback period.
See Note
10
for further discussion on other assets.
REO
REO property acquired through, or in lieu of, foreclosure is initially recorded at fair value, and subsequently reported at the lower of its carrying amount or
fair value (less estimated cost to sell). Changes in the fair value of an REO property that has a fair value at or below its carrying amount are recorded in Investment
fair value changes, net on our consolidated statements of income.
See Note
10
for further discussion on other assets.
F- 17
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
Short-Term
Debt
Short-term debt includes borrowings under master repurchase agreements, loan warehouse facilities, and other forms of borrowings that expire within one year
with various counterparties. These borrowings are typically collateralized by cash, loans, or securities, and in some cases may be unsecured. If the value (as
determined by the applicable counterparty) of the collateral securing those borrowings decreases, we may be subject to margin calls during the period the
borrowings are outstanding. In instances where we do not satisfy the margin calls within the required time frame, the counterparty may retain the collateral and
pursue any outstanding debt amount from us.
See Note
11
for further discussion on short-term debt.
Accrued
Interest
Payable
Accrued interest payable includes interest that is due and payable to third parties. Interest is generally paid within one to three months of recording the
payable, based upon our remittance requirements, and is paid semi-annually for our convertible and exchangeable debt. Interest on our FHLB borrowings is paid
every 13 weeks. 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.
Asset-Backed
Securities
Issued
ABS issued represents asset-backed securities issued through the Legacy Sequoia and Sequoia Choice securitization entities. Assets at these entities are held in
the custody of securitization trustees and are not owned by Redwood. 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. In accordance with accounting guidance for CFEs, we account for the
ABS issued under our consolidated Sequoia entities at fair value, with periodic changes in fair value recorded in Investment fair value changes, net on our
consolidated statements of income.
See Note
12
for further discussion on ABS issued.
Long-Term
Debt
FHLBC
Borrowings
FHLBC borrowings include amounts borrowed by our FHLB-member subsidiary, also referred to as “advances,” from the Federal Home Loan Bank of
Chicago that are secured by eligible collateral, including, but not limited to, residential mortgage loans and residential mortgage-backed securities. FHLBC
borrowings are carried at their unpaid principal balance and interest on advances is paid every 13 weeks from when each respective advance is made. If the value
(as determined by the FHLBC) of the collateral securing those borrowings decreases, we may be subject to margin calls during the period the borrowings are
outstanding. In instances where we do not satisfy the margin calls within the required time frame, the FHLBC may foreclose upon the collateral and pursue any
outstanding debt amount from us.
Convertible
Notes
Convertible notes include unsecured convertible and exchangeable debt that are carried at their unpaid principal balance net of any unamortized deferred
issuance costs. Interest on the notes is payable semiannually until such time the notes mature or are converted or exchanged into shares. If converted or exchanged
by a holder, the holder of the notes would receive shares of our common stock.
Trust
Preferred
Securities
and
Subordinated
Notes
Trust preferred securities and subordinated notes are carried at their unpaid principal balance net of any unamortized deferred issuance costs. This long-term
debt is unsecured and interest is paid quarterly until it is redeemed in whole or matures at a future date.
F- 18
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
Deferred
Debt
Issuance
Costs
Deferred debt issuance costs are expenses associated with the issuance of long-term debt. These expenses typically include underwriting, rating agency, legal,
accounting, and other fees. Deferred debt issuance costs are included in the carrying value of the related long-term debt issued and are amortized as an adjustment
to interest expense using the interest method, based upon the actual and estimated repayment schedules of the related long-term debt issued.
See Note
13
for further discussion on long-term debt.
Equity
Accumulated
Other
Comprehensive
Income
(Loss)
Net unrealized gains and losses on real estate securities available-for-sale and interest rate agreements designated as cash flow hedges are reported as
components of Accumulated other comprehensive income on our consolidated statements of changes in stockholders' equity and our consolidated balance sheets.
Net unrealized gains and losses on securities and interest rate agreements held by our taxable subsidiaries that are reported in other comprehensive income are
adjusted for the effects of taxation and may create deferred tax assets or liabilities.
Earnings
per
Common
Share
Basic earnings per common share (“EPS”) is computed by dividing net income allocated to common shareholders by the weighted average common shares
outstanding. Net income allocated to common shareholders represents net income less income allocated to participating securities (as described herein). Diluted
EPS is computed by dividing income allocated to common shareholders by the weighted average common shares outstanding plus amounts representing the
dilutive effect of share-based payment awards. In addition, if the assumed conversion or exchange of convertible or exchangeable debt into common shares is
dilutive, diluted EPS is adjusted by adding back the periodic interest expense (net of any tax effects) associated with dilutive convertible or exchangeable debt to
net income and adding the shares issued in an assumed conversion or exchange to the diluted weighted average share count.
The two-class method is an earnings allocation formula under which EPS is calculated for common stock and participating securities according to dividends
declared and participating rights in undistributed earnings. Under this method, all earnings (distributed and undistributed) are allocated between participating
securities and common shares based on their respective rights to receive dividends or dividend equivalents. GAAP defines vested and unvested share-based
payment awards containing nonforfeitable rights to dividends or dividend equivalents as participating securities that are included in computing EPS under the two-
class method.
See Note
15
for further discussion on equity.
Incentive
Plans
In May 2014, our shareholders approved the 2014 Redwood Trust, Inc. Incentive Plan (“Incentive Plan”) for executive officers, employees, and non-employee
directors, which replaced the 2002 Redwood Trust, Inc. Incentive Plan. The Incentive Plan provides for the grant of restricted stock, deferred stock, deferred stock
units, performance-based awards (including performance stock units), dividend equivalents, stock payments, restricted stock units, and other types of awards to
eligible participants. Long-term incentive awards granted under the Incentive Plan generally vest over a three - or four -year period. Awards made under the
Incentive Plan to officers and other employees in lieu of the payment in cash of a portion of annual bonuses earned generally vest immediately, but are subject to a
three -year mandatory holding period. Deferred stock units and restricted stock have attached dividend equivalent rights, resulting in the payment of dividend
equivalents each time we pay a common stock dividend. Non-employee directors are also provided annual awards under the Incentive Plan that generally vest
immediately. The cost of the awards is amortized over the vesting period on a straight-line basis. Upon adoption of ASU 2016-09 in 2016, we elected to begin
accounting for forfeitures on employee equity awards as they occur.
F- 19
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
Employee
Stock
Purchase
Plan
In 2013, our shareholders approved an amendment to our previously amended 2002 Redwood Trust, Inc. Employee Stock Purchase Plan (“ESPP”) to increase
the number of shares available under the ESPP. The purpose of the ESPP is to give our employees an opportunity to acquire an equity interest in the Company
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 last day
of the calendar quarter.
Executive
Deferred
Compensation
Plan
In 2013, our Board of Directors approved an amendment to our 2002 Executive Deferred Compensation Plan (“EDCP”) to allow non-employee directors to
defer certain cash payments and dividends into DSUs. The EDCP allows eligible employees and directors to defer portions of current salary and certain other
forms of compensation. The Company matches some deferrals. Compensation deferred under the EDCP is recorded as a liability on our consolidated balance
sheets. The EDCP allows for the investment of deferrals in either an interest crediting account or DSUs.
401(k)
Plan
We offer a tax-qualified 401(k) Plan to all employees for retirement savings. Under this Plan, employees are allowed to defer and invest up to 100% of their
cash earnings, subject to the maximum 401(k) Plan contribution limit set forth by the Internal Revenue Service. We match some employee contributions to
encourage participation and to provide a retirement planning benefit to employees. Plan matching contributions made by the Company for the years ended
December 31, 2017 , 2016 , and 2015 were $0.5 million , $0.6 million , and $0.8 million , respectively. Vesting of the 401(k) Plan matching contributions is based
on the employee’s tenure at the Company, and over time an employee becomes increasingly vested in matching contributions.
See Note
16
for further discussion on equity compensation plans.
Taxes
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 frame
set forth in the Internal Revenue Code and also meet certain other requirements related to assets, income, and stock ownership. We assess our tax positions for all
open tax years and record tax benefits only if tax positions meet a more-likely-than-not threshold in accordance with GAAP guidance on accounting for uncertain
tax positions. We classify interest and penalties on material uncertain tax positions as interest expense and operating expense, respectively, in our consolidated
statements of income.
See Note
20
for further discussion on taxes.
Recent Accounting Pronouncements
Newly
Adopted
Accounting
Standards
Updates
("ASUs")
In January 2017, the FASB issued ASU 2017-03, "Accounting Changes and Error Corrections (Topic 250) and Investments - Equity Method and Joint
Ventures (Topic 323)." This new guidance requires that companies evaluate ASUs that have not been adopted to determine the appropriate financial statement
disclosures about the potential material effects of those ASUs on the financial statements when adopted. This new guidance was effective immediately. We
adopted this guidance, as required, in the first quarter of 2017, which did not have a material impact on our consolidated financial statements.
F- 20
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
Other
Recent
Accounting
Pronouncements
In August 2017, the FASB issued ASU 2017-12, "Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities." This
new guidance amends previous guidance to better align an entity's risk management activities and financial reporting for hedging relationships through changes to
both the designation and measurement guidance for qualifying hedging relationships and the presentation of hedge results. This new guidance is effective for fiscal
years beginning after December 15, 2018. Early adoption is permitted. We plan to adopt this new guidance by the required date and we are currently evaluating the
impact that this update will have on our consolidated financial statements.
In July 2017, the FASB issued ASU 2017-11, "Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging
(Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily
Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception." This new
guidance changes the classification analysis of certain equity-linked financial instruments (or embedded conversion options) with down round features. This new
guidance is effective for fiscal years beginning after December 15, 2018. Early adoption is permitted. We plan to adopt this new guidance by the required date and
do not anticipate that this update will have a material impact on our consolidated financial statements.
In May 2017, the FASB issued ASU 2017-09, "Compensation - Stock Compensation (Topic 718)." This new guidance provides guidance about which changes
to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718. This new guidance is effective for
fiscal years beginning after December 15, 2017, and should be applied prospectively to an award modified on or after the adoption date. Early adoption is
permitted. We plan to adopt this new guidance by the required date and do not anticipate that this update will have a material impact on our consolidated financial
statements.
In March 2017, the FASB issued ASU 2017-08, "Receivables - Nonrefundable Fees and Other Costs (Subtopic 310-20)." This new guidance shortens the
amortization period for certain callable debt securities purchased at a premium by requiring the premium to be amortized to the earliest call date. This new
guidance is effective for fiscal years beginning after December 15, 2018. Early adoption is permitted. We plan to adopt this new guidance by the required date and
do not anticipate that this update will have a material impact on our consolidated financial statements.
In November 2016, the FASB issued ASU 2016-18, "Statement of Cash Flows (Topic 230): Restricted Cash." This new guidance amends previous guidance
on how to classify and present changes in restricted cash on the statement of cash flows. This new guidance is effective for fiscal years beginning after December
15, 2017. Early adoption is permitted. We plan to adopt this new guidance by the required date and we will modify the presentation of our cash flow statement as
required.
In October 2016, the FASB issued ASU 2016-16, "Income Taxes (Topic 740): Intra-Entity Transfers of Assets Other Than Inventory." This new guidance
allows an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs. It also eliminates the
exceptions for an intra-entity transfer of assets other than inventory. This new guidance is effective for fiscal years beginning after December 15, 2017. Early
adoption is permitted. We plan to adopt this new guidance by the required date and do not anticipate that this update will have a material impact on our
consolidated financial statements.
In August 2016, the FASB issued ASU 2016-15, "Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments." This
new guidance provides guidance on how to present and classify certain cash receipts and cash payments in the statement of cash flows. This new guidance is
effective for fiscal years beginning after December 15, 2017. Early adoption is permitted. We plan to adopt this new guidance by the required date and do not
anticipate that this update will have a material impact on our consolidated financial statements.
F- 21
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
In June 2016, the FASB issued ASU 2016-13, "Financial Instruments - Credit Losses." This new guidance provides a new impairment model that is based on
expected losses rather than incurred losses to determine the allowance for credit losses. This new guidance is effective for fiscal years beginning after December
15, 2019. Early adoption is permitted for fiscal years beginning December 15, 2018. Currently, we have no financial instruments for which we maintain an
allowance for loan losses. As such, based on our initial evaluation of this new guidance, we do not believe the provisions in this guidance will have a material
impact to how we account for these instruments. Separately, we account for our available-for-sale securities under the other-than-temporary impairment ("OTTI")
model for debt securities. This new guidance requires that credit impairments on our available-for-sale securities be recorded in earnings using an allowance for
credit losses, with the allowance limited to the amount by which the security's fair value is less than its amortized cost basis. Subsequent reversals in credit loss
estimates are recognized in income. We plan to adopt this new guidance by the required date and continue to evaluate the impact that this update will have on our
consolidated financial statements.
In February 2016, the FASB issued ASU 2016-02, "Leases." This new guidance requires lessees to recognize most leases on their balance sheet as a right-of-
use asset and a lease liability. This new guidance retains a dual lease accounting model, which requires leases to be classified as either operating or capital leases
for lessees, for purposes of income statement recognition. This new guidance is effective for fiscal years beginning after December 15, 2018. Early adoption is
permitted. As discussed in Note
14
, our only material leases are those related to our leased office space, for which future payments under these leases totaled $18
million at December 31, 2017. Upon adoption of this standard in the first quarter of 2019, we will record a right-of-use asset and lease liability equal to the present
value of these future lease payments discounted at our incremental borrowing rate. Based on our initial evaluation of this new guidance, and taking into
consideration our current in-place leases, we do not expect that its adoption will have a material impact on our consolidated financial statements. We will continue
evaluating this new standard and caution that any changes in our business or additional leases we may enter into could change our initial assessment.
In January 2016, the FASB issued ASU 2016-01, "Recognition and Measurement of Financial Assets and Financial Liabilities." This new guidance amends
accounting related to the classification and measurement of investments in equity securities and the presentation of certain fair value changes for financial
liabilities measured at fair value. This new guidance also amends certain disclosure requirements associated with the fair value of financial instruments and it is
effective for fiscal years beginning after December 15, 2017. We plan to adopt this new guidance by the required date and do not anticipate that this update will
have a material impact on our consolidated financial statements.
In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers.” The update modifies the guidance companies use to recognize
revenue from contracts with customers for transfers of goods or services and transfers of nonfinancial assets, unless those contracts are within the scope of other
standards. The guidance also requires new qualitative and quantitative disclosures, including information about contract balances and performance obligations. In
July 2015, the FASB approved a one-year deferral of the effective date. Accordingly, the update is effective for us in the first quarter of 2018 with retrospective
application to prior periods presented or as a cumulative effect adjustment in the period of adoption. Early adoption was permitted in the first quarter of 2017. In
March 2016, the FASB issued ASU 2016-08, "Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue
Gross versus Net)." This new guidance provides additional implementation guidance on how an entity should identify the unit of accounting for the principal
versus agent evaluations. In May 2016, the FASB issued ASU 2016-12, "Revenue from Contracts with Customers (Topic 606): Narrow-Scope Improvements and
Practical Expedients," and in December 2016, the FASB issued ASU 2016-20, "Technical Corrections and Improvements to Topic 606, Revenue from Contracts
with Customers." These new ASUs provide more specific guidance on certain aspects of Topic 606. In September 2017, the FASB issued ASU 2017-13, "Revenue
Recognition (Topic 605), Revenue from Contracts with Customers (Topic 606), Leases (Topic 840), and Leases (Topic 842): Amendments to SEC Paragraphs
Pursuant to the Staff Announcement at the July 20, 2017 EITF Meeting and Rescission of Prior SEC Staff Announcements and Observer Comments (SEC
Update)." This new ASU allows certain public business entities to use the nonpublic business entity effective dates for adoption of the new revenue standard. In
November 2017, the FASB issued ASU 2017-14, "Income Statement - Reporting Comprehensive Income (Topic 220), Revenue Recognition (Topic 605), and
Revenue from Contracts with Customers (Topic 606): Amendments to SEC Paragraphs Pursuant to Staff Accounting Bulletin No. 116 and SEC Release No. 33-
10403." This new ASU amends various paragraphs that contain SEC guidance. The adoption of these accounting standards will not have a material impact on our
consolidated financial statements, as financial instruments are explicitly scoped out of these standards and nearly all of our income is generated from financial
instruments. Any changes in our business or additional amendments to these standards could change our initial assessment of these accounting standards.
F- 22
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
Balance Sheet Netting
Certain of our derivatives and short-term debt are subject to master netting arrangements or similar agreements. Under GAAP, in certain circumstances we
may elect to present certain financial assets, liabilities and related collateral subject to master netting arrangements in a net position on our consolidated balance
sheets. However, we do not report any of these financial assets or liabilities on a net basis, and instead present them on a gross basis on our consolidated balance
sheets.
The table below presents financial assets and liabilities that are subject to master netting arrangements or similar agreements categorized by financial
instrument, together with corresponding financial instruments and corresponding collateral received or pledged at December 31, 2017 and December 31, 2016 .
Table 3.1 – Offsetting of Financial Assets, Liabilities, and Collateral
Gross Amounts
of Recognized
Assets
(Liabilities)
Gross Amounts
Offset in
Consolidated
Balance Sheet
Net Amounts of
Assets
(Liabilities)
Presented in
Consolidated
Balance Sheet
Gross Amounts Not Offset in
Consolidated
Balance Sheet (1)
Financial
Instruments
Cash Collateral
(Received)
Pledged
Net Amount
December 31, 2017
(In Thousands)
Assets (2)
Interest rate agreements
$
10,164 $
— $
10,164 $
(6,196) $
(42) $
3,926
TBAs
Futures
Total Assets
Liabilities (2)
133
1
—
—
133
1
(133)
—
—
—
—
1
$
10,298 $
— $
10,298 $
(6,329) $
(42) $
3,927
Interest rate agreements
$
(55,567) $
— $
(55,567) $
6,196 $
49,371 $
TBAs
Loan warehouse debt
Security repurchase agreements
(3,808)
(1,039,666)
(648,746)
—
—
—
(3,808)
133
1,376
(1,039,666)
1,039,666
(648,746)
648,746
—
—
—
(2,299)
—
—
Total Liabilities
$
(1,747,787) $
— $
(1,747,787) $
1,694,741 $
50,747 $
(2,299)
F- 23
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 3. Summary of Significant Accounting Policies - (continued)
—
12,460
—
(745)
—
—
—
Gross Amounts
of Recognized
Assets
(Liabilities)
Gross Amounts
Offset in
Consolidated
Balance Sheet
Net Amounts of
Assets
(Liabilities)
Presented in
Consolidated
Balance Sheet
Gross Amounts Not Offset in
Consolidated
Balance Sheet (1)
Financial
Instruments
Cash Collateral
(Received)
Pledged
Net Amount
$
$
24,980 $
8,300
33,280 $
— $
—
— $
24,980 $
8,300
(7,736) $
(3,936)
(4,784) $
12,460
(4,364)
33,280 $
(11,672)
$
(9,148) $
December 31, 2016
(In Thousands)
Assets (2)
Interest rate agreements
TBAs
Total Assets
Liabilities (2)
Interest rate agreements
$
(56,919) $
— $
(56,919) $
7,736 $
49,183 $
TBAs
Futures
Loan warehouse debt
Security repurchase agreements
(4,681)
(928)
(485,544)
(305,995)
—
—
—
—
(4,681)
(928)
(485,544)
(305,995)
3,936
—
485,544
305,995
—
928
—
—
Total Liabilities
$
(854,067) $
— $
(854,067) $
803,211 $
50,111 $
(745)
(1) Amounts presented in these columns are limited in total to the net amount of assets or liabilities presented in the prior column by instrument. In certain cases, there is excess
cash collateral or financial assets we have pledged to a counterparty (which may, in certain circumstances, be a clearinghouse) that exceed the financial liabilities subject to
a master netting arrangement or similar agreement. Additionally, in certain cases, counterparties may have pledged excess cash collateral to us that exceeds our
corresponding financial assets. In each case, any of these excess amounts are excluded from the table although they are separately reported in our consolidated balance
sheets as assets or liabilities, respectively.
(2)
Interest rate agreements, TBAs, credit default index swaps, and futures are components of derivatives instruments on our consolidated balance sheets. Loan warehouse debt,
which is secured by residential mortgage loans, and security repurchase agreements are components of Short-term debt on our consolidated balance sheets.
For each category of financial instrument set forth in the table above, the assets and liabilities resulting from individual transactions within that category
between us and a counterparty are subject to a master netting arrangement or similar agreement with that counterparty that provides for individual transactions to
be aggregated and treated as a single transaction. For certain categories of these instruments, some of our transactions are cleared and settled through one or more
clearinghouses that are substituted as our counterparty. References herein to master netting arrangements or similar agreements include the arrangements and
agreements governing the clearing and settlement of these transactions through the clearinghouses. In the event of the termination and close-out of any of those
transactions, the corresponding master netting agreement or similar agreement provides for settlement on a net basis. Any such settlement would include the
proceeds of the liquidation of any corresponding collateral, subject to certain limitations on termination, settlement, and liquidation of collateral that may apply in
the event of the bankruptcy or insolvency of a party. Such limitations should not inhibit the eventual practical realization of the principal benefits of those
transactions or the corresponding master netting arrangement or similar agreement and any corresponding collateral.
Note 4. Principles of Consolidation
GAAP requires us to consider whether securitizations we sponsor and other transfers of financial assets should be treated as sales or financings, as well as
whether any VIEs that we hold variable interests in – for example, certain legal entities often used in securitization and other structured finance transactions –
should be included in our consolidated financial statements. The GAAP principles we apply require us to reassess our requirement to consolidate VIEs each quarter
and therefore our determination may change based upon new facts and circumstances pertaining to each VIE. This could result in a material impact to our
consolidated financial statements during subsequent reporting periods.
F- 24
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 4. Principles of Consolidation - (continued)
Analysis of Consolidated VIEs
As of December 31, 2017 , we consolidated certain Legacy Sequoia and our Sequoia Choice securitization entities that we determined were VIEs and for
which we determined we were the primary beneficiary. Each of these entities is independent of Redwood and of each other and the assets and liabilities of these
entities are not owned by and are not legal obligations of ours. Our exposure to these entities is primarily through the financial interests we have retained, although
we are exposed to certain financial risks associated with our role as a sponsor, servicing administrator, or depositor of these entities or as a result of our having sold
assets directly or indirectly to these entities. At December 31, 2017 , the estimated fair value of our investments in the consolidated Legacy Sequoia and Sequoia
Choice entities was $14 million and $78 million , respectively. The following table presents a summary of the assets and liabilities of these VIEs.
Table 4.1 – Assets and Liabilities of Consolidated VIEs
December 31, 2017
(Dollars in Thousands)
Residential loans, held-for-investment
Restricted cash
Accrued interest receivable
REO
Total Assets
Accrued interest payable
Accrued expenses and other liabilities
Asset-backed securities issued
Total Liabilities
Number of VIEs
December 31, 2016
(Dollars in Thousands)
Residential loans, held-for-investment
Restricted cash
Accrued interest receivable
REO
Total Assets
Accrued interest payable
Asset-backed securities issued
Total Liabilities
Number of VIEs
Legacy
Sequoia
Sequoia
Choice
Total
Consolidated
VIEs
$
632,817 $
620,062 $
1,252,879
$
$
$
147
867
3,353
637,184
$
537 $
—
622,445
622,982
$
4
2,524
—
622,590 $
2,031 $
4
542,140
544,175 $
151
3,391
3,353
1,259,774
2,568
4
1,164,585
1,167,157
20
2
22
Legacy
Sequoia
Sequoia
Choice
$
791,636 $
148
1,000
5,533
798,317
$
518 $
773,462
773,980
$
20
$
$
$
F- 25
Total
Consolidated
VIEs
791,636
148
1,000
5,533
798,317
518
773,462
773,980
20
— $
—
—
—
— $
— $
—
— $
—
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 4. Principles of Consolidation - (continued)
We consolidate the assets and liabilities of certain Sequoia securitization entities, as we did not meet the GAAP sale criteria at the time we transferred
financial assets to these entities. Our involvement in consolidated Sequoia entities continues in the following ways: (i) we continue to hold subordinate investments
in each entity, and for certain entities, more senior investments; (ii) we maintain certain discretionary rights associated with our sponsorship of, or our subordinate
investments in, each entity; and (iii) we continue to hold a right to call the assets of certain entities (once they have been paid down below a specified threshold) at
a price equal to, or in excess of, the current outstanding principal amount of the entity’s asset-backed securities issued. These factors have resulted in our
continuing to consolidate the assets and liabilities of these Sequoia entities in accordance with GAAP.
Analysis of Unconsolidated VIEs with Continuing Involvement
Since 2012, we have transferred residential loans to 36 Sequoia securitization entities sponsored by us and accounted for these transfers as sales for financial
reporting purposes, in accordance with ASC 860. We also determined we were not the primary beneficiary of these VIEs as we lacked the power to direct the
activities that will have the most significant economic impact on the entities. For certain of these transfers to securitization entities, for the transferred loans where
we held the servicing rights prior to the transfer and continued to hold the servicing rights following the transfer, we recorded MSRs on our consolidated balance
sheets, and classified those MSRs as Level 3 assets. We also retained senior and subordinate securities in these securitizations that we classified as Level 3 assets.
Our continuing involvement in these securitizations is limited to customary servicing obligations associated with retaining servicing rights (which we retain a third-
party sub-servicer to perform) and the receipt of interest income associated with the securities we retained.
During the years ended December 31, 2017 and 2016 , we transferred residential loans to seven and three Sequoia securitization entities sponsored by us,
respectively, and accounted for these transfers as sales for financial reporting purposes. The following table presents information related to securitization
transactions that occurred during the years ended December 31, 2017 and 2016 .
Table 4.2 – Securitization Activity Related to Unconsolidated VIEs Sponsored by Redwood
(In Thousands)
Principal balance of loans transferred
Trading securities retained, at fair value
AFS securities retained, at fair value
MSRs recognized
Years Ended December 31,
2017
2016
$
2,573,789 $
1,036,584
66,321
13,341
7,123
3,573
5,554
6,451
The following table summarizes the cash flows during the years ended December 31, 2017 and 2016 between us and the unconsolidated VIEs sponsored by us
and accounted for as sales since 2012.
Table 4.3 – Cash Flows Related to Unconsolidated VIEs Sponsored by Redwood
(In Thousands)
Proceeds from new transfers
MSR fees received
Funding of compensating interest, net
Cash flows received on retained securities
Years Ended December 31,
2017
2016
$
2,563,499 $
1,057,688
14,302
(151)
27,156
13,842
(338)
30,191
F- 26
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 4. Principles of Consolidation - (continued)
The following table presents the key weighted average assumptions used to measure MSRs and securities retained at the date of securitization for
securitizations completed during 2017 and 2016 .
Table 4.4 – Assumptions Related to Assets Retained from Unconsolidated VIEs Sponsored by Redwood
Year Ended December 31, 2017
Year Ended December 31, 2016
At Date of Securitization
MSRs
Senior IO
Securities
Subordinate
Securities
MSRs
Senior IO
Securities
Subordinate
Securities
Prepayment rates
Discount rates
Credit loss assumptions
9%
11%
N/A
10%
14%
0.25%
10%
5%
0.25%
21%
11%
N/A
N/A
N/A
N/A
15%
6%
0.25%
The following table presents additional information at December 31, 2017 and December 31, 2016 , related to unconsolidated VIEs sponsored by Redwood
and accounted for as sales since 2012.
Table 4.5 – Unconsolidated VIEs Sponsored by Redwood
(In Thousands)
On-balance sheet assets, at fair value:
Interest-only, senior and subordinate securities, classified as trading
Subordinate securities, classified as AFS
Mortgage servicing rights
Maximum loss exposure (1)
Assets transferred:
Principal balance of loans outstanding
Principal balance of loans 30+ days delinquent
December 31, 2017
December 31, 2016
$
$
$
101,426 $
219,255
60,980
381,661 $
8,364,148 $
27,926
41,909
234,025
58,800
334,734
6,870,398
21,427
(1) Maximum loss exposure from our involvement with unconsolidated VIEs pertains to the carrying value of our securities and MSRs retained from these VIEs and represents
estimated losses that would be incurred under severe, hypothetical circumstances, such as if the value of our interests and any associated collateral declines to zero. This
does not include, for example, any potential exposure to representation and warranty claims associated with our initial transfer of loans into a securitization.
F- 27
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 4. Principles of Consolidation - (continued)
The following table presents key economic assumptions for assets retained from unconsolidated VIEs and the sensitivity of their fair values to immediate
adverse changes in those assumptions at December 31, 2017 and December 31, 2016 .
Table 4.6 – Key Assumptions and Sensitivity Analysis for Assets Retained from Unconsolidated VIEs Sponsored by Redwood
December 31, 2017
(Dollars in Thousands)
Fair value at December 31, 2017
Expected life (in years) (2)
Prepayment speed assumption (annual CPR) (2)
Decrease in fair value from:
10% adverse change
25% adverse change
Discount rate assumption (2)
Decrease in fair value from:
100 basis point increase
200 basis point increase
Credit loss assumption (2)
Decrease in fair value from:
10% higher losses
25% higher losses
December 31, 2016
(Dollars in Thousands)
Fair value at December 31, 2016
Expected life (in years) (2)
Prepayment speed assumption (annual CPR) (2)
Decrease in fair value from:
10% adverse change
25% adverse change
Discount rate assumption (2)
Decrease in fair value from:
100 basis point increase
200 basis point increase
Credit loss assumption (2)
Decrease in fair value from:
10% higher losses
25% higher losses
MSRs
Senior
Securities (1)
Subordinate
Securities
$
60,980
$
33,773
$
286,908
8
9%
$
2,022
$
4,839
11%
$
2,386
$
4,597
N/A
N/A $
N/A
6
10%
$
1,371
3,289
11%
$
1,158
2,265
0.25%
— $
—
13
11%
611
1,506
5%
25,827
47,885
0.25%
1,551
3,873
MSRs
Senior
Securities (1)
Subordinate
Securities
$
58,800
$
26,618
$
249,317
7
11%
$
2,226
$
5,284
11%
$
2,088
$
4,032
N/A
N/A $
N/A
6
8%
$
1,075
2,569
8%
$
1,105
2,128
0.25%
$
19
49
12
12%
997
2,494
6%
19,574
36,574
0.25%
1,174
2,933
(1) Senior securities included $34 million and $27 million of interest-only securities at December 31, 2017 and December 31, 2016 , respectively.
(2) Expected life, prepayment speed assumption, discount rate assumption, and credit loss assumption presented in the tables above represent weighted averages.
F- 28
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 4. Principles of Consolidation - (continued)
Analysis of Third-Party VIEs
Third-party VIEs are securitization entities in which we maintain an economic interest, but do not sponsor. Our economic interest may include several
securities from the same third-party VIE, and in those cases, the analysis is performed in consideration of all of our interests. The following table presents a
summary of our interests in third-party VIEs at December 31, 2017 , grouped by security type.
Table 4.7 – Third-Party Sponsored VIE Summary
(Dollars in Thousands)
Mortgage-Backed Securities
Senior
Re-REMIC
Subordinate
Total Investments in Third-Party Sponsored VIEs
December 31, 2017
$
$
177,191
38,875
939,763
1,155,829
We determined that we are not the primary beneficiary of any third-party VIEs, as we do not have the required power to direct the activities that most
significantly impact the economic performance of these entities. Specifically, we do not service or manage these entities or otherwise solely hold decision making
powers that are significant. As a result of this assessment, we do not consolidate any of the underlying assets and liabilities of these third-party VIEs – we only
account for our specific interests in them.
Our assessments of whether we are required to consolidate a VIE may change in subsequent reporting periods based upon changing facts and circumstances
pertaining to each VIE. Any related accounting changes could result in a material impact to our financial statements.
Note 5. Fair Value of Financial Instruments
For financial reporting purposes, we follow a fair value hierarchy established under GAAP that is used to determine the fair value of financial instruments.
This hierarchy prioritizes relevant market inputs in order to determine an “exit price” at the measurement date, 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. Level 1 inputs are observable inputs that reflect quoted prices
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 required to be 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 at which the fair value
measurement 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.
F- 29
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
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 at
December 31, 2017 and December 31, 2016 .
Table 5.1 – Carrying Values and Fair Values of Assets and Liabilities
(In Thousands)
Assets
Residential loans, held-for-sale
At fair value
At lower of cost or fair value
Residential loans, held-for-investment
At fair value
Trading securities
Available-for-sale securities
MSRs
Cash and cash equivalents
Restricted cash
Accrued interest receivable
Derivative assets
REO (1)
Margin receivable (1)
FHLBC stock (1)
Guarantee asset (1)
Commercial loans (1)
Pledged collateral (1)
Liabilities
Short-term debt facilities
Accrued interest payable
Margin payable (2)
Guarantee obligation (2)
Derivative liabilities
ABS issued at fair value, net
FHLBC long-term borrowings
Convertible notes, net
Trust preferred securities and subordinated notes, net
December 31, 2017
December 31, 2016
Carrying
Value
Fair
Value
Carrying
Value
Fair
Value
$
1,427,052 $
1,427,052 $
834,193 $
893
993
1,206
834,193
1,365
3,687,265
3,687,265
3,052,652
3,052,652
968,844
507,666
63,598
144,663
2,144
27,013
15,718
3,354
85,044
43,393
2,869
—
42,615
968,844
507,666
63,598
144,663
2,144
27,013
15,718
3,806
85,044
43,393
2,869
—
42,615
445,687
572,752
118,526
212,844
8,623
18,454
36,595
5,533
68,038
43,393
4,092
2,700
42,875
445,687
572,752
118,526
212,844
8,623
18,454
36,595
5,560
68,038
43,393
4,092
2,700
42,875
$
1,688,412 $
1,688,412 $
791,539 $
791,539
18,435
390
19,487
63,081
1,164,585
1,999,999
686,759
138,535
18,435
390
18,878
63,081
1,164,585
1,999,999
692,369
103,230
9,608
12,783
21,668
66,329
773,462
1,999,999
482,195
138,489
9,608
12,783
22,181
66,329
773,462
1,999,999
493,365
96,255
(1) These assets are included in Other assets on our consolidated balance sheets.
(2) These liabilities are included in Accrued expenses and other liabilities on our consolidated balance sheets.
During the years ended December 31, 2017 and 2016 , we elected the fair value option for $47 million and $5 million of residential senior securities, $594
million and $288 million of subordinate securities, $5.64 billion and $4.85 billion of residential loans (principal balance), and $8 million and $25 million of MSRs,
respectively. We anticipate electing the fair value option for all future purchases of residential loans that we intend to sell to third parties or transfer to
securitizations as well as for MSRs purchased or retained from sales of residential loans, and for certain securities we purchase, including IO securities and fixed-
rate securities rated investment grade or higher.
F- 30
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
The following table presents the assets and liabilities that are reported at fair value on our consolidated balance sheets on a recurring basis at December 31,
2017 and December 31, 2016 , as well as the fair value hierarchy of the valuation inputs used to measure fair value.
Table 5.2 – Assets and Liabilities Measured at Fair Value on a Recurring Basis
December 31, 2017
(In Thousands)
Assets
Residential loans
Trading securities
Available-for-sale securities
Derivative assets
MSRs
Pledged collateral
FHLBC stock
Guarantee asset
Liabilities
Derivative liabilities
ABS issued
December 31, 2016
(In Thousands)
Assets
Residential loans
Trading securities
Available-for-sale securities
Derivative assets
MSRs
Pledged collateral
FHLBC stock
Guarantee asset
Liabilities
Derivative liabilities
ABS issued
Carrying Value
Level 1
Level 2
Level 3
Fair Value Measurements Using
$
5,114,317 $
— $
— $
5,114,317
968,844
507,666
15,718
63,598
42,615
43,393
2,869
—
—
134
—
42,615
—
—
—
—
10,164
—
—
43,393
—
968,844
507,666
5,420
63,598
—
—
2,869
$
63,081 $
3,808 $
55,567 $
3,706
1,164,585
—
—
1,164,585
Carrying
Value
Fair Value Measurements Using
Level 1
Level 2
Level 3
— $
3,886,845
$
3,886,845 $
445,687
572,752
36,595
118,526
42,875
43,393
4,092
— $
—
—
8,300
—
42,875
—
—
—
—
24,980
—
—
43,393
—
445,687
572,752
3,315
118,526
—
—
4,092
3,801
773,462
$
66,329 $
5,609 $
56,919 $
773,462
—
—
F- 31
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
The following table presents additional information about Level 3 assets and liabilities measured at fair value on a recurring basis for the years ended
December 31, 2017 and 2016.
Table 5.3 – Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis
(In Thousands)
Residential Loans
Trading Securities
Assets
AFS
Securities
MSRs
Guarantee Asset
Derivatives (1)
Beginning balance -
December 31, 2016
Acquisitions
Sales
Principal paydowns
Gains (losses) in net
income, net
Unrealized losses in OCI,
net
Other settlements, net (2)
Ending balance -
December 31, 2017
$
3,886,845 $
445,687 $
572,752 $
118,526 $
4,092 $
(486) $
5,741,427
(3,982,683)
(573,168)
640,760
(137,886)
(19,224)
39,700
(90,440)
(58,554)
8,026
(52,788)
—
—
—
—
—
—
—
46,119
39,507
31,892
(10,166)
(1,223)
37,220
29,187
—
(4,223)
—
—
12,316
—
—
—
—
—
—
(35,020)
—
—
$
5,114,317 $
968,844 $
507,666 $
63,598 $
2,869 $
1,714 $
1,164,585
Liabilities
ABS
Issued
773,462
567,099
—
(205,163)
Residential
Loans
Commercial
Loans
Trading
Securities
AFS
Securities
MSRs
Guarantee
Asset
Derivatives (1)
Assets
Liabilities
Commercial
Secured
Borrowings
ABS
Issued
$
3,797,551 $
106,798 $
404,011 $
829,245 $
191,976 $
5,697 $
3,208 $
63,152 $
996,820
4,747,564
37,625
292,875
34,520
25,362
(3,813,538)
(81,523)
(244,219)
(252,696)
(62,440)
(806,081)
(476)
(17,827)
(62,229)
—
—
—
—
—
—
—
—
—
—
—
(306)
(208,215)
(33,893)
2,791
10,847
48,399
(36,372)
(1,605)
30,193
2,369
(8,275)
—
—
(4,758)
(65,215)
—
—
(24,487)
—
—
—
—
—
—
—
—
(33,887)
(65,215)
(6,868)
$
3,886,845 $
— $
445,687 $
572,752 $
118,526 $
4,092 $
(486) $
— $
773,462
(In Thousands)
Beginning balance -
December 31, 2015
Acquisitions
Sales
Principal paydowns
Gains (losses) in net
income, net
Unrealized gains in
OCI, net
Other settlements, net
(2)
Ending balance -
December 31, 2016
(1) For the purpose of this presentation, derivative assets and liabilities, which consist of loan purchase and forward sale commitments, are presented on a net basis.
(2) Other settlements, net for residential loans represents the transfer of loans to REO, and for derivatives, the transfer of the fair value of loan purchase commitments at the
time loans are acquired to the basis of residential loans. For commercial secured borrowings and commercial loans, the reduction in 2016 represents the derecognition of
our commercial secured borrowings and related commercial A-note investments upon sale of the associated B-notes.
F- 32
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
The following table presents the portion of gains or losses included in our consolidated statements of income that were attributable to Level 3 assets and
liabilities recorded at fair value on a recurring basis and held at December 31, 2017 , 2016 , and 2015 . Gains or losses incurred on assets or liabilities sold,
matured, called, or fully written down during the years ended December 31, 2017 , 2016 , and 2015 are not included in this presentation.
Table 5.4 – Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at December 31, 2017 , 2016 , and 2015 Included in Net
Income
(In Thousands)
Assets
Residential loans at Redwood
Residential loans at consolidated Sequoia entities
Commercial loans
Trading securities
Available-for-sale securities
MSRs
Loan purchase commitments
Loan forward sale commitments
Other assets - Guarantee asset
Liabilities
Loan purchase commitments
Commercial secured borrowing
ABS issued
Included in Net Income
Years Ended December 31,
2017
2016
2015
$
523 $
17,727
—
28,612
(1,011)
1,277
3,243
2,177
(1,223)
$
(3,706) $
—
(29,187)
F- 33
(17,370) $
(14,391)
—
7,184
(368)
42,964
—
—
(1,605)
(486) $
—
8,275
(5,541)
7,422
(2,620)
(13,391)
(246)
(3,471)
4,252
—
(1,504)
—
3,011
(8,366)
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
The following table presents information on assets recorded at fair value on a non-recurring basis at December 31, 2017 and December 31, 2016 . This table
does not include the carrying value and gains or losses associated with the asset types below that were not recorded at fair value on our consolidated balance sheets
at December 31, 2017 and December 31, 2016 .
Table 5.5 – Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis
December 31, 2017
(In Thousands)
Assets
Carrying
Fair Value Measurements Using
Gain (Loss) for
Year Ended
Value
Level 1
Level 2
Level 3
December 31, 2017
Residential loans, at lower of cost or fair value
$
854 $
REO
2,034
— $
—
— $
—
854 $
2,034
22
(393)
December 31, 2016
(In Thousands)
Assets
Carrying
Fair Value Measurements Using
Gain (Loss) for
Year Ended
Value
Level 1
Level 2
Level 3
December 31, 2016
Residential loans, at lower of cost or fair value
$
867 $
— $
— $
867 $
Commercial loans, at lower of cost or fair value
REO
2,700
5,207
F- 34
—
—
—
—
2,700
5,207
(17)
(300)
(1,831)
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
The following table presents the net market valuation gains and losses recorded in each line item of our consolidated statements of income for the years ended
December 31, 2017 , 2016 , and 2015 .
Table 5.6 – Market Valuation Gains and Losses, Net
(In Thousands)
Mortgage Banking Activities, Net
Residential loans held-for-sale, at fair value
Residential loan purchase and forward sale commitments
Commercial loans, at fair value
Sequoia securities
Risk management derivatives, net
Total mortgage banking activities, net (1)
Investment Fair Value Changes, Net
Residential loans held-for-investment at Redwood
Trading securities
Valuation adjustments on commercial loans held-for-sale
Net investments in Legacy Sequoia entities (2)
Net investments in Sequoia Choice entities (2)
Risk-sharing investments
Risk management derivatives, net
Impairments on AFS securities
Total investment fair value changes, net
MSR Income (Loss), Net
MSRs
Risk management derivatives, net
Total MSR loss, net (3)
Total Market Valuation Gains (Losses), Net
Years Ended December 31,
2017
2016
2015
31,493 $
37,880
—
—
(17,529)
5,786 $
25,613
433
1,455
3,158
51,844 $
36,445 $
(5,765) $
(23,102) $
39,526
300
(8,027)
(323)
(1,484)
(12,842)
(1,011)
9,666
(307)
(4,200)
—
(1,151)
(9,112)
(368)
3,712
50,234
10,265
(15,261)
(42,468)
6,482
(6,337)
(2,019)
—
(1,192)
—
(1,886)
(9,677)
(246)
10,374 $
(28,574) $
(21,357)
(10,166) $
(36,372) $
(568)
(10,734) $
51,484 $
15,584
(20,788) $
(12,917) $
(24,392)
(12,708)
(37,100)
(51,975)
$
$
$
$
$
$
$
(1) Mortgage banking activities, net presented above does not include fee income or provisions for repurchases that are components of Mortgage banking activities, net
presented on our consolidated statements of income, as these amounts do not represent market valuation changes.
(2)
Includes changes in fair value of the residential loans held-for-investment, REO and the ABS issued at the entities, which netted together represent the change in value of
our retained investments at the consolidated VIEs.
(3) MSR income (loss), net presented above does not include net fee income or provisions for repurchases that are components of MSR income (loss), net on our consolidated
statements of income, as these amounts do not represent market valuation adjustments.
F- 35
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
Valuation Policy
We maintain a policy that specifies the methodologies we use to value different types of financial instruments. Significant changes to the valuation
methodologies are reviewed by members of senior management to confirm the changes are appropriate and reasonable. Valuations based on information from
external sources are performed on an instrument-by-instrument basis with the resulting amounts analyzed individually against internal calculations as well as in the
aggregate by product type classification. Initial valuations are performed by our portfolio management groups using the valuation processes described below. Our
finance department then independently reviews all fair value estimates using available market, portfolio, and industry information to ensure they are reasonable.
Finally, members of senior management review all fair value estimates, including an analysis of the methodology and valuation changes from prior reporting
periods.
Valuation Process
We estimate fair values for financial assets or liabilities based on available inputs observed in the marketplace as well as unobservable inputs. We primarily
use two pricing valuation techniques: market comparable pricing and discounted cash flow analysis. Market comparable pricing is used to determine the estimated
fair value of certain instruments by incorporating known inputs and performance metrics, such as observed prepayment rates, delinquencies, severities, credit
support, recent transaction prices, pending transactions, or prices of other similar instruments. Discounted cash flow analysis techniques generally consist of
developing an estimate of future cash flows that are expected to occur over the life of an instrument and then discounting those cash flows at a rate of return that
results in an estimate of fair value. 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. We also consider counterparty credit
quality and risk as part of our fair value assessments.
F- 36
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
The following table provides quantitative information about the significant unobservable inputs used in the valuation of our Level 3 assets and liabilities
measured at fair value.
Table 5.7 – Fair Value Methodology for Level 3 Financial Instruments
December 31, 2017
(Dollars in Thousands, except
Input Values)
Fair
Value
Unobservable Input
Range
Input Values
Weighted
Average
Assets
Residential loans, at fair value:
Jumbo fixed rate loans
$
3,372,329 Whole loan spread to TBA price
$
2.25
- $
3.11
$
3.09
Jumbo hybrid loans
251,847 Prepayment rate (annual CPR)
Whole loan spread to swap rate
Whole loan spread to swap rate
175
15
100
-
-
-
225 bps
15 %
185 bps
224 bps
15 %
159 bps
Jumbo loans committed to sell
237,262 Whole loan committed sales price
$
100.78
- $
103.01
$
101.42
Loans held by Legacy Sequoia (1)
632,817 Liability price
Loans held by Sequoia Choice (1)
620,062 Liability price
Residential loans, at lower of cost or fair
value
854
Loss severity
Trading and AFS securities
1,476,510 Discount rate
Prepayment rate (annual CPR)
Default rate
Loss severity
MSRs
63,598 Discount rate
Prepayment rate (annual CPR)
Per loan annual cost to service
$
Guarantee asset
2,869 Discount rate
REO
Liabilities
Loan purchase commitments, net (2)
Prepayment rate (annual CPR)
2,034 Loss severity
462 MSR multiple
Pull-through rate
N/A
N/A
N/A
N/A
12
3
-
-
— -
— -
— -
10
5
79
11
13
6
1.7
9
-
-
- $
-
-
-
-
-
30 %
15 %
50 %
27 %
40 %
130 %
26 %
82
11 %
13 %
42 %
5.1 x
100 %
$
18 %
5 %
10 %
3 %
22 %
11 %
9 %
82
11 %
13 %
21 %
3.6 x
75 %
Whole loan spread to TBA price
$
2.25
- $
3.10
$
3.06
Whole loan spread to swap rate - fixed rate
Prepayment rate (annual CPR)
Whole loan spread to swap rate - hybrid
ABS issued (1)
1,164,585 Discount rate
Prepayment rate (annual CPR)
Default rate
Loss severity
175
15
100
3
8
-
-
-
-
-
— -
20
-
225 bps
15 %
185 bps
15 %
25 %
16 %
54 %
225 bps
15 %
151 bps
4 %
17 %
3 %
23 %
(1) The fair value of the loans held by consolidated Sequoia entities was based on the fair value of the ABS issued by these entities, which we determined were more readily
observable, in accordance with accounting guidance for collateralized financing entities.
(2) For the purpose of this presentation, loan purchase commitment assets and liabilities are presented net.
F- 37
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
Determination of Fair Value
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 herein. We generally use both market comparable information and discounted cash flow modeling techniques to determine the fair
value of our Level 3 assets and liabilities. Use of these techniques requires determination of relevant inputs and assumptions, some of which represent significant
unobservable inputs as indicated in the preceding table. Accordingly, a significant increase or decrease in any of these inputs – such as anticipated credit losses,
prepayment rates, interest rates, or other valuation assumptions – in isolation would likely result in a significantly lower or higher fair value measurement.
Residential
loans
at
Redwood
Estimated fair values for residential loans are determined using models that incorporate various observable inputs, including pricing information from whole
loan sales and securitizations. Certain significant inputs in these models are considered unobservable and are therefore Level 3 in nature. Pricing inputs obtained
from market whole loan transaction activity include indicative spreads to indexed TBA prices and indexed swap rates for fixed-rate loans and indexed swap rates
for hybrid loans (Level 3). Pricing inputs obtained from market securitization activity include indicative spreads to indexed TBA prices for senior RMBS, indexed
swap rates for subordinate RMBS, and credit support levels (Level 3). Other unobservable inputs also include assumed future prepayment rates. Observable inputs
include benchmark interest rates, swap rates, and TBA prices. These assets would generally decrease in value based upon an increase in the credit spread,
prepayment speed, or credit support assumptions.
Residential
loans
at
consolidated
Sequoia
entities
We have elected to account for the consolidated Sequoia securitization entities as collateralized financing entities in accordance with GAAP. A CFE is a
variable interest entity that holds financial assets and issues beneficial interests in those assets, and these beneficial interests have contractual recourse only to the
related assets of the CFE. Accounting guidance for CFEs allow companies to elect to measure both the financial assets and financial liabilities of a CFE using the
more observable of the fair value of the financial assets or fair value of the financial liabilities. Pursuant to this guidance, we use the fair value of the ABS issued
by the Sequoia CFEs (which we determined to be more observable) to determine the fair value of the loans held at these entities, whereby the net assets we
consolidate in our financial statements related to these entities represent the estimated fair value of our retained interests in the Sequoia CFEs.
Real
estate
securities
Real estate securities include residential, commercial, and other asset-backed securities that are generally illiquid in nature and trade infrequently. Significant
inputs in the valuation analysis are predominantly Level 3 in nature, due to the lack of readily available market quotes and related inputs. For real estate securities,
we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Relevant market indicators that are factored into the analysis
include bid/ask spreads, the amount and timing of credit losses, interest rates, and collateral prepayment rates. Estimated fair values are based on applying the
market indicators to generate discounted cash flows (Level 3). These cash flow models use significant unobservable inputs such as a discount rate, prepayment
rate, default rate, loss severity and credit support. The estimated fair value of our securities would generally decrease based upon an increase in default rates, loss
severities, or a decrease in prepayment rates or credit support.
As part of our securities valuation process, we request and consider indications of value from third-party securities dealers. For purposes of pricing our
securities at December 31, 2017 , we received dealer price indications on 80% of our securities, representing 85% of our carrying value. In the aggregate, our
internal valuations of the securities for which we received dealer price indications were within 1% of the aggregate average dealer valuations. Once we receive the
price indications from dealers, they are compared to other relevant market inputs, such as actual or comparable trades, and the results of our discounted cash flow
analysis. In circumstances where relevant market inputs cannot be obtained, increased reliance on discounted cash flow analysis and management judgment are
required to estimate fair value.
F- 38
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
Derivative
assets
and
liabilities
Our derivative instruments include swaps, swaptions, TBAs, financial futures, loan purchase commitments, and forward sale commitments. Fair values of
derivative instruments are determined using quoted prices from active markets, when available, or from valuation models and are supported by valuations provided
by dealers active in derivative markets. Fair values of TBAs and financial futures are generally obtained using quoted prices from active markets (Level 1). Our
derivative valuation models for swaps and swaptions require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of
volatility, prepayment rates, and correlations of certain inputs. Model inputs can generally be verified and model selection does not involve significant
management judgment (Level 2).
LPC and FSC fair values for jumbo loans are estimated based on the estimated fair values of the underlying loans (as described in " Residential
loans
" above).
In addition, fair value for LPCs are estimated based on the probability that the mortgage loan will be purchased (the "Pull-through rate") (Level 3).
For other derivatives, valuations are based on various factors such as liquidity, bid/ask spreads, and credit considerations for which we rely on available
market inputs. In the absence of such inputs, management’s best estimate is used (Level 3).
MSRs
MSRs include the rights to service jumbo and conforming residential mortgage loans. Significant inputs in the valuation analysis are predominantly Level 3,
due to the nature of these instruments and the lack of readily available market quotes. Changes in the fair value of MSRs occur primarily due to the
collection/realization of expected cash flows, as well as changes in valuation inputs and assumptions. Estimated fair values are based on applying the inputs to
generate the net present value of estimated future MSR income (Level 3). These discounted cash flow models utilize certain significant unobservable inputs
including market discount rates, assumed future prepayment rates of serviced loans, and the market cost of servicing. An increase in these unobservable inputs
would generally reduce the estimated fair value of the MSRs.
As part of our MSR valuation process, we received a valuation estimate from a third-party valuations firm. In the aggregate, our internal valuation of the
MSRs were within 2% of the third-party valuation.
FHLBC
Stock
Our Federal Home Loan Bank ("FHLB") member subsidiary is required to purchase Federal Home Loan Bank of Chicago ("FHLBC") stock under a
borrowing agreement between our FHLB-member subsidiary and the FHLBC. Under this agreement, the stock is redeemable at face value, which represents the
carrying value and fair value of the stock (Level 2).
Guarantee
Asset
The guarantee asset represents the estimated fair value of cash flows we are contractually entitled to receive related to a risk-sharing arrangement with Fannie
Mae. Significant inputs in the valuation analysis are Level 3, due to the nature of this asset and the lack of market quotes. The fair value of the guarantee asset is
determined using a discounted cash flow model, for which significant unobservable inputs include assumed future prepayment rates and market discount rate
(Level 3). An increase in prepayment rates or discount rate would generally reduce the estimated fair value of the guarantee asset.
Pledged
Collateral
Pledged collateral consists of cash and U.S. Treasury securities held by a custodian in association with certain agreements we have entered into. Treasury
securities are carried at their fair value, which is determined using quoted prices in active markets (Level 1).
Cash
and
cash
equivalents
Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less. Fair values equal carrying
values (Level 1).
F- 39
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
Restricted
cash
Restricted cash primarily includes interest-earning cash balances related to risk-sharing transactions with the Agencies, cash held in association with
borrowings from the FHLBC, and cash held at consolidated Sequoia entities for the purpose of distribution to investors and reinvestment. Due to the short-term
nature of the restrictions, fair values approximate carrying values (Level 1).
Accrued
interest
receivable
and
payable
Accrued interest receivable and payable includes interest due on our assets and payable on our liabilities. Due to the short-term nature of when these interest
payments will be received or paid, fair values approximate carrying values (Level 1).
REO
REO includes properties owned in satisfaction of foreclosed loans. Fair values are determined using available market quotes, appraisals, broker price opinions,
comparable properties, or other indications of value (Level 3).
Margin
receivable
Margin receivable reflects cash collateral we have posted with our various derivative and debt counterparties as required to satisfy margin requirements. Fair
values approximate carrying values (Level 2).
Guarantee
Obligations
In association with our risk-sharing transactions with the Agencies, we have made certain guarantees. These obligations are initially recorded at fair value and
subsequently carried at amortized cost. Fair values of guarantee obligations are determined using internal models that incorporate certain significant inputs that are
considered unobservable and are therefore Level 3 in nature. Pricing inputs include assumed future prepayment rates, credit losses, and market discount rates. A
decrease in future prepayment rates or discount rates, or an increase in credit losses, would generally cause the fair value of the guarantee obligations to decrease
(i.e., become a larger liability).
Short-term
debt
Short-term debt includes our credit facilities that mature within one year. As these borrowings are secured and subject to margin calls and as the rates on these
borrowings reset frequently to market rates, we believe that carrying values approximate fair values (Level 2). Additionally, at December 31, 2017 , short-term
debt included unsecured convertible senior notes with a maturity of less than one year. The fair value of the convertible notes is determined using quoted prices in
generally active markets (Level 2).
ABS
issued
ABS issued includes asset-backed securities issued through the Legacy Sequoia and Sequoia Choice securitization entities. These instruments are generally
illiquid in nature and trade infrequently. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack
of readily available market quotes. For ABS issued, we utilize both market comparable pricing and discounted cash flow analysis valuation techniques. Relevant
market indicators factored into the analysis include bid/ask spreads, the amount and timing of collateral credit losses, interest rates, and collateral prepayment rates.
Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3). These cash flow models use significant
unobservable inputs such as a discount rate, prepayment rate, default rate, loss severity and credit support. A decrease in credit losses or discount rates, or an
increase in prepayment rates, would generally cause the fair value of the ABS issued to decrease (i.e., become a larger liability).
FHLBC
Borrowings
FHLBC borrowings include amounts borrowed from the FHLBC that are secured, generally by residential mortgage loans. As these borrowings are secured
and subject to margin calls and as the rates on these borrowings reset frequently to market rates, we believe that carrying values approximate fair values (Level 2).
F- 40
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 5. Fair Value of Financial Instruments - (continued)
Convertible
notes
Convertible notes include unsecured convertible and exchangeable senior notes. Fair values are determined using quoted prices in generally active markets
(Level 2).
Trust
preferred
securities
and
subordinated
notes
Estimated fair values of trust preferred securities and subordinated notes are determined using discounted cash flow analysis valuation techniques. Significant
inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. Estimated fair
values are based on applying the market indicators to generate discounted cash flows (Level 3).
Note 6. Residential Loans
We acquire residential loans from third-party originators and may sell or securitize these loans or hold them for investment. The following table summarizes
the classifications and carrying values of the residential loans owned at Redwood and at consolidated Sequoia entities at December 31, 2017 and December 31,
2016 .
Table 6.1 – Classifications and Carrying Values of Residential Loans
December 31, 2017
(In Thousands)
Held-for-sale
At fair value
At lower of cost or fair value
Total held-for-sale
Held-for-investment at fair value
Total Residential Loans
December 31, 2016
(In Thousands)
Held-for-sale
At fair value
At lower of cost or fair value
Total held-for-sale
Held-for-investment at fair value
Total Residential Loans
Redwood
Legacy
Sequoia
Sequoia
Choice
Total
$
1,427,052 $
893
1,427,945
2,434,386
$
3,862,331 $
— $
—
—
632,817
632,817
$
— $
1,427,052
—
—
620,062
620,062 $
893
1,427,945
3,687,265
5,115,210
Redwood
Legacy
Sequoia
Sequoia
Choice
$
834,193 $
1,206
835,399
2,261,016
$
3,096,415 $
— $
—
—
791,636
791,636
$
Total
834,193
1,206
835,399
3,052,652
3,888,051
— $
—
—
—
— $
At December 31, 2017 , we owned mortgage servicing rights associated with $3.03 billion (principal balance) of consolidated residential loans purchased from
third-party originators. The value of these MSRs is included in the carrying value of the associated loans on our consolidated balance sheets. We contract with
licensed sub-servicers that perform servicing functions for these loans.
F- 41
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 6. Residential Loans - (continued)
Residential Loans Held-for-Sale
At
Fair
Value
At December 31, 2017 , we owned 2,009 loans held-for-sale at fair value with an aggregate unpaid principal balance of $1.41 billion and a fair value of $1.43
billion , compared to 1,114 loans with an aggregate unpaid principal balance of $0.83 billion and a fair value of $0.83 billion at December 31, 2016 . At
December 31, 2017 , one of these loans with a fair value of $0.5 million was greater than 90 days delinquent and none of these loans were in foreclosure. At
December 31, 2016 , none of these loans were greater than 90 days delinquent or in foreclosure.
During the years ended December 31, 2017 and 2016 , we purchased $5.64 billion and $4.85 billion (principal balance) of loans, respectively, for which we
elected the fair value option, and we sold $4.21 billion and $4.04 billion (principal balance) of loans, respectively, for which we recorded net market valuation gain
s of $31 million and $6 million , respectively, through Mortgage banking activities, net on our consolidated statements of income. At December 31, 2017 , loans
held-for-sale with a market value of $1.15 billion were pledged as collateral under short-term borrowing agreements.
At
Lower
of
Cost
or
Fair
Value
At December 31, 2017 and December 31, 2016 , we held four and seven residential loans, respectively, at the lower of cost or fair value with $1 million and $2
million in outstanding principal balance, respectively, and a carrying value of $1 million for both periods. At both December 31, 2017 and December 31, 2016 ,
one of these loans with an unpaid principal balance of $0.3 million was greater than 90 days delinquent and none of these loans were in foreclosure.
Residential Loans Held-for-Investment at Fair Value
At
Redwood
At December 31, 2017 , we owned 3,292 held-for-investment loans at Redwood with an aggregate unpaid principal balance of $2.41 billion and a fair value of
$2.43 billion , compared to 3,068 loans with an aggregate unpaid principal balance of $2.23 billion and a fair value of $2.26 billion at December 31, 2016 . At
December 31, 2017 , none of these loans was greater than 90 days delinquent or in foreclosure. At December 31, 2016 , one of these loans with an unpaid principal
balance of $0.2 million was greater than 90 days delinquent and none of these loans were in foreclosure.
During the years ended December 31, 2017 and 2016 , we transferred loans with a fair value of $0.60 billion and $1.06 billion , respectively, from held-for-
sale to held-for-investment. During the years ended December 31, 2017 and 2016 , we transferred loans with a fair value of $99 million and $56 million ,
respectively, from held-for-investment to held-for-sale.
During the year s ended December 31, 2017 and 2016 , we recorded net market valuation loss es of $5 million and $23 million , respectively, on residential
loans held-for-investment at fair value through Investment fair value changes, net on our consolidated statements of income. At December 31, 2017 , loans with a
fair value of $2.43 billion were pledged as collateral under a borrowing agreement with the FHLBC.
The outstanding loans held-for-investment at Redwood at December 31, 2017 were prime-quality, first lien loans, of which 96% were originated between 2013
and 2017, and 4% were originated in 2012 and prior years. The weighted average FICO score of borrowers backing these loans was 770 (at origination) and the
weighted average loan-to-value ("LTV") ratio of these loans was 65% (at origination). At December 31, 2017 , these loans were comprised of 92% fixed-rate loans
with a weighted average coupon of 4.08% , and the remainder were hybrid or ARM loans with a weighted average coupon of 4.07% .
F- 42
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 6. Residential Loans - (continued)
At
Consolidated
Legacy
Sequoia
Entities
At December 31, 2017 , we owned 3,178 held-for-investment loans at consolidated Legacy Sequoia entities, with an aggregate unpaid principal balance of
$698 million and a fair value of $633 million , as compared to 3,735 loans at December 31, 2016 with an aggregate unpaid principal balance of $887 million and a
fair value of $792 million . At origination, the weighted average FICO score of borrowers backing these loans was 728 , the weighted average LTV ratio of these
loans was 66% , and the loans were nearly all first lien and prime-quality.
At December 31, 2017 and December 31, 2016 , the unpaid principal balance of loans at consolidated Sequoia entities delinquent greater than 90 days was $25
million and $30 million , respectively, of which the unpaid principal balance of loans in foreclosure was $10 million and $11 million , respectively. During the
years ended December 31, 2017 and 2016 , we recorded a net market valuation gain of $23 million and a net market valuation loss of $14 million , respectively, on
these loans through Investment fair value changes, net on our consolidated statements of income. Pursuant to the collateralized financing entity guidelines, the
market valuation changes of these loans are based on the estimated fair value of the associated ABS issued. The net impact to our income statement associated with
our retained economic investment in the Legacy Sequoia securitization entities is presented in Note
5.
At
Consolidated
Sequoia
Choice
Entities
At December 31, 2017 , we owned 806 held-for-investment loans at consolidated Sequoia Choice entities, with an aggregate unpaid balance of $605 million
and a fair value of $620 million . There were no loans held at the Sequoia Choice entities a t December 31, 2016 . At origination, the weighted average FICO score
of borrowers backing these loans was 742 , the weighted average LTV ratio of these loans was 75% , and the loans were all first lien and prime-quality. At
December 31, 2017 , none of these loans were greater than 90 days delinquent or in foreclosure.
During the year ended December 31, 2017 , we transferred loans with a fair value of $646 million from held-for-sale to held-for-investment, associated with
Choice securitizations. During the year ended December 31, 2017 , we recorded a net market valuation loss of $5 million on these loans through Investment fair
value changes, net on our consolidated statements of income. Pursuant to the collateralized financing entity guidelines, the market valuation changes of these loans
are based on the estimated fair value of the ABS issued associated with Choice securitizations .
The net impact to our income statement associated with our
retained economic investment in the Sequoia Choice securitization entities is presented in Note
5.
F- 43
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 6. Residential Loans - (continued)
Residential Loan Characteristics
The following table presents the geographic concentration of residential loans recorded on our consolidated balance sheets at December 31, 2017 and
December 31, 2016.
Table 6.2 – Geographic Concentration of Residential Loans
Geographic Concentration
(by Principal)
California
Washington
Texas
Florida
Georgia
New York
Other states (none greater than 5%)
Total
Geographic Concentration
(by Principal)
California
Texas
Washington
Florida
Georgia
New York
Other states (none greater than 5%)
Total
December 31, 2017
Held-for-Sale
Held-for-
Investment at Legacy
Sequoia
Held-for-
Investment at Sequoia
Choice
Held-for-
Investment at
FVO
35%
9%
7%
4%
2%
2%
41%
100%
18%
2%
5%
13%
5%
9%
48%
100%
39%
7%
10%
4%
3%
3%
34%
100%
45%
5%
9%
5%
1%
4%
31%
100%
December 31, 2016
Held-for-Sale
Held-for-
Investment at Legacy
Sequoia
Held-for-
Investment at Sequoia
Choice
Held-for-
Investment at
FVO
40%
9%
8%
3%
2%
2%
36%
100%
18%
6%
2%
14%
5%
8%
47%
100%
—%
—%
—%
—%
—%
—%
—%
—%
42%
10%
4%
5%
1%
4%
34%
100%
T he following table displays the loan product type and accompanying loan characteristics of residential loans recorded on our consolidated balance sheets at
December 31, 2017 and December 31, 2016.
F- 44
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 6. Residential Loans - (continued)
Table 6.3 – Product Types and Characteristics of Residential Loans
December 31, 2017
(In Thousands)
Loan Balance
Held-for-Investment at Redwood:
Hybrid ARM loans
$ — to
$250
$
$
$
251
501
751
to
to
to
$500
$750
$1,000
over $1,000
Fixed loans
$ — to
$250
$
$
$
251
501
751
to
to
to
$500
$750
$1,000
over $1,000
Total HFI at Redwood:
Held-for-Investment at Legacy Sequoia:
ARM loans:
Number of
Loans
Interest
Rate (1)
Maturity
Date
Total
Principal
30-89
Days
DQ
90+
Days
DQ
3.50% to 3.88%
2043-08 - 2044-01
$
1,589 $
438 $
7
43
87
82
40
259
34
681
2.63% to 4.88%
2043-07 - 2047-10
2.88% to 5.13%
2040-09 - 2047-11
2.88% to 6.00%
2043-12 - 2047-11
3.00% to 5.00%
2040-10 - 2047-11
3.13% to 5.08%
2022-10 - 2046-02
2.80% to 6.13%
2028-02 - 2047-12
1,261
2.75% to 6.75%
2027-09 - 2047-12
2.75% to 5.00%
2027-07 - 2047-12
2.80% to 5.00%
2030-11 - 2048-01
649
408
3,033
3,292
16,703
55,709
71,819
57,641
566
1,226
984
—
203,461
3,214
6,758
296,950
777,103
559,426
564,295
2,204,532
—
1,380
3,818
2,566
—
7,764
$
2,407,993 $
10,978 $
$ — to
$250
2,324
1.25% to 5.16%
2019-02 - 2035-11
$
253,438 $
7,436 $
$
$
$
251
501
751
to
to
to
$500
$750
$1,000
over $1,000
Hybrid ARM loans:
$ — to
$250
$
$
251
501
to
to
$500
$750
over $1,000
Total HFI at Legacy Sequoia:
Held-for-Investment at Sequoia Choice:
Fixed loans:
$
$
$
$
0
251
501
751
to
to
to
to
$250
$500
$750
$1,000
over $1,000
Total HFI at Sequoia Choice:
Held-for-Sale:
ARM loans
541
151
76
53
3,145
4
17
11
1
33
3,178
4
85
388
239
90
806
1.00% to 5.63%
2021-03 - 2036-05
1.63% to 4.00%
2024-05 - 2035-09
1.38% to 3.38%
2022-01 - 2035-07
1.00% to 4.63%
2027-03 - 2036-05
189,360
91,244
65,276
83,393
9,082
1,995
1,790
—
3.25% to 3.75%
2033-08 - 2034-06
2.63% to 3.75%
2033-07 - 2034-12
3.38% to 3.75%
2033-07 - 2034-11
3.75% to 3.75%
2033-09 - 2033-09
682,711
20,303
24,816
530
6,170
7,091
1,420
15,211
—
—
—
—
—
—
—
641
—
641
$
697,922 $
20,303 $
25,457
2.75% to 4.75%
2043-05 - 2047-07
$
641 $
— $
3.13% to 5.75%
2042-11 - 2047-10
3.13% to 6.25%
2037-02 - 2047-11
3.25% to 6.50%
2043-05 - 2047-10
3.13% to 5.88%
2045-01 - 2047-10
38,900
240,538
210,235
114,433
486
672
—
—
$
604,747 $
1,158 $
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
7,284
9,178
2,589
1,725
4,040
$
58
to
$290
Hybrid ARM loans
$
443
to
$2,000
Fixed loans
$
132
to
$1,950
Total Held-for-Sale
3
1.50% to 3.00%
2032-11 - 2033-10
$
444 $
— $
93
2.88% to 4.00%
2044-08 - 2048-01
78,884
—
1,917
2,013
2.88% to 6.25%
2029-05 - 2048-01
1,329,851
1,913
$
1,409,179 $
1,913 $
—
—
459
459
F- 45
Note 6. Residential Loans - (continued)
December 31, 2016
(In Thousands)
Loan Balance
Held-for-Investment at Redwood:
Hybrid ARM loans
$
$
$
251
501
751
to
to
to
$500
$750
$1,000
over $1,000
Fixed loans
$ — to
$250
$
$
$
251
501
751
to
to
to
$500
$750
$1,000
over $1,000
Total HFI at Redwood:
Held-for-Investment at Legacy Sequoia:
ARM loans:
$
$
$
251
501
751
to
to
to
$500
$750
$1,000
over $1,000
Hybrid ARM loans:
$ — to
$250
$
$
$
251
501
751
to
to
to
$500
$750
$1,000
over $1,000
Total HFI at Legacy Sequoia:
Held-for-Sale:
ARM loans
$
61
to
$396
Hybrid ARM loans
$
2
to
$1,947
Fixed loans
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Number of
Loans
Interest
Rate (1)
Maturity
Date
Total
Principal
30-89
Days
DQ
90+
Days
DQ
3.63% to 3.63%
2044-07 - 2044-07
$
264 $
— $
1
4
2
4
11
2.88% to 4.65%
2040-09 - 2045-10
3.50% to 4.00%
2045-09 - 2045-10
3.00% to 4.20%
2040-10 - 2045-10
26
633
3.67% to 5.08%
2039-04 - 2045-10
2.80% to 5.13%
2028-02 - 2046-12
1,306
2.75% to 6.25%
2027-09 - 2046-12
2.75% to 5.63%
2027-07 - 2046-12
2.80% to 5.00%
2027-04 - 2047-01
690
402
3,057
3,068
2,722
1,726
5,545
10,257
4,643
278,560
807,714
597,002
535,621
2,223,540
—
—
—
—
—
264
2,803
—
1,232
4,299
$
2,233,797 $
4,299 $
0.25% to 5.75%
2019-12 - 2036-05
0.88% to 3.89%
2024-05 - 2035-09
0.63% to 3.00%
2022-01 - 2035-07
0.25% to 3.75%
2027-03 - 2036-05
3.00% to 3.00%
2033-09 - 2034-06
2.63% to 3.13%
2033-07 - 2034-12
2.75% to 3.13%
2033-07 - 2034-12
3.13% to 3.13%
2033-08 - 2033-08
3.00% to 3.00%
2033-09 - 2033-09
694
203
100
78
3,698
4
18
13
1
1
37
3,735
241,253
121,919
86,988
121,484
869,290
453
6,516
8,483
751
1,488
17,691
9,177
5,812
2,750
4,790
31,687
30,166
—
—
669
—
—
669
—
—
—
—
—
—
$
886,981 $
32,356 $
30,166
6
1.88% to 2.75%
2033-10 - 2032-11
$
882 $
— $
300
173
2.50% to 6.00%
2037-06 - 2047-01
144,174
—
—
—
—
—
—
237
—
—
—
—
237
237
7,410
10,059
5,069
3,322
4,306
—
—
300
$
404
to
$1,997
942
2.99% to 6.25%
2026-12 - 2047-01
688,329
Total Held-for-Sale
1,121
$
833,385 $
—
— $
(1) Rate is net of servicing fee for consolidated loans for which we do not own the MSR.
F- 46
$ — to
$250
2,623
0.63% to 5.60%
2019-02 - 2035-11
$
297,646 $
9,158 $
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 7. Real Estate Securities
We invest in real estate securities that we acquire from third parties or create and retain from our Sequoia securitizations. The following table presents the fair
values of our real estate securities by type at December 31, 2017 and December 31, 2016 .
Table 7.1 – Fair Values of Real Estate Securities by Type
(In Thousands)
Trading
Available-for-sale
Total Real Estate Securities
December 31, 2017
December 31, 2016
$
$
968,844 $
507,666
1,476,510 $
445,687
572,752
1,018,439
Our real estate securities include mortgage backed securities, which are presented in accordance with their general position within a securitization structure
based on their rights to cash flows. Senior securities are those interests in a securitization that generally 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 security interests to provide additional credit
support to those interests. These re-REMIC securities are therefore subordinate to the remaining senior security interests, but senior to any subordinate tranches of
the securitization from which they were created. Subordinate securities are all interests below senior and re-REMIC interests. We further separate our subordinate
securities into mezzanine and subordinate, where mezzanine includes securities initially rated AA through BBB- and issued in 2012 or later. Nearly all of our
residential securities are supported by collateral that was designated as prime at the time of issuance.
Trading Securities
The following table presents the fair value of trading securities by position and collateral type at December 31, 2017 and December 31, 2016 .
Table 7.2 – Trading Securities by Position and Collateral Type
(In Thousands)
Senior Securities
Subordinate Securities
Mezzanine
Subordinate
Total Subordinate Securities
Total Trading Securities
December 31, 2017
December 31, 2016
$
$
69,975 $
563,474
335,395
898,869
968,844 $
37,067
256,226
152,394
408,620
445,687
We elected the fair value option for certain securities and classify them as trading securities. Our trading securities include both residential and
commercial/multifamily securities. At December 31, 2017 , trading securities with a carrying value of $593 million were pledged as collateral under short-term
borrowing agreements. See Note
11
for additional information on short-term debt.
At December 31, 2017 and 2016 , our senior trading securities were comprised of interest-only securities, for which there is no principal balance, and our
subordinate trading securities had an unpaid principal balance of $943 million and $434 million , respectively.
At December 31, 2017 and 2016, subordinate trading securities included $301 million and $152 million , respectively, of Agency residential mortgage credit
risk transfer (or "CRT") securities, $68 million and $15 million , respectively, of Sequoia securities, $206 million and $149 million , respectively, of other third
party residential securities, and $324 million and $92 million , respectively, of third-party commercial/multifamily securities.
F- 47
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 7. Real Estate Securities - (continued)
During the year s ended December 31, 2017 and 2016 , we acquired $661 million and $307 million (principal balance), respectively, of securities for which we
elected the fair value option and classified as trading, and sold $132 million and $241 million , respectively, of such securities. During the year s ended
December 31, 2017 and 2016 , we recorded net market valuation gain s of $40 million and $11 million , respectively, on trading securities, included in Investment
fair value changes, net and Mortgage banking activities, net on our consolidated statements of income.
AFS Securities
The following table presents the fair value of our available-for-sale securities by position and collateral type at December 31, 2017 and December 31, 2016 .
Table 7.3 – Available-for-Sale Securities by Position and Collateral Type
(In Thousands)
Senior Securities
Re-REMIC Securities
Subordinate Securities
Mezzanine
Subordinate
Total Subordinate Securities
Total AFS Securities
December 31, 2017
December 31, 2016
$
$
140,989 $
38,875
92,002
235,800
327,802
507,666 $
136,546
85,479
163,715
187,012
350,727
572,752
At December 31, 2017 and December 31, 2016 , all of our available-for-sale securities were comprised of residential mortgage backed securities. At
December 31, 2017 , AFS securities with a carrying value of $195 million were pledged as collateral under short-term borrowing agreements. See Note
11
for
additional information on short-term debt.
During the years ended December 31, 2017 and 2016 , we purchased $40 million and $35 million of AFS securities, respectively, and sold $90 million and
$253 million of AFS securities, respectively, which resulted in net realized gains of $14 million and $21 million , respectively. In addition, during 2017 we
exchanged our interests in three Re-REMICs, which together had a fair value of $47 million , for the senior securities underlying the Re-REMICs, and reclassified
our interests from Re-REMIC to Senior.
We often purchase AFS securities at a discount to their outstanding principal balances. To the extent we purchase an AFS security that has a likelihood of
incurring a loss, we do not amortize into income the portion of the purchase discount that we 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 any
amount of unpaid principal balance that we do not expect to receive, and thus do not expect to earn or recover, as a credit reserve on the security. Any remaining
net unamortized discounts or premiums on the security are amortized into income over time using the effective yield method.
At December 31, 2017 , there were $0.1 million of AFS securities with contractual maturities less than five years , $5 million with contractual maturities
greater than five years but less than 10 years , and the remainder of our AFS securities had contractual maturities greater than 10 years .
F- 48
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 7. Real Estate Securities - (continued)
The following table presents the components of carrying value (which equals fair value) of AFS securities at December 31, 2017 and December 31, 2016 .
Table 7.4 – Carrying Value of AFS Securities
December 31, 2017
(In Thousands)
Principal balance
Credit reserve
Unamortized discount, net
Amortized cost
Gross unrealized gains
Gross unrealized losses
Carrying Value
December 31, 2016
(In Thousands)
Principal balance
Credit reserve
Unamortized discount, net
Amortized cost
Gross unrealized gains
Gross unrealized losses
Carrying Value
Senior
Re-REMIC
Subordinate
Total
$
144,512 $
44,613 $
419,020 $
(2,936)
(34,379)
107,197
35,027
(1,235)
(5,820)
(9,662)
29,131
9,744
—
(37,793)
(139,712)
241,515
86,419
(132)
$
140,989 $
38,875 $
327,802 $
608,145
(46,549)
(183,753)
377,843
131,190
(1,367)
507,666
Senior
Re-REMIC
Subordinate
Total
$
148,862 $
95,608 $
456,359 $
(4,814)
(41,877)
102,171
36,304
(1,929)
(6,857)
(19,613)
69,138
16,341
—
(35,802)
(136,622)
283,935
68,032
(1,240)
$
136,546 $
85,479 $
350,727 $
700,829
(47,473)
(198,112)
455,244
120,677
(3,169)
572,752
The following table presents the changes for the years ended December 31, 2017 and 2016 , in unamortized discount and designated credit reserves on
residential AFS securities.
Table 7.5 – Changes in Unamortized Discount and Designated Credit Reserves on AFS Securities
Year Ended December 31, 2017
Year Ended December 31, 2016
Credit
Reserve
Unamortized
Discount, Net
Credit
Reserve
Unamortized
Discount, Net
(In Thousands)
Beginning balance
Amortization of net discount
Realized credit losses
Acquisitions
Sales, calls, other
Impairments
Transfers to (release of) credit reserves, net
$
47,473 $
—
(4,187)
9,118
(3,404)
1,011
(3,462)
198,112 $
(18,795)
—
13,080
(12,106)
—
3,462
48,869 $
—
(5,830)
9,311
(4,968)
368
(277)
Ending Balance
$
46,549 $
183,753 $
47,473 $
F- 49
237,107
(26,253)
—
11,461
(24,480)
—
277
198,112
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 7. Real Estate Securities - (continued)
AFS Securities with Unrealized Losses
The following table presents the components comprising the total carrying value of residential AFS securities that were in a gross unrealized loss position at
December 31, 2017 and December 31, 2016 .
Table 7.6 – Components of Fair Value of Residential AFS Securities by Holding Periods
(In Thousands)
December 31, 2017
December 31, 2016
Less Than 12 Consecutive Months
12 Consecutive Months or Longer
Amortized
Cost
Unrealized
Losses
Fair
Value
Amortized
Unrealized
Cost
Losses
$
8,637 $
(132)
$
8,505 $
28,557 $
(1,235) $
15,772
(330)
15,442
60,035
(2,839)
Fair
Value
27,322
57,196
At December 31, 2017 , after giving effect to purchases, sales, and extinguishment due to credit losses, our consolidated balance sheet included 167 AFS
securities, of which nine were in an unrealized loss position and three were in a continuous unrealized loss position for 12 consecutive months or longer. At
December 31, 2016 , our consolidated balance sheet included 186 AFS securities, of which 19 were in an unrealized loss position and 10 were in a continuous
unrealized loss position for 12 consecutive months or longer.
Evaluating AFS Securities for Other-than-Temporary Impairments
Gross unrealized losses on our AFS securities were $1 million at December 31, 2017 . We evaluate all securities in an unrealized loss position to determine if
the impairment is temporary or other-than-temporary (resulting in an OTTI). At December 31, 2017 , we did not intend to sell any of our AFS securities that were
in an unrealized loss position, and it is more likely than not that we will not be required to sell these securities before recovery of their amortized cost basis, which
may be at their maturity. We review our AFS securities that are in an unrealized loss position to identify those securities with losses that are other-than-temporary
based on an assessment of changes in expected cash flows for such securities, which considers recent security performance and expected future performance of the
underlying collateral.
For the year ended December 31, 2017 , other-than-temporary impairments related to our AFS securities were $1 million , of which $1 million were
recognized through our consolidated statements of income and $0.4 million were recognized in Accumulated other comprehensive income, a component of our
consolidated balance sheet. AFS securities for which OTTI is recognized have experienced, or are expected to experience, credit-related adverse cash flow
changes. In determining our estimate of cash flows for AFS securities we may consider factors such as structural credit enhancement, past and expected future
performance of underlying mortgage loans, including timing of expected future cash flows, which are informed by prepayment rates, default rates, loss severities,
delinquency rates, percentage of non-performing loans, FICO scores at loan origination, year of origination, loan-to-value ratios, and geographic concentrations, as
well as general market assessments. Changes in our evaluation of these factors impacted the cash flows expected to be collected at the OTTI assessment date and
were used to determine if there were credit-related adverse cash flows and if so, the amount of credit related losses. Significant judgment is used in both our
analysis of the expected cash flows for our AFS securities and any determination of the credit loss component of OTTI.
The table below summarizes the significant valuation assumptions we used for our AFS securities in unrealized loss positions at December 31, 2017 .
Table 7.7 – Significant Valuation Assumptions
December 31, 2017
Prepayment rates
Projected losses
Range for Securities
8% - 20%
0.22% - 5%
F- 50
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 7. Real Estate Securities - (continued)
The following table details the activity related to the credit loss component of OTTI (i.e., OTTI recognized through earnings) for AFS securities held at
December 31, 2017 , 2016 , and 2015 for which a portion of an OTTI was recognized in other comprehensive income.
Table 7.8 – Activity of the Credit Component of Other-than-Temporary Impairments
(In Thousands)
Balance at beginning of period
Additions
Initial credit impairments
Subsequent credit impairments
Reductions
Securities sold, or expected to sell
Securities with no outstanding principal at period end
Balance at End of Period
Years Ended December 31,
2017
2016
2015
$
28,261 $
28,277 $
33,849
178
47
(4,898)
(2,551)
346
8
(261)
(109)
$
21,037 $
28,261 $
246
—
(4,567)
(1,251)
28,277
Gains and losses from the sale of AFS securities are recorded as Realized gains, net, in our consolidated statements of income. The following table presents
the gross realized gains and losses on sales and calls of AFS securities for the year s ended December 31, 2017 , 2016 , and 2015 .
Table 7.9 – Gross Realized Gains and Losses on AFS Securities
(In Thousands)
Gross realized gains - sales
Gross realized gains - calls
Gross realized losses - sales
Gross realized losses - calls
Years Ended December 31,
2017
2016
2015
$
13,927 $
23,598 $
677
—
(497)
1,210
(2,293)
—
34,922
2,167
(608)
(112)
Total Realized Gains on Sales and Calls of AFS Securities, net
$
14,107 $
22,515 $
36,369
F- 51
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 8. Mortgage Servicing Rights
We invest in mortgage servicing rights associated with residential mortgage loans and contract with licensed sub-servicers to perform all servicing functions
for these loans. The following table presents the fair value of MSRs and the aggregate principal amounts of associated loans as of December 31, 2017 and
December 31, 2016 .
Table 8.1 – Fair Value of MSRs and Aggregate Principal Amounts of Associated Loans
(In Thousands)
Mortgage Servicing Rights
Conforming Loans
Jumbo Loans
Total Mortgage Servicing Rights
December 31, 2017
December 31, 2016
MSR Fair Value
Associated
Principal
MSR Fair Value
Associated
Principal
$
$
1,194 $
107,416 $
62,404
5,449,239
58,523 $
60,003
4,989,720
5,467,169
63,598 $
5,556,655 $
118,526 $
10,456,889
The following table presents activity for MSRs for the years ended December 31, 2017 , 2016 , and 2015 .
Table 8.2 – Activity for MSRs
(In Thousands)
Balance at beginning of period
Additions
Sales
Changes in fair value due to:
Changes in assumptions (1)
Other changes (2)
Balance at End of Period
(1) Primarily reflects changes in prepayment assumptions due to changes in market interest rates.
(2) Represents changes due to the realization of expected cash flows.
F- 52
Years Ended December 31,
2017
2016
2015
$
118,526 $
191,976 $
8,026
(52,788)
(1,088)
(9,078)
25,362
(62,440)
(14,512)
(21,860)
$
63,598 $
118,526 $
139,293
95,281
(18,206)
(5,453)
(18,939)
191,976
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 8. Mortgage Servicing Rights - (continued)
We make investments in MSRs through the retention of servicing rights associated with the residential mortgage loans that we acquire and subsequently
transfer to third parties or through the direct acquisition of MSRs sold by third parties. We hold our MSR investments at our taxable REIT subsidiary. The
following table details the retention and purchase of MSRs during the years ended December 31, 2017 and 2016 .
Table 8.3 – MSR Additions
(In Thousands)
Jumbo MSR additions:
From securitization
From loan sales
Total jumbo MSR additions
Conforming MSR additions:
From loan sales
From purchases
Total conforming MSR additions
Total MSR Additions
Years Ended December 31,
2017
2016
MSR Fair Value
Associated
Principal
MSR Fair Value
Associated
Principal
$
7,123 $
654,605 $
6,451 $
263
7,386
—
640
640
31,658
686,263
—
106,108
106,108
177
6,628
3,380
15,354
18,734
$
8,026 $
792,371 $
25,362 $
939,861
26,844
966,705
316,290
1,643,577
1,959,867
2,926,572
The following table presents the components of our MSR income for the years ended December 31, 2017 , 2016 , and 2015 .
Table 8.4 – Components of MSR Income (Loss), net
(In Thousands)
Servicing income
Cost of sub-servicer
Net servicing fee income
Market valuation changes of MSRs
Market valuation changes of associated derivatives (1)
MSR reversal of provision for repurchases
MSR Income (Loss), Net
Years Ended December 31,
2017
2016
2015
$
21,120 $
41,152 $
(2,828)
18,292
(10,166)
(568)
302
(6,281)
34,871
(36,372)
15,584
270
$
7,860 $
14,353 $
38,964
(5,079)
33,885
(24,392)
(12,708)
(707)
(3,922)
(1)
In the second quarter of 2015, we began to identify specific derivatives used to hedge the exposure of our MSRs to changes in market interest rates.
F- 53
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 9. Derivative Financial Instruments
The following table presents the fair value and notional amount of our derivative financial instruments at December 31, 2017 and December 31, 2016 .
Table 9.1 – Fair Value and Notional Amount of Derivative Financial Instruments
(In Thousands)
Assets - Risk Management Derivatives
Interest rate swaps
TBAs
Futures
Swaptions
Assets - Other Derivatives
Loan purchase commitments
Loan forward sale commitments
Total Assets
Liabilities - Cash Flow Hedges
Interest rate swaps
Liabilities - Risk Management Derivatives
Interest rate swaps
TBAs
Futures
Liabilities - Other Derivatives
Loan purchase commitments
Total Liabilities
Total Derivative Financial Instruments, Net
December 31, 2017
December 31, 2016
Fair
Value
Notional
Amount
Fair
Value
Notional
Amount
$
10,122 $
1,765,000 $
19,859 $
1,009,000
133
1
42
3,243
2,177
295,000
7,500
200,000
547,434
343,681
8,300
—
5,121
3,315
—
850,000
—
345,000
352,981
—
15,718 $
3,158,615 $
36,595 $
2,556,981
(43,679) $
139,500 $
(44,822) $
139,500
(11,888)
(3,808)
—
1,248,000
1,400,000
—
(3,706)
697,966
(63,081) $
3,485,466 $
(47,363) $
6,644,081 $
(12,097)
1,101,500
(4,681)
(928)
(3,801)
(66,329) $
(29,734) $
510,000
87,500
584,862
2,423,362
4,980,343
$
$
$
$
F- 54
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 9. Derivative Financial Instruments - (continued)
Risk Management Derivatives
To manage, to varying degrees, risks associated with certain assets and liabilities on our consolidated balance sheets, we may enter into derivative contracts.
At December 31, 2017 , we were party to swaps and swaptions with an aggregate notional amount of $3.21 billion , TBA agreements sold with an aggregate
notional amount of $1.70 billion , and financial futures contracts with an aggregate notional amount of $8 million . At December 31, 2016 , we were party to swaps
and swaptions with an aggregate notional amount of $2.46 billion , TBA agreements sold with an aggregate notional amount of $1.36 billion , and financial futures
contracts with an aggregate notional amount of $88 million .
For the years ended December 31, 2017 , 2016 , and 2015 , risk management derivatives had a net market valuation loss of $31 million , a net market valuation
gain of $10 million , and a net market valuation loss of $65 million , respectively. These market valuation gains and losses are recorded in Mortgage banking
activities, net, Investment fair value changes, net and MSR income (loss), net on our consolidated statements of income.
Loan Purchase and Forward Sale Commitments
LPCs and FSCs that qualify as derivatives are recorded at their estimated fair values. Net market valuation gains on LPCs and FSCs were $38 million , $26
million , and $50 million for the years ended December 31, 2017 , 2016 , and 2015 , respectively, and were recorded in Mortgage banking activities, net on our
consolidated statements of income.
Derivatives Designated as Cash Flow Hedges
To manage the variability in interest expense related to portions of our long-term debt and certain adjustable-rate securitization entity liabilities that are
included in our consolidated balance sheets for financial reporting purposes, we designated certain interest rate swaps as cash flow hedges with an aggregate
notional balance of $140 million .
For the years ended December 31, 2017 , 2016 , and 2015 , changes in the values of designated cash flow hedges were positive $1 million , positive $3 million
, and negative $1 million , respectively, and were recorded in Accumulated other comprehensive income, a component of equity. For interest rate agreements
currently or previously designated as cash flow hedges, our total unrealized loss reported in Accumulated other comprehensive income was $43 million and $44
million at December 31, 2017 and December 31, 2016 , respectively.
The following table illustrates the impact on interest expense of our interest rate agreements accounted for as cash flow hedges for the years ended
December 31, 2017 , 2016 , and 2015 .
Table 9.2 – Impact on Interest Expense of Interest Rate Agreements Accounted for as Cash Flow Hedges
(In Thousands)
Net interest expense on cash flows hedges
Realized net losses reclassified from other comprehensive income
Total Interest Expense
F- 55
Years Ended December 31,
2017
2016
2015
$
$
(4,602) $
(5,317) $
(45)
(72)
(4,647) $
(5,389) $
(5,883)
(95)
(5,978)
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 9. Derivative Financial Instruments - (continued)
Derivative Counterparty Credit Risk
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. Each of our
derivative counterparties that is not a clearinghouse must maintain compliance with International Swaps and Derivatives Association (“ISDA”) agreements or other
similar agreements (or receive a waiver of non-compliance after a specific assessment) in order to conduct derivative transactions with us. Additionally, we review
non-clearinghouse derivative counterparty credit standings, and in the case of a deterioration of creditworthiness, appropriate remedial action is taken. To further
mitigate counterparty risk, we exit derivatives contracts with counterparties that (i) do not maintain compliance with (or obtain a waiver from) the terms of their
ISDA or other agreements with us; or (ii) do not meet internally established guidelines regarding creditworthiness. Our ISDA and similar agreements currently
require full bilateral collateralization of unrealized loss exposures with our derivative counterparties. Through a margin posting process, our positions are revalued
with counterparties each business day and cash margin is generally transferred to either us or our derivative counterparties as collateral based upon the directional
changes in fair value of the positions. We also attempt to transact with several different counterparties in order to reduce our specific counterparty exposure. With
respect to certain of our derivatives, clearing and settlement is through one or more clearinghouses, which may be substituted as a counterparty. Clearing and
settlement of derivative transactions through a clearinghouse is also intended to reduce specific counterparty exposure. We consider counterparty risk as part of our
fair value assessments of all derivative financial instruments at each quarter-end. At December 31, 2017 , we assessed this risk as remote and did not record a
specific valuation adjustment.
At December 31, 2017 , we had outstanding derivative agreements with three counterparties (other than clearinghouses) and were in compliance with ISDA
agreements governing our open derivative positions.
Note 10. Other Assets and Liabilities
Other assets at December 31, 2017 and December 31, 2016 , are summarized in the following table.
Table 10.1 – Components of Other Assets
(In Thousands)
Margin receivable
FHLBC stock
Pledged collateral
MSR holdback receivable
REO
Guarantee asset
Fixed assets and leasehold improvements (1)
Commercial loans
Other
Total Other Assets
December 31, 2017
December 31, 2016
$
85,044 $
43,393
42,615
8,141
3,354
2,869
2,645
—
6,905
$
194,966 $
68,038
43,393
42,875
1,862
5,533
4,092
2,750
2,700
10,702
181,945
(1) Fixed assets and leasehold improvements had a basis of $6 million and accumulated depreciation of $4 million at December 31, 2017 .
F- 56
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 10. Other Assets and Liabilities - (continued)
Accrued expenses and other liabilities at December 31, 2017 and December 31, 2016 are summarized in the following table.
Table 10.2 – Components of Accrued Expenses and Other Liabilities
(In Thousands)
Accrued compensation
Guarantee obligations
Deferred tax liabilities
Residential loan and MSR repurchase reserve
Legal reserve
Accrued operating expenses
Current accounts payable
Margin payable
Restructuring liabilities
Other
Total Other Liabilities
Margin
Receivable
and
Payable
December 31, 2017
December 31, 2016
$
$
24,025 $
19,487
11,764
4,916
2,000
1,481
1,339
390
—
2,327
67,729 $
18,830
21,668
898
5,432
2,000
4,493
1,151
12,783
2,297
2,876
72,428
Margin receivable and payable resulted from margin calls between us and our counterparties under derivatives, master repurchase agreements, and warehouse
facilities, whereby we or the counterparty posted collateral.
FHLB
Stock
In accordance with our FHLB-member subsidiary's borrowing agreement with the FHLBC, our subsidiary is required to purchase and hold stock in the
FHLBC. See Note
3
and Note
13
for additional information on this borrowing agreement.
Guarantee
Asset,
Pledged
Collateral,
and
Guarantee
Obligations
The pledged collateral, guarantee asset, and guarantee obligations presented in the tables above are related to our risk-sharing arrangements with Fannie Mae
and Freddie Mac. In accordance with these arrangements, we are required to pledge collateral to secure our guarantee obligations. See Note
3
and Note
14
for
additional information on our risk-sharing arrangements.
MSR
Holdback
Receivable
MSR holdback receivable represents amounts owed to us from third parties related to the sale of MSRs.
REO
The carrying value of REO at December 31, 2017 , was $3 million , which includes the net effect of $4 million related to transfers into REO during the year
ended December 31, 2017 , offset by $10 million of REO liquidations and $3 million of unrealized gains resulting from market valuation adjustments. At
December 31, 2017 and December 31, 2016 , there were 14 and 23 REO properties, respectively, recorded on our consolidated balance sheets, all of which were
owned at consolidated Legacy Sequoia entities.
F- 57
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 10. Other Assets and Liabilities - (continued)
Commercial
Loans
Prior to 2017, we originated and acquired commercial loans for our investment portfolio and for sale through our commercial mortgage banking activities.
During 2016, we sold nearly all of our commercial loans as we wound down our commercial mortgage banking and commercial investment activities. In 2016, we
recorded a reversal of provision for loan losses related to the sale of our commercial loan investments and recorded any net gains or losses from the sale of
commercial loans in Mortgage banking activities, net and Investment fair value changes, net on our consolidated statements of income.
At December 31, 2016, we held one commercial loan at the lower of cost or fair value with $3 million in outstanding principal balance, a carrying value of $3
million , and an estimated net fair value of $3 million . This loan prepaid in full during 2017.
Legal
and
Repurchase
Reserves
See Note
14
for additional information on the legal and residential repurchase reserves.
Restructuring
Liabilities
In January 2016, we announced plans to restructure certain aspects of our residential mortgage loan operations by ceasing the acquisition and aggregation of
conforming loans for resale to the Agencies. Additionally, in February 2016, we announced our plans to restructure our commercial business and no longer
originate commercial loans. These restructuring activities were substantially completed during the second quarter of 2016.
In connection with these activities, we incurred restructuring expenses, including one-time termination benefits, contract termination costs, and other
associated costs. During the first quarter of 2016, we established a restructuring liability and for the year ended December 31, 2016, we recorded restructuring
charges totaling $10 million in Operating expenses on our consolidated statements of income, which included $9 million of severance related charges (including $3
million of equity compensation expense) and $2 million of contract termination costs. The remaining restructuring liability was settled in 2017 and no further
adjustments were recorded. For segment reporting, we consider these restructuring charges as corporate charges and included them in the Corporate/Other
reconciling column in our business segment financial information tables in Note
21
—
Segment
Information
.
F- 58
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 11. Short-Term Debt
We enter into repurchase agreements, bank warehouse agreements, and other forms of collateralized (and generally uncommitted) short-term borrowings with
several banks and major investment banking firms. At December 31, 2017 , we had outstanding agreements with several counterparties and we were in compliance
with all of the related covenants. For additional information about these financial covenants and our short-term debt, see Part II, Item 7 of this Annual Report on
Form 10-K under the heading “ Risks
Relating
to
Debt
Incurred
Under
Short-
and
Long-Term
Borrowing
Facilities.
”
The table below summarizes our short-term debt, including the facilities that are available to us, the outstanding balances, the weighted average interest rate,
and the maturity information at December 31, 2017 and December 31, 2016 .
Table 11.1 – Short-Term Debt
(Dollars in Thousands)
Facilities
Residential loan warehouse
Real estate securities repo
Total Short-Term Debt Facilities
Convertible notes, net
Total Short-Term Debt
(Dollars in Thousands)
Facilities
Residential loan warehouse
Real estate securities repo
Total Short-Term Debt
Number of
Facilities
Outstanding
Balance
December 31, 2017
Weighted
Average
Limit
Interest Rate
Maturity
Weighted
Average Days
Until
Maturity
4 $
1,039,666 $
1,575,000
—
3.17%
2.69%
1/2018-12/2018
1/2018-3/2018
197
28
—
4.63%
4/2018
105
9
13
N/A
648,746
1,688,412
250,270
$
1,938,682
Number of
Facilities
Outstanding
Balance
December 31, 2016
Weighted
Average
Limit
Interest Rate
Maturity
Weighted
Average Days
Until
Maturity
4 $
7
11 $
485,544 $
1,325,000
305,995
791,539
—
2.40%
1.91%
1/2017-12/2017
1/2017-3/2017
206
24
Borrowings under our facilities are generally charged interest based on a specified margin over the one-month LIBOR interest rate. At December 31, 2017 , all
of these borrowings were under uncommitted facilities and were due within 364 days (or less) of the borrowing date.
The fair value of held-for-sale residential loans and real estate securities pledged as collateral was $1.15 billion and $788 million , respectively, at
December 31, 2017 and $534 million and $363 million , respectively, at December 31, 2016 . For the years ended December 31, 2017 and 2016 , the average
balances of our short-term debt facilities were $1.08 billion and $1.09 billion , respectively. At December 31, 2017 and December 31, 2016 , accrued interest
payable on our short-term debt facilities was $2 million and $1 million , respectively.
F- 59
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 11. Short-Term Debt - (continued)
During the second quarter of 2017, $288 million principal amount of 4.625% convertible senior notes and $2 million of unamortized deferred issuance costs
were reclassified from long-term debt to short-term debt, as the maturity of the notes was less than one year as of April 2017. Additionally, during the second
quarter of 2017, we repurchased $37 million par value of these notes at a premium and recorded a loss on extinguishment of debt of $1 million in Realized gains,
net on our consolidated statements of income. At December 31, 2017 , the accrued interest payable balance on this debt was $2 million . See Note
13
for additional
information on our convertible notes.
We also maintain a $10 million committed line of credit with a financial institution that is secured by certain mortgage-backed securities with a fair market
value of $5 million at December 31, 2017 . At both December 31, 2017 and December 31, 2016 , we had no outstanding borrowings on this facility.
Remaining Maturities of Short-Term Debt
The following table presents the remaining maturities of our secured short-term debt by the type of collateral securing the debt as well as our convertible notes
at December 31, 2017 .
Table 11.2 – Short-Term Debt by Collateral Type and Remaining Maturities
(In Thousands)
Collateral Type
Held-for sale residential loans
Real estate securities
Total Secured Short-Term Debt
Convertible notes, net
Total Short-Term Debt
Note 12. Asset-Backed Securities Issued
Within 30 days
31 to 90 days
Over 90 days
Total
December 31, 2017
$
150,095 $
320,024 $
569,547 $
517,847
667,942
—
130,899
450,923
—
—
569,547
250,270
$
667,942
$
450,923 $
819,817 $
1,039,666
648,746
1,688,412
250,270
1,938,682
Through our Sequoia securitization program, we sponsor securitization transactions in which ABS backed by residential mortgage loans are issued by Sequoia
entities. We consolidated the Legacy Sequoia securitizations entities, and beginning in September 2017, the Sequoia Choice securitization entities, that we
determined were VIEs and for which we determined we were the primary beneficiary. Each consolidated securitization entity is independent of Redwood and of
each other and the assets and liabilities are not owned by and are not legal obligations of Redwood. Our exposure to these entities is primarily through the financial
interests we have retained, although we are exposed to certain financial risks associated with our role as a sponsor, servicing administrator, or depositor of these
entities or as a result of our having sold assets directly or indirectly to these entities.
We account for the ABS issued under our consolidated Sequoia entities at fair value, with periodic changes in fair value recorded in Investment fair value
changes, net on our consolidated statements of income. Pursuant to the CFE guidelines, the market valuation changes on our Sequoia loans are based on the
estimated fair value of the associated ABS issued. The net impact to our income statement associated with our retained economic investment in the Sequoia
securitization entities is presented in Note
5.
The ABS issued by these entities consist of various classes of securities that pay interest on a monthly or quarterly basis. All ABS issued by the Sequoia
Choice entities pay fixed rates of interest and substantially all ABS issued by the Legacy Sequoia entities pay variable rates of interest, which are indexed to one-,
three-, or six-month LIBOR. Some ABS issued by the Legacy Sequoia entities pay hybrid rates, which are fixed rates that subsequently adjust to variable rates.
ABS issued also includes some interest-only classes with coupons set at a fixed spread to a benchmark rate, 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.
F- 60
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 12. Asset-Backed Securities Issued - (continued)
The carrying values of ABS issued by Sequoia securitization entities we sponsored at December 31, 2017 and December 31, 2016 , along with other selected
information, are summarized in the following table.
Table 12.1 – Asset-Backed Securities Issued
(Dollars in Thousands)
Legacy
Sequoia
Sequoia
Choice
Total
Legacy
Sequoia
Sequoia
Choice
Total
Certificates with principal balance
$
691,125 $
526,657 $
1,217,782 $
880,517 $
— $
880,517
December 31, 2017
December 31, 2016
Interest-only certificates
Market valuation adjustments
1,972
(70,652)
7,695
7,788
9,667
(62,864)
3,774
(110,829)
ABS Issued, Net
$
622,445
$
542,140 $
1,164,585 $
773,462
$
Range of weighted average interest rates,
by series
Stated maturities
Number of series
1.46% to
2.78%
2024 - 2036
20
4.52% to
4.73%
2047
2
0.74% to
2.23%
2024 - 2036
N/A
20
—
3,774
(110,829)
773,462
—
—
— $
—%
The actual 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 prior to the stated maturity according to the terms of the respective governing documents of each ABS issuing entity. As a result, the
actual maturity of ABS issued may occur earlier than its stated maturity. At December 31, 2017 , all of the ABS issued and outstanding had contractual maturities
beyond five years .
At both December 31, 2017 and December 31, 2016 , accrued interest payable on ABS issued by the Legacy Sequoia entities was $1 million . At
December 31, 2017 , accrued interest payable on ABS issued by the Sequoia Choice entities was $2 million . Interest due on consolidated ABS issued is payable
monthly.
The following table summarizes the carrying value components of the collateral for ABS issued and outstanding at December 31, 2017 and December 31,
2016 .
Table 12.2 – Collateral for Asset-Backed Securities Issued
(In Thousands)
Residential loans
Restricted cash
Accrued interest receivable
REO
December 31, 2017
December 31, 2016
Legacy
Sequoia
Sequoia
Choice
Total
Legacy
Sequoia
Sequoia
Choice
Total
$
632,817 $
620,062 $
1,252,879 $
791,636 $
— $
791,636
147
867
3,353
4
2,524
—
151
3,391
3,353
148
1,000
5,533
—
—
—
148
1,000
5,533
Total Collateral for ABS Issued
$
637,184
$
622,590 $
1,259,774 $
798,317 $
— $
798,317
F- 61
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 13. Long-Term Debt
FHLBC Borrowings
In July 2014, our FHLB-member subsidiary entered into a borrowing agreement with the Federal Home Loan Bank of Chicago. At December 31, 2017 , under
this agreement, our subsidiary could incur borrowings up to $2.00 billion , also referred to as “advances,” from the FHLBC secured by eligible collateral, including
residential mortgage loans. During the year ended December 31, 2016, we borrowed an additional $519 million under this agreement, which increased our total
borrowings to $2.00 billion . Under a final rule published by the Federal Housing Finance Agency in January 2016, our FHLB-member subsidiary will remain an
FHLB member through the five -year transition period for captive insurance companies. Our FHLB-member subsidiary's existing $2.00 billion of FHLB debt,
which matures beyond this transition period, is permitted to remain outstanding until its stated maturity. As residential loans pledged as collateral for this debt pay
down, we are permitted to pledge additional loans or other eligible assets to collateralize this debt; however, we do not expect to be able to increase our subsidiary's
FHLB debt above the existing $2.00 billion maximum.
At December 31, 2017 , $2.00 billion of advances were outstanding under this agreement, which were classified as long-term debt, with a weighted average
interest rate of 1.38% and a weighted average maturity of approximately eight years . At December 31, 2016 , $2.00 billion of advances were outstanding under
this agreement, which were classified as long-term debt, with a weighted average interest rate of 0.64% and a weighted average maturity of nine years . Advances
under this agreement incur interest charges based on a specified margin over the FHLBC’s 13 -week discount note rate, which resets every 13 weeks. Total
advances under this agreement were secured by residential mortgage loans with a fair value of $2.43 billion at December 31, 2017 . This agreement also requires
our subsidiary to purchase and hold stock in the FHLBC in an amount equal to a specified percentage of outstanding advances. At December 31, 2017 , our
subsidiary held $43 million of FHLBC stock that is included in Other assets in our consolidated balance sheets.
The following table presents maturities of our FHLBC borrowings by year at December 31, 2017 .
Table 13.1 – Maturities of FHLBC Borrowings by Year
(In Thousands)
2024
2025
2026
Total FHLBC Borrowings
December 31, 2017
470,171
887,639
642,189
1,999,999
$
$
For additional information about our FHLBC borrowings, see Part II, Item 7 of this Annual Report on Form 10-K under the heading “ Risks
Relating
to
Debt
Incurred
under
Short-
and
Long-Term
Borrowing
Facilities.
”
Convertible Notes
In August 2017, we issued $245 million principal amount of 4.75% convertible senior notes due 2023 . These convertible notes require semi-annual interest
payments at a fixed coupon rate of 4.75% until maturity or conversion, which will be no later than August 15, 2023 . After deducting the underwriting discount and
offering costs, we received $238 million of net proceeds. Including amortization of deferred debt issuance costs, the weighted average interest expense yield on
these convertible notes is approximately 5.3% per annum. At December 31, 2017 , these notes were convertible at the option of the holder at a conversion rate of
53.8394 common shares per $1,000 principal amount of convertible senior notes (equivalent to a conversion price of $18.57 per common share). Upon conversion
of these notes by a holder, the holder will receive shares of our common stock. At December 31, 2017 , the outstanding principal amount of these notes was $245
million . At December 31, 2017 , the accrued interest payable balance on this debt was $4 million and the unamortized deferred issuance costs were $7 million .
F- 62
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 13. Long-Term Debt - (continued)
In November 2014, RWT Holdings, Inc., a wholly-owned subsidiary of Redwood Trust, Inc., issued $205 million principal amount of 5.625% exchangeable
senior notes due 2019 . These exchangeable notes require semi-annual interest payments at a fixed coupon rate of 5.625% until maturity or exchange, which will be
no later than November 15, 2019 . After deducting the underwriting discount and offering costs, we received $198 million of net proceeds. Including amortization
of deferred debt issuance costs, the weighted average interest expense yield on these exchangeable notes is approximately 6.3% per annum. At December 31, 2017
, these notes were exchangeable at the option of the holder at an exchange rate of 46.1798 common shares per $1,000 principal amount of exchangeable senior
notes (equivalent to an exchange price of $21.65 per common share). Upon exchange of these notes by a holder, the holder will receive shares of our common
stock. During the year ended December 31, 2017 , we did no t repurchase any of these notes. During the year ended December 31, 2016, we repurchased $4 million
par value of these notes at a discount and recorded a gain on extinguishment of debt of $0.3 million in Realized gains, net on our consolidated statements of
income. At December 31, 2017 , the outstanding principal amount of these notes was $201 million . At December 31, 2017 , the accrued interest payable balance
on this debt was $1 million and the unamortized deferred issuance costs were $2 million .
In March 2013, we issued $288 million principal amount of 4.625% convertible senior notes due 2018 . These convertible notes require semi-annual interest
payments at a fixed coupon rate of 4.625% until maturity or conversion, which will be no later than April 15, 2018 . After deducting the underwriting discount and
offering costs, we received $279 million of net proceeds. Including amortization of deferred debt issuance costs, the weighted average interest expense yield on
these convertible notes is approximately 4.8% per annum. At December 31, 2017 , these notes were convertible at the option of the holder at a conversion rate of
41.1320 common shares per $1,000 principal amount of convertible senior notes (equivalent to a conversion price of $24.31 per common share). Upon conversion
of these notes by a holder, the holder will receive shares of our common stock. During the second quarter of 2017, $288 million principal amount of these
convertible notes and $2 million of unamortized deferred issuance costs were reclassified from long-term debt to short-term debt, as the maturity of the notes was
less than one year as of April 2017. Additionally, during the year ended December 31, 2017, we repurchased $37 million par value of these notes at a premium and
recorded a loss on extinguishment of debt of $1 million in Realized gains, net on our consolidated statements of income. At December 31, 2017 , the outstanding
principal amount of these notes was $250 million . At December 31, 2017 , the accrued interest payable balance on this debt was $2 million and the unamortized
deferred issuance costs were $0.2 million .
Trust Preferred Securities and Subordinated Notes
At December 31, 2017 , we had trust preferred securities and subordinated notes outstanding of $100 million and $40 million , respectively. This debt requires
quarterly interest payments at a floating rate equal to three-month LIBOR plus 2.25% until the notes are redeemed. The $100 million trust preferred securities will
be redeemed no later than January 30, 2037, and the $40 million subordinated notes will be redeemed no later than July 30, 2037. Prior to 2014, we entered into
interest rate swaps with aggregate notional values totaling $140 million to hedge the variability in this long-term debt interest expense. Including hedging costs and
amortization of deferred debt issuance costs, the weighted average interest expense yield on our trust preferred securities and subordinated notes is approximately
6.9% per annum. At both December 31, 2017 and December 31, 2016 , the accrued interest payable balance on our trust preferred securities and subordinated notes
was $1 million .
Under the terms of this debt, we covenant, among other things, to use our best efforts to continue to qualify as a REIT. If an event of default were to occur in
respect of this debt, we would generally be restricted under its terms (subject to certain exceptions) from making dividend distributions to stockholders, from
repurchasing common stock or repurchasing or redeeming any other then-outstanding equity securities, and from making any other payments in respect of any
equity interests in us or in respect of any then-outstanding debt that is pari passu or subordinate to this debt.
Note 14. Commitments and Contingencies
Lease Commitments
At December 31, 2017 , we were obligated under four non-cancelable operating leases with expiration dates through 2028 for $18 million of cumulative lease
payments. Our operating lease expense was $2 million for the year ended December 31, 2017 , and $3 million for each of the years ended December 31, 2016 and
2015 , respectively.
F- 63
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 14. Commitments and Contingencies - (continued)
The following table presents our future lease commitments at December 31, 2017 .
Table 14.1 – Future Lease Commitments by Year
(In Thousands)
2018
2019
2020
2021 and thereafter
Total Lease Commitments
December 31, 2017
1,948
1,987
1,965
11,691
17,591
$
$
Leasehold improvements for our offices are amortized into expense over the lease term. There were $0.1 million of unamortized leasehold improvements at
December 31, 2017 . For each of the years ended December 31, 2017 , 2016 , and 2015 , we recognized less than $0.1 million of leasehold amortization expense.
Loss Contingencies — Risk-Sharing
At December 31, 2017 , we had sold conforming loans to the Agencies with an original unpaid principal balance of $3.19 billion , subject to our risk-sharing
arrangements with the Agencies. At December 31, 2017 , the maximum potential amount of future payments we could be required to make under these
arrangements was $44 million and this amount was fully collateralized by assets we transferred to pledged accounts and is presented as pledged collateral in Other
assets on our consolidated balance sheets. We have no recourse to any third parties that would allow us to recover any amounts related to our obligations under the
arrangements. At December 31, 2017 , we had incurred losses of less than $0.1 million under these arrangements. For the years ended December 31, 2017 , 2016,
and 2015, other income related to these arrangements was $3 million , $5 million , and $3 million , respectively, and was included in Other income on our
consolidated statements of income. For the years ended December 31, 2017 , 2016, and 2015, we recorded net market valuation losses related to these
arrangements of $1 million , $1 million , and $2 million , respectively, through Investment fair value changes, net, on our consolidated statements of income.
All of the loans in the reference pools subject to these risk-sharing arrangements were originated in 2014 and 2015, and at December 31, 2017 , the loans had
an unpaid principal balance of $2.10 billion and a weighted average FICO score of 758 (at origination) and LTV of 77% (at origination). At December 31, 2017 ,
$8 million of the loans were 90 days or more delinquent, of which $1 million were in foreclosure. At December 31, 2017 , the carrying value of our guarantee
obligation was $19 million and included $10 million designated as a non-amortizing credit reserve, which we believe is sufficient to cover current expected losses
under these obligations.
Our consolidated balance sheets include assets of special purpose entities ("SPEs") associated with these risk-sharing arrangements (i.e., the "pledged
collateral" referred to above) that can only be used to settle obligations of these SPEs for which the creditors of these SPEs (the Agencies) do not have recourse to
Redwood Trust, Inc. or its affiliates. At December 31, 2017 and December 31, 2016, assets of such SPEs totaled $48 million and $49 million , respectively, and
liabilities of such SPEs totaled $19 million and $22 million , respectively.
Loss Contingencies — Residential Repurchase Reserve
We maintain a repurchase reserve for potential obligations arising from representation and warranty violations related to residential loans we have sold to
securitization trusts or third parties and for conforming residential loans associated with MSRs that we have purchased from third parties. We do not originate
residential loans and we believe the initial risk of loss due to loan repurchases (i.e., due to a breach of representations and warranties) would generally be a
contingency to the companies from whom we acquired the loans. However, in some cases, for example, where loans were acquired from companies that have since
become insolvent, repurchase claims may result in our being liable for a repurchase obligation.
F- 64
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 14. Commitments and Contingencies - (continued)
At both December 31, 2017 and December 31, 2016 , our repurchase reserve associated with our residential loans and MSRs was $5 million and was recorded
in Accrued expenses and other liabilities on our consolidated balance sheets. We received 17 repurchase requests during the year ended December 31, 2017 and 59
during the year ended December 31, 2016 . During the years ended December 31, 2017 , 2016 , and 2015 , we repurchased one loan, one loan, and zero loans,
respectively. During the years ended December 31, 2017 and 2016, we recorded $0.3 million and $1 million of reversals of repurchase provisions, respectively,
that were recorded in Mortgage banking activities, net and MSR income (loss), net on our consolidated statements of income and had charge-offs of $0.2 million
and $0.1 million , respectively. During the year ended December 31, 2015 we recorded a repurchase provision of $3 million that was recorded in Mortgage
banking activities, net and MSR income (loss), net on our consolidated statements of income, and had no charge-offs.
Loss Contingencies — Litigation
On or about December 23, 2009, the Federal Home Loan Bank of Seattle (the “FHLB-Seattle”) filed a complaint in the Superior Court for the State of
Washington (case number 09-2-46348-4 SEA) against Redwood Trust, Inc., our subsidiary, Sequoia Residential Funding, Inc. (“SRF”), Morgan Stanley & Co.,
and Morgan Stanley Capital I, Inc. (collectively, the “FHLB-Seattle Defendants”), which alleged that the FHLB-Seattle Defendants made false or misleading
statements in offering materials for a mortgage pass-through certificate (the “Seattle Certificate”) issued in the Sequoia Mortgage Trust 2005-4 securitization
transaction (the “2005-4 RMBS”) and purchased by the FHLB-Seattle. Specifically, the complaint alleged that the alleged misstatements concerned the (1) loan-to-
value ratio of mortgage loans and the appraisals of the properties that secured loans supporting the 2005-4 RMBS, (2) occupancy status of the properties, (3)
standards used to underwrite the loans, and (4) ratings assigned to the Seattle Certificate. The FHLB-Seattle alleged claims under the Securities Act of Washington
(Section 21.20.005, et seq.) and sought to rescind the purchase of the Seattle Certificate and to collect interest on the original purchase price at the statutory interest
rate of 8% per annum from the date of original purchase (net of interest received) as well as attorneys’ fees and costs. The Seattle Certificate was issued with an
original principal amount of approximately $133 million , and, at December 31, 2017 , approximately $125 million of principal and $11 million of interest
payments had been made in respect of the Seattle Certificate. The matter was subsequently resolved and the claims were dismissed by the FHLB Seattle as to all
the FHLB Seattle Defendants. At the time the Seattle Certificate was issued, Redwood agreed to indemnify the underwriters of the 2005-4 RMBS, which
underwriters were named as defendants in the action, for certain losses and expenses they might incur as a result of claims made against them relating to this
RMBS, including, without limitation, certain legal expenses. Regardless of the resolution of this litigation, we could incur a loss as a result of these indemnities.
On or about July 15, 2010, The Charles Schwab Corporation (“Schwab”) filed a complaint in the Superior Court for the State of California in San Francisco
(case number CGC-10-501610) against SRF and 26 other defendants (collectively, the “Schwab Defendants”), which alleged that the Schwab Defendants made
false or misleading statements in offering materials for various residential mortgage-backed securities sold or issued by the Schwab Defendants. Schwab alleged
only a claim for negligent misrepresentation under California state law against SRF and sought unspecified damages and attorneys’ fees and costs from SRF.
Schwab claimed that SRF made false or misleading statements in offering materials for a mortgage pass-through certificate (the “Schwab Certificate”) issued in the
2005-4 RMBS and purchased by Schwab. Specifically, the complaint alleged that the misstatements for the 2005-4 RMBS concerned the (1) loan-to-value ratio of
mortgage loans and the appraisals of the properties that secured loans supporting the 2005-4 RMBS, (2) occupancy status of the properties, (3) standards used to
underwrite the loans, and (4) ratings assigned to the Schwab Certificate. The Schwab Certificate was issued with an original principal amount of approximately
$15 million , and, at December 31, 2017 , approximately $14 million of principal and $1 million of interest payments had been made in respect of the Schwab
Certificate. On November 14, 2014, Schwab voluntarily dismissed with prejudice its negligent misrepresentation claim, which resulted in the dismissal with
prejudice of SRF from the action. Subsequently, the matter was resolved and Schwab dismissed its claims against the lead underwriter of the 2005-4 RMBS. At the
time the Schwab Certificate was issued, Redwood agreed to indemnify the underwriters of the 2005-4 RMBS, which underwriters were also named as defendants
in the action, for certain losses and expenses they might incur as a result of claims made against them relating to this RMBS, including, without limitation, certain
legal expenses. Regardless of the resolution of this litigation, Redwood could incur a loss as a result of these indemnities.
F- 65
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 14. Commitments and Contingencies - (continued)
Through certain of our wholly-owned subsidiaries, we have in the past engaged in, and expect to continue to engage in, activities relating to the acquisition
and securitization of residential mortgage loans. In addition, certain of our wholly-owned subsidiaries have in the past engaged in activities relating to the
acquisition and securitization of debt obligations and other assets through the issuance of collateralized debt obligations (commonly referred to as CDO
transactions). Because of this involvement in the securitization and CDO businesses, we could become the subject of litigation relating to these businesses,
including additional litigation of the type described above, and we could also become the subject of governmental investigations, enforcement actions, or lawsuits,
and governmental authorities could allege that we violated applicable law or regulation in the conduct of our business. As an example, in July 2016 we became
aware of a complaint filed by the State of California on April 1, 2016 against Morgan Stanley & Co. and certain of its affiliates alleging, among other things, that
there were misleading statements contained in offering materials for 28 different mortgage pass-through certificates purchased by various California investors,
including various California public pension systems, from Morgan Stanley and alleging that Morgan Stanley made false or fraudulent claims in connection with the
sale of those certificates. Of the 28 mortgage pass-through certificates that were the subject of the complaint, two were Sequoia mortgage pass-through certificates
issued in 2004 and two were Sequoia mortgage pass-through certificates issued in 2007. With respect to each of those certificates, our wholly-owned subsidiary,
RWT Holdings, Inc., was the sponsor and our wholly-owned subsidiary, Sequoia Residential Funding, Inc., was the depositor. The plaintiffs subsequently
withdrew from the litigation their claims based on eight of the 28 mortgage pass-through certificates, including one of the Sequoia mortgage pass-through
certificates issued in 2004. At the time these Sequoia mortgage pass-through certificates were issued, Sequoia Residential Funding, Inc. and Redwood Trust agreed
to indemnify the underwriters of these certificates for certain losses and expenses they might incur as a result of claims made against them relating to these
certificates, including, without limitation, certain legal expenses. Regardless of the outcome of this litigation, we could incur a loss as a result of these indemnities.
In accordance with GAAP, we review the need for any loss contingency reserves and establish reserves when, in the opinion of management, it is probable
that a matter would result in a liability and the amount of loss, if any, can be reasonably estimated. Additionally, we record receivables for insurance recoveries
relating to litigation-related losses and expenses if and when such amounts are covered by insurance and recovery of such losses or expenses are due. At
December 31, 2017 , the aggregate amount of loss contingency reserves established in respect of the FHLB-Seattle and Schwab litigation matters described above
was $2 million . We review our litigation matters each quarter to assess these loss contingency reserves and make adjustments in these reserves, upwards or
downwards, as appropriate, in accordance with GAAP based on our review.
In the ordinary course of any litigation matter, including certain of the above-referenced matters, we have engaged and may continue to engage in formal or
informal settlement communications with the plaintiffs or co-defendants. Settlement communications we have engaged in relating to certain of the above-
referenced litigation matters are one of the factors that have resulted in our determination to establish the loss contingency reserves described above. We cannot be
certain that any of these matters will be resolved through a settlement prior to trial and we cannot be certain that the resolution of these matters, whether through
trial or settlement, will not have a material adverse effect on our financial condition or results of operations in any future period.
Future developments (including resolution of substantive pre-trial motions relating to these matters, receipt of additional information and documents relating
to these matters (such as through pre-trial discovery), new or additional settlement communications with plaintiffs relating to these matters, or resolutions of
similar claims against other defendants in these matters) could result in our concluding in the future to establish additional loss contingency reserves or to disclose
an estimate of reasonably possible losses in excess of our established reserves with respect to these matters. Our actual losses with respect to the above-referenced
litigation matters may be materially higher than the aggregate amount of loss contingency reserves we have established in respect of these litigation matters,
including in the event that any of these matters proceeds to trial and the plaintiff prevails. Other factors that could result in our concluding to establish additional
loss contingency reserves or estimate additional reasonably possible losses, or could result in our actual losses with respect to the above-referenced litigation
matters being materially higher than the aggregate amount of loss contingency reserves we have established in respect of these litigation matters include that: there
are significant factual and legal issues to be resolved; information obtained or rulings made during the lawsuits could affect the methodology for calculation of the
available remedies; and we may have additional obligations pursuant to indemnity agreements, representations and warranties, and other contractual provisions
with other parties relating to these litigation matters that could increase our potential losses.
F- 66
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 15. Equity
The following table provides a summary of changes to accumulated other comprehensive income by component for the years ended December 31, 2017 and
2016 .
Table 15.1 – Changes in Accumulated Other Comprehensive Income by Component
Years Ended December 31,
2017
2016
Net Unrealized Gains
on Available-for-Sale
Securities
Net Unrealized Losses on
Interest Rate Agreements
Accounted for as Cash
Flow Hedges
Net Unrealized Gains
on Available-for-Sale
Securities
Net Unrealized Losses on
Interest Rate Agreements
Accounted for as Cash
Flow Hedges
(In Thousands)
Balance at beginning of period
$
115,873 $
(44,020) $
139,356 $
(47,363)
Other comprehensive income (loss)
before reclassifications (1)
Amounts reclassified from other
accumulated comprehensive income
Net current-period other comprehensive income
(loss)
Balance at End of Period
$
22,864
(10,536)
12,328
128,201 $
1,022
(2,316)
45
(21,167)
1,067
(42,953) $
(23,483)
115,873 $
3,271
72
3,343
(44,020)
(1) Amounts presented for net unrealized gains (losses) on available-for-sale securities are net of tax benefit (provision) of zero and $1 million for the years ended
December 31, 2017 and 2016 , respectively.
The following table provides a summary of reclassifications out of accumulated other comprehensive income for the years ended December 31, 2017 and 2016
.
Table 15.2 – Reclassifications Out of Accumulated Other Comprehensive Income
(In Thousands)
Income Statement
2017
2016
Affected Line Item in the
Years Ended December 31,
Amount Reclassified From Accumulated Other
Comprehensive Income
Net Realized (Gain) Loss on AFS Securities
Other than temporary impairment (1)
Investment fair value changes, net
$
Gain on sale of AFS securities
Realized gains, net
Net Realized Loss on Interest Rate
Agreements Designated as Cash Flow Hedges
Amortization of deferred loss
Interest expense
$
$
$
1,012 $
(11,548)
(10,536) $
45 $
45 $
368
(21,535)
(21,167)
72
72
(1) For the year ended December 31, 2017 , other-than-temporary impairments were $1 million , of which $1 million were recognized through our consolidated statements of
income and $0.4 million were recognized in Accumulated other comprehensive income, a component of our consolidated balance sheet. For the year ended December 31,
2016 , other-than-temporary impairments were $3 million , of which $0.4 million were recognized through our consolidated statements of income, and $3 million were
recognized in Accumulated other comprehensive income, a component of our consolidated balance sheet.
F- 67
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 15. Equity - (continued)
Earnings per Common Share
The following table provides the basic and diluted earnings per common share computations for the years ended December 31, 2017 , 2016 , and 2015 .
Table 15.3 – Basic and Diluted Earnings per Common Share
(In Thousands, except Share Data)
Basic Earnings per Common Share:
Net income attributable to Redwood
Less: Dividends and undistributed earnings allocated to participating securities
Net income allocated to common shareholders
Basic weighted average common shares outstanding
Basic Earnings per Common Share
Diluted Earnings per Common Share:
Net income attributable to Redwood
Less: Dividends and undistributed earnings allocated to participating securities
Add back: Interest expense on convertible notes for the period, net of tax
Net income allocated to common shareholders
Weighted average common shares outstanding
Net effect of dilutive equity awards
Net effect of assumed convertible notes conversion to common shares
Diluted weighted average common shares outstanding
Diluted Earnings per Common Share
Years Ended December 31,
2017
2016
2015
$
$
$
$
140,406 $
131,252 $
102,088
(3,632)
(3,742)
136,774 $
127,510 $
(2,806)
99,282
76,792,957
76,747,047
82,945,103
1.78 $
1.66 $
1.20
140,406 $
131,252 $
102,088
(3,836)
26,898
(4,035)
23,862
$
163,468 $
151,079 $
(2,677)
—
99,411
76,792,957
76,747,047
82,945,103
185,383
28,435
1,573,292
24,996,668
21,133,608
—
101,975,008
97,909,090
84,518,395
$
1.60 $
1.54 $
1.18
We included participating securities, which are certain equity awards that have non-forfeitable dividend participation rights, in the calculations of basic and
diluted earnings per common share as we determined that the two-class method was more dilutive than the alternative treasury stock method for these shares.
Dividends and undistributed earnings allocated to participating securities under the basic and diluted earnings per share calculations require specific shares to be
included that may differ in certain circumstances.
During the year ended December 31, 2017 , certain of our convertible notes were determined to be dilutive and were included in the calculation of diluted EPS
under the "if-converted" method. Under this method, the periodic interest expense (net of applicable taxes) for dilutive notes is added back to the numerator and the
weighted average number of shares that the notes are entitled to (if converted, regardless of whether they are in or out of the money) are included in the
denominator.
For the years ended December 31, 2017 and 2016, no common shares related to the assumed conversion of our convertible notes were antidilutive and
excluded from the calculation of diluted earnings per share. For the year ended December 31, 2015 , 21,292,309 common shares related to the assumed conversion
of the convertible notes were antidilutive and were excluded in the calculation of diluted earnings per share.
For the years ended December 31, 2017 , 2016 , and 2015 , the number of outstanding equity awards that were antidilutive totaled 5,843 , zero , and 103,253 ,
respectively.
F- 68
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 15. Equity - (continued)
Stock Repurchases
In February 2016, our Board of Directors approved an authorization for the repurchase of up to $100 million of our common stock and also authorized the
repurchase of outstanding debt securities, including convertible and exchangeable debt. This authorization replaced all previous share repurchase plans and has no
expiration date. During the year ended December 31, 2017 , we repurchased 610,342 shares of common stock pursuant to this authorization for $9 million . At
December 31, 2017 , approximately $77 million of this current authorization remained available for the repurchase of shares of our common stock. During the
period between December 31, 2017 and February 26, 2018, we repurchased 1,040,829 shares of our common stock pursuant to this authorization for $16 million .
In February 2018, our Board of Directors approved an authorization for the repurchase of an additional $39 million of our common stock, increasing the total
amount authorized for repurchases of common stock to $100 million , and also authorized the repurchase of outstanding debt securities, including convertible and
exchangeable debt. As noted above, this authorization increased the previous share repurchase authorization approved in February 2016 and has no expiration date.
This repurchase authorization does not obligate us to acquire any specific number of shares or securities. Under this authorization, shares or securities may be
repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of
1934, as amended. At February 26, 2018, approximately $100 million of this current authorization remained available for repurchases of shares of our common
stock. Like other investments we may make, any repurchases of our common stock or debt securities under this authorization would reduce our available capital
described above.
Note 16. Equity Compensation Plans
At December 31, 2017 and December 31, 2016 , 1,356,438 and 1,787,974 shares of common stock, respectively, were available for grant under our Incentive
Plan. The unamortized compensation cost of awards issued under the Incentive Plan and purchases under the Employee Stock Purchase Plan totaled $21 million at
December 31, 2017 , as shown in the following table.
Table 16.1 – Activities of Equity Compensation Costs by Award Type
(In Thousands)
Restricted Stock
Deferred Stock
Units
Performance Stock
Units
Employee Stock
Purchase Plan
Total
Unrecognized compensation cost at beginning of period
$
2,091 $
11,506 $
4,549
$
— $
Equity grants
Equity grant forfeitures
Equity compensation expense
2,247
(286)
(1,244)
8,797
(472)
(6,467)
3,050
—
(2,301)
129
—
(129)
Unrecognized Compensation Cost at End of Period
$
2,808 $
13,364 $
5,298
$
— $
18,146
14,223
(758)
(10,141)
21,470
Year Ended December 31, 2017
At December 31, 2017 , the weighted average amortization period remaining for all of our equity awards was less than two years.
F- 69
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 16. Equity Compensation Plans - (continued)
Restricted Stock
The following table summarizes the activities related to restricted stock for the years ended December 31, 2017 , 2016 , and 2015 .
Table 16.2 – Restricted Stock Activities
2017
2016
2015
Years Ended December 31,
Weighted
Average
Grant Date
Fair Market
Value
14.27
16.52
14.97
14.78
15.23
Weighted
Average
Grant Date
Fair Market
Value
18.22
11.89
17.28
18.01
14.27
Weighted
Average
Grant Date
Fair Market
Value
15.97
19.03
14.87
18.74
18.22
Shares
109,464 $
141,069
(42,675)
(20,678)
187,180 $
Shares
187,180 $
144,056
(50,107)
(76,614)
204,515 $
Shares
204,515 $
134,364
(61,928)
(19,444)
257,507 $
Outstanding at beginning of period
Granted
Vested
Forfeited
Outstanding at End of Period
The expenses recorded for restricted stock awards were $1 million for each of the years ended December 31, 2017 , 2016, and 2015 . As of December 31,
2017 , there was $3 million of unrecognized compensation cost related to unvested restricted stock. This cost will be recognized over a weighted average period of
less than two years. Restrictions on shares of restricted stock outstanding lapse through 2021 .
Deferred Stock Units (“DSUs”)
The following table summarizes the activities related to DSUs for the years ended December 31, 2017 , 2016 , and 2015 .
Table 16.3 – Deferred Stock Units Activities
2017
2016
2015
Years Ended December 31,
Weighted
Average
Grant Date
Fair Market
Value
16.46
16.01
18.09
14.80
15.92
F- 70
Units
1,848,862 $
565,921
(504,417)
(31,875)
1,878,491 $
Weighted
Average
Grant Date
Fair Market
Value
16.45
13.33
14.64
18.66
16.46
Weighted
Average
Grant Date
Fair Market
Value
16.20
16.11
14.20
16.60
16.45
Units
2,168,824 $
583,958
(335,461)
(10,167)
2,407,154 $
Units
2,407,154 $
565,061
(1,060,459)
(62,894)
1,848,862 $
Outstanding at beginning of period
Granted
Distributions
Forfeitures
Balance at End of Period
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 16. Equity Compensation Plans - (continued)
We generally grant DSUs annually, as part of our compensation process. In addition, DSUs are granted from time to time in connection with hiring and
promotions and in lieu of the payment in cash of a portion of annual bonus earned. At December 31, 2017 , 2016 , and 2015 , the number of outstanding DSUs that
were unvested was 988,656 , 908,963 , and 1,043,606 , respectively. The weighted average grant-date fair value of these unvested DSUs was $15.20 , $14.96 , and
$17.22 at December 31, 2017 , 2016 , and 2015 , respectively. Unvested DSUs at December 31, 2017 will vest through 2021 .
Expenses related to DSUs were $6 million , $9 million , and $7 million for the years ended December 31, 2017 , 2016 , and 2015 , respectively. During the
first quarter of 2016, equity compensation expense of $3 million was recognized in connection with the announced departures of two executives due to the full
vesting of their DSUs in accordance with the terms of their employment agreements. At December 31, 2017 , there was $13 million of unrecognized compensation
cost related to unvested DSUs. This cost will be recognized over a weighted average period of less than two years. At December 31, 2017 , 2016 , and 2015 , the
number of outstanding DSUs that had vested was 889,835 , 939,899 , and 1,363,548 , respectively.
Performance Stock Units (“PSUs”)
At December 31, 2017 and December 31, 2016 , the target number of PSUs that were unvested was 704,270 and 642,879 , respectively. During 2017 , 2016 ,
and 2015 , 273,054 , 194,484 , and 356,762 target number of PSUs were granted, respectively, with per unit grant date fair values of $11.17 , $13.24 , and $9.46 ,
respectively. During the years ended December 31, 2017 and 2015, there were no PSUs forfeited due to employee departures. During the year ended December 31,
2016 , there were 208,330 target number of PSUs forfeited due to employee departures.
With respect to the PSUs granted in 2017 and 2015, vesting will generally occur at the end of three years from their grant date, with the level of vesting at that
time contingent on total shareholder return ("TSR"). TSR for the PSUs granted in 2017 and 2015 is defined as the percentage by which our common stock “per
share price” has increased or decreased as of the last day of the three -year vesting period relative to the first day of such vesting period, adjusted to reflect the
reinvestment of all dividends declared and/or paid on our common stock (“ Three -Year TSR”). The number of underlying shares of our common stock that will
vest in future years will vary between 0% (if Three -Year TSR is zero or negative) and 200% (if Three -Year TSR is greater than or equal to 125% ) of the target
number of PSUs originally granted, adjusted upward (if vesting is greater than 0% ) to reflect the value of dividends paid during the three -year vesting period.
With respect to the PSUs granted in 2016, vesting will generally occur at the end of three years from their grant date based on four different two -year TSR
performance measurement periods and continued employment through December 13, 2019. For purposes of measuring TSR over a three -year vesting period, the
PSUs granted in 2016 are divided into four tranches with staggered two -year performance measurement periods beginning on: the grant date; the three-month
anniversary of the grant date; the six-month anniversary of the grant date; and the nine-month anniversary of the grant date, respectively. Performance-based
vesting of each tranche is based on TSR over the respective two -year performance measurement period. TSR for the PSUs granted in 2016 is defined as the
percentage by which our common stock “per share price” has increased or decreased as of the last day of each two -year performance measurement period relative
to the first day of such performance measurement period, adjusted to reflect the reinvestment of all dividends declared and/or paid on our common stock (“ Two -
Year TSR”). The PSUs earned for each of the four two -year periods will vest and be distributed in December 2019. The number of underlying common shares of
our common stock that will vest will vary between 0% (if the Two -Year TSR for a tranche is zero or negative) and 200% (if the Two -Year TSR for a tranche is
greater than or equal to 72% ) of the target number of PSUs originally granted in each tranche, adjusted upward (if vesting is greater than 0% ) to reflect the value
of dividends paid during the three -year vesting period.
The grant date fair values of 2017 PSUs were determined through Monte-Carlo simulations using the following assumptions: our common stock closing price
at the grant date, the average closing price of our common stock price for the 60 trading days prior to the grant date and the range of performance-based vesting
based on TSR over three years from the grant date. For the 2017 PSU grant, an implied volatility assumption of 27% (based on historical volatility), a risk-free rate
of 1.90% (the three -year Treasury rate on the grant date), and a 0% dividend yield (the mathematical equivalent to reinvesting the dividends over the three -year
performance period as is consistent with the terms of the PSUs) were used.
F- 71
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 16. Equity Compensation Plans - (continued)
The grant date fair values of the 2016 PSUs were determined through Monte-Carlo simulations using the following assumptions: our common stock closing
price at the grant date, the average closing price of our common stock price for the 60 trading days prior to the grant date and the range of performance-based
vesting based on TSR over four separate two -year performance periods. For the 2016 PSU grant, an implied volatility assumption of 29% (based on historical
volatility), a risk-free rate of 1.57% (the three -year Treasury rate on the grant date), and a 0% dividend yield (the mathematical equivalent to reinvesting the
dividends over the three -year performance period as is consistent with the terms of the PSUs), were used.
The grant date fair values of the 2015 PSUs were determined through Monte-Carlo simulations using the following assumptions: our common stock closing
price at the grant date, the average closing price of our common stock price for the 40 trading days prior to the grant date and the range of performance-based
vesting based on TSR over three years from the grant date. For the 2015 PSU grant, an implied volatility assumption of 26% (based on historical volatility), a risk-
free rate of 1.35% (the three -year Treasury rate on the grant date), and a 0% dividend yield (the mathematical equivalent to reinvesting the dividends over the
three -year performance period as is consistent with the terms of the PSUs) were used.
Expenses related to PSUs were $2 million for the year ended December 31, 2017 , and $3 million for each of the years ended December 31, 2016 , and 2015 .
During the first quarter of 2016, equity compensation expense of $0.6 million was recognized in connection with the announced departures of two executives to
reflect the pro-rated vesting of their PSUs through their departure dates in 2016 in accordance with the terms of their employment agreements. As of December 31,
2017 , there was $5 million of unrecognized compensation cost related to unvested PSUs.
With respect to the PSUs granted in 2014, the three -year performance period ended during the fourth quarter of 2017, resulting in the vesting of zero shares of
our underlying common stock. With respect to the PSUs granted in 2013, the three -year performance period ended during the fourth quarter of 2016, resulting in
the vesting of zero shares of our underlying common stock. With respect to the PSUs granted in 2012, the three -year performance period ended during the fourth
quarter of 2015, resulting in the vesting of 57,049 shares of our underlying common stock. The distribution of these underlying shares of common stock occurred
in December 2015 in accordance with the terms of the PSUs and our Executive Deferred Compensation Plan.
Employee Stock Purchase Plan ("ESPP")
The ESPP allows a maximum of 450,000 shares of common stock to be purchased in aggregate for all employees. As of December 31, 2017 , 361,006 shares
had been purchased, respectively, and there remained a negligible amount of uninvested employee contributions in the ESPP at December 31, 2017 .
The following table summarizes the activities related to the ESPP for the years ended December 31, 2017 , 2016 , and 2015 .
Table 16.4 – Employee Stock Purchase Plan Activities
(In Thousands)
Balance at beginning of period
Employee purchases
Cost of common stock issued
Balance at End of Period
Years Ended December 31,
2017
2016
2015
$
$
3 $
305
(304)
4 $
18 $
290
(305)
3 $
3
475
(460)
18
F- 72
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 16. Equity Compensation Plans - (continued)
Executive Deferred Compensation Plan
The following table summarizes the cash account activities related to the EDCP for the years ended December 31, 2017 , 2016 , and 2015 .
Table 16.5 – EDCP Cash Accounts Activities
(In Thousands)
Balance at beginning of period
New deferrals
Accrued interest
Withdrawals
Balance at End of Period
Note 17. Mortgage Banking Activities, Net
Years Ended December 31,
2017
2016
2015
$
2,088 $
2,095 $
750
58
(725)
558
53
(618)
$
2,171 $
2,088 $
2,049
600
61
(615)
2,095
The following table presents the components of Mortgage banking activities, net, recorded in our consolidated statements of income for the years ended
December 31, 2017 , 2016 , and 2015 .
Table 17.1 – Mortgage Banking Activities
(In Thousands)
Residential Mortgage Banking Activities, Net
Changes in fair value of:
Residential loans, at fair value (1)
Sequoia securities
Risk management derivatives (2)
Other income (expense), net (3)
Total residential mortgage banking activities, net
Commercial Mortgage Banking Activities, Net
Mortgage Banking Activities, Net
Years Ended December 31,
2017
2016
2015
$
69,373 $
31,399 $
—
(17,529)
2,064
53,908
—
1,455
5,696
2,203
40,753
(2,062)
$
53,908 $
38,691 $
53,946
(15,261)
(34,457)
4,040
8,268
2,704
10,972
Includes changes in fair value for associated loan purchase and forward sale commitments.
(1)
(2) Represents market valuation changes of derivatives that were used to manage risks associated with our accumulation of residential loans.
(3) Amounts in this line item include other fee income from loan acquisitions and the provision for repurchases expense, presented net.
F- 73
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 18. Investment Fair Value Changes, Net
The following table presents the components of Investment fair value changes, net, recorded in our consolidated statements of income for the years ended
December 31, 2017 , 2016 and 2015 .
Table 18.1 – Investment Fair Value Changes
(In Thousands)
Investment Fair Value Changes, Net
Changes in fair value of:
Years Ended December 31,
2017
2016
2015
Residential loans held-for-investment, at Redwood
$
(5,765) $
(23,102) $
Trading securities
Net investments in Legacy Sequoia entities (1)
Net investments in Sequoia Choice entities (1)
Risk-sharing investments
Risk management derivatives, net
Valuation adjustments on commercial loans held-for-sale
Impairments on AFS securities
Investment Fair Value Changes, Net
39,526
(8,027)
(323)
(1,484)
(12,842)
300
(1,011)
9,666
(4,200)
—
(1,151)
(9,112)
(307)
(368)
(6,337)
(2,019)
(1,192)
—
(1,886)
(9,677)
—
(246)
$
10,374 $
(28,574) $
(21,357)
(1)
Includes changes in fair value of the residential loans held-for-sale, REO and the ABS issued at the entities, which netted together represent the change in value of our
retained investments at the consolidated VIEs.
F- 74
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 19. Operating Expenses
Components of our operating expenses for the years ended December 31, 2017 , 2016 and 2015 are presented in the following table.
Table 19.1 – Components of Operating Expenses
(In Thousands)
Fixed compensation expense
Variable compensation expense (1)
Equity compensation expense
Total compensation expense
Systems and consulting
Loan acquisition costs (2)
Office costs
Accounting and legal
Corporate costs
Other operating expenses
Years Ended December 31,
2017
2016
2015
$
22,111 $
24,332 $
20,574
10,141
52,826
7,073
5,022
4,248
2,842
1,856
3,289
77,156
—
77,156 $
16,581
9,093
50,006
9,037
5,744
4,550
3,658
2,106
3,284
78,385
10,401
88,786 $
35,093
12,606
11,921
59,620
10,212
10,326
5,270
4,837
2,049
5,102
97,416
—
97,416
Operating expenses before restructuring charges
Restructuring charges (3)
Total Operating Expenses
$
(1) Variable compensation expense in 2017 includes $2 million of costs associated with the hiring of a new executive officer.
(2) Loan acquisition costs primarily includes underwriting and due diligence costs related to the acquisition of residential loans held-for-sale at fair value.
(3) For the year ended December 31, 2016, restructuring charges included $5 million of fixed compensation expense and $3 million of equity compensation expense related to
one-time termination benefits, as well as $2 million of other contract termination costs, associated with the restructuring of our conforming and commercial mortgage
banking operations and related charges associated with the departure of Redwood's President announced in the first quarter of 2016. See Note
10
for further discussion on
restructuring charges.
F- 75
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 20. Taxes
Components of our net deferred tax assets at December 31, 2017 and December 31, 2016 are presented in the following table.
Table 20.1 – Deferred Tax Assets (Liabilities)
(In Thousands)
Deferred Tax Assets
Net operating loss carryforward – state
Net capital loss carryforward – state
Net operating loss carryforward – federal
Net capital loss carryforward – federal
Real estate assets
Interest rate agreements
Allowances and accruals
Other
Total Deferred Tax Assets
Deferred Tax Liabilities
Real estate assets
Mortgage Servicing Rights
Interest rate agreements
Tax effect of unrealized gains – OCI
Total Deferred Tax Liabilities
Valuation allowance
December 31, 2017
December 31, 2016
$
108,085 $
—
—
535
—
1,380
2,044
1,844
89,350
15,346
9,537
2,283
5,601
—
3,059
2,192
113,888
127,368
(562)
(20,540)
—
(1,166)
(22,268)
(103,384)
—
(22,531)
(2,167)
(1,636)
(26,334)
(101,932)
(898)
Total Deferred Tax Asset (Liability), net of Valuation Allowance
$
(11,764) $
The deferred tax assets and liabilities reported above, with the exception of the state net operating loss and capital loss carryforwards, relate solely to our TRS.
For state purposes, the REIT files a unitary combined return with its TRS. Because the REIT may have state taxable income apportioned to it from the activity of
its TRS, we report the entire combined unitary state net operating loss and capital loss carryforwards as deferred tax assets, including the carryforwards allocated to
the REIT.
Realization of our deferred tax assets ("DTAs") at December 31, 2017 , is dependent on many factors, including generating sufficient taxable income prior to
the expiration of NOL carryforwards and generating sufficient capital gains in future periods prior to the expiration of capital loss carryforwards. We determine the
extent to which realization of the deferred assets is not assured and establish a valuation allowance accordingly.
As a result of GAAP income generated at our TRS in 2017 and 2016, we are reporting net federal ordinary and capital deferred tax liabilities ("DTLs") at
December 31, 2017 and December 31, 2016 and consequently no valuation allowance was recorded against any federal DTA in either of these periods. Consistent
with prior periods, at December 31, 2017 , we continued to maintain a valuation allowance against our net state DTAs as we remain uncertain about our ability to
generate sufficient income in future periods needed to utilize net state DTAs beyond the reversal of our state DTLs.
Our estimate of net deferred tax assets could change in future periods to the extent that actual or revised estimates of future taxable income during the
carryforward periods change from current expectations. We assessed our tax positions for all open tax years (i.e., Federal, 2014 to 2017 , and State, 2013 to 2017 )
and, at December 31, 2017 and December 31, 2016 , concluded that we had no uncertain tax positions that resulted in material unrecognized tax benefits.
F- 76
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 20. Taxes - (continued)
At December 31, 2017 , our federal NOL carryforward at the REIT was $57 million , which will expire in 2029 . In order to utilize NOLs at the REIT, taxable
income must exceed dividend distributions. At December 31, 2017 , our taxable REIT subsidiaries had no federal NOLs, as they were fully utilized in 2017.
Redwood and its taxable subsidiaries accumulated an estimated state NOL of $1.26 billion at December 31, 2017 . These NOLs expire beginning in 2029 . If
certain substantial changes in the Company’s ownership occur, there could be an annual limitation on the amount of the carryforwards that can be utilized.
The following table summarizes the provision for income taxes for the years ended December 31, 2017 , 2016 , and 2015 .
Table 20.2 – Provision for Income Taxes
(In Thousands)
Current Provision for Income Taxes
Federal
State
Total Current Provision for Income Taxes
Deferred Provision for Income Taxes
Federal
State
Total Deferred Provision for (Benefit from) Income Taxes
Total Provision for (Benefit from) Income Taxes
Years Ended December 31,
2017
2016
2015
$
512 $
361
873
10,991
(112)
10,879
1,477 $
331
1,808
1,910
(10)
1,900
$
11,752 $
3,708 $
144
167
311
(10,198)
(459)
(10,657)
(10,346)
The total provision for income taxes for the year ended December 31, 2017 included a benefit of $8 million due to a reduction of net deferred tax liabilities
resulting from the Tax Cuts and Jobs Act of 2017 (the "Tax Act”) that reduces the federal statutory tax rate for tax years beginning after December 31, 2017 . In
accordance with Staff Accounting Bulletin No. 118, the Company has determined that the income tax effects for the year ended December 31, 2017 related to the
Tax Act are complete and no amounts are estimated, provisional, or incomplete.
The following is a reconciliation of the statutory federal and state tax rates to our effective tax rate at December 31, 2017 , 2016 , and 2015 .
Table 20.3 – Reconciliation of Statutory Tax Rate to Effective Tax Rate
Federal statutory rate
State statutory rate, net of Federal tax effect
Differences in taxable (loss) income from GAAP income
Change in valuation allowance
Dividends paid deduction
Federal statutory rate change
Effective Tax Rate
December 31, 2017
December 31, 2016
December 31, 2015
34.0 %
7.2 %
(3.9)%
(1.0)%
(23.4)%
(5.2)%
7.7 %
F- 77
34.0 %
7.2 %
(1.0)%
(11.2)%
(26.3)%
— %
2.7 %
34.0 %
7.2 %
(20.3)%
6.1 %
(38.3)%
— %
(11.3)%
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 20. Taxes - (continued)
We believe that we have met all requirements for qualification as a REIT for federal income tax purposes. Many requirements for qualification as a REIT are
complex and require analysis of particular facts and circumstances. Often there is only limited judicial or administrative interpretive guidance and as such there can
be no assurance that the Internal Revenue Service or courts would agree with our various tax positions. If we did not meet the requirements for statutory relief, we
could be subject to a 100% prohibited transaction tax for certain transactions, be required to distribute additional dividends, or be subject to federal corporate
income tax on our taxable income. We could also potentially lose our REIT status. Any of these outcomes could have a material adverse impact on our
consolidated financial statements.
Note 21. Segment Information
Redwood operates in two segments: Investment Portfolio and Residential Mortgage Banking. Beginning in the first quarter of 2017, we eliminated our
Commercial segment and renamed our Residential Investments segment as the Investment Portfolio segment. Our segments are based on our organizational and
management structure, which aligns with how our results are monitored and performance is assessed. The accounting policies of the reportable segments are the
same as those described in Note
3
—
Summary
of
Significant
Accounting
Policies
. For a full description of our segments, see Item 1 —Business
in this Annual
Report on Form 10-K.
Segment contribution represents the measure of profit that management uses to assess the performance of our business segments and make resource allocation
and operating decisions. Certain corporate expenses not directly assigned or allocated to one of our two segments, as well as activity from certain consolidated
Sequoia entities and commercial mortgage banking activities (in prior years) are included in the Corporate/Other column as reconciling items to our consolidated
financial statements. These unallocated corporate expenses primarily include interest expense associated with certain long-term debt, indirect operating expenses,
and other expense.
The following tables present financial information by segment for the years ended December 31, 2017 , 2016 , and 2015 .
Table 21.1 – Business Segment Financial Information
Year Ended December 31, 2017
Investment
Portfolio
Residential
Mortgage Banking
Corporate/
Other
39,309
$
19,988 $
(In Thousands)
Interest income
Interest expense
Net interest income (loss)
Non-interest income
Mortgage banking activities, net
MSR income, net
Investment fair value changes, net
Other income
Realized gains, net
Total non-interest income, net
Direct operating expenses
Provision for income taxes
Segment Contribution
Net Income
Non-cash amortization income (expense), net
$
$
$
188,760 $
(36,690)
152,070
—
7,860
18,414
4,576
14,107
44,957
(6,028)
(5,328)
185,671
$
(17,369)
21,940
53,908
—
—
—
—
53,908
(25,113)
(6,424)
44,311
$
$
Total
248,057
(108,816)
139,241
53,908
7,860
10,374
4,576
13,355
90,073
(77,156)
(11,752)
(54,757)
(34,769)
—
—
(8,040)
—
(752)
(8,792)
(46,015)
—
(89,576)
$
(3,410) $
140,406
17,462
20,974 $
(102)
F- 78
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Year Ended December 31, 2016
Investment
Portfolio
Residential
Mortgage Banking
Corporate/
Other
Total
$
192,200
$
33,661
$
20,494 $
(22,997)
169,203
7,102
—
14,353
(24,367)
6,338
27,717
24,041
(10,421)
(1,848)
188,077
29,806
$
$
(14,191)
19,470
—
40,753
—
—
—
—
40,753
(23,252)
(1,860)
35,111
(130)
$
$
(51,340)
(30,846)
—
(2,062)
—
(4,207)
—
292
(5,977)
(55,113)
—
(91,936)
$
(3,972) $
246,355
(88,528)
157,827
7,102
38,691
14,353
(28,574)
6,338
28,009
58,817
(88,786)
(3,708)
131,252
25,704
Year Ended December 31, 2015
Investment
Portfolio
Residential
Mortgage Banking
Corporate/
Other
Total
177,595 $
(22,684)
154,911
355
—
(3,922)
(20,089)
3,192
36,369
15,550
(7,179)
846
52,260 $
(17,207)
35,053
—
8,268
—
—
—
—
8,268
(43,182)
4,169
164,483
$
4,308
$
36,583 $
(1,070)
(186) $
1,120
29,577 $
(55,992)
(26,415)
—
2,704
—
(1,268)
—
—
1,436
(47,055)
5,331
(66,703)
$
(3,994) $
(50)
259,432
(95,883)
163,549
355
10,972
(3,922)
(21,357)
3,192
36,369
25,254
(97,416)
10,346
102,088
32,403
—
$
$
$
$
$
Note 21. Segment Information - (continued)
(In Thousands)
Interest income
Interest expense
Net interest income (loss)
Reversal of provision for loan losses
Non-interest income
Mortgage banking activities, net
MSR income, net
Investment fair value changes, net
Other income
Realized gains, net
Total non-interest income, net
Direct operating expenses (1)
Provision for income taxes
Segment Contribution
Net Income
Non-cash amortization income (expense), net
(In Thousands)
Interest income
Interest expense
Net interest income (loss)
Reversal of provision for loan losses
Non-interest income
Mortgage banking activities, net
MSR loss, net
Investment fair value changes, net
Other income
Realized gains, net
Total non-interest income, net
Direct operating expenses
Benefit from income taxes
Segment Contribution
Net Income
Non-cash amortization income (expense), net
Hedging allocations
(1) For the year ended December 31, 2016, charges associated with the restructuring of our conforming residential mortgage loan operations and commercial operations,
included in the direct operating expense line item, are presented under the Corporate/Other column. See Note
10
for further discussion of these restructuring charges.
F- 79
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 21. Segment Information - (continued)
The following table presents the components of Corporate/Other for the years ended December 31, 2017 , 2016 , and 2015 .
Table 21.2 – Components of Corporate/Other
(In Thousands)
Interest income
Interest expense
Net interest income (loss)
Non-interest income
Mortgage banking activities,
net
Investment fair value
changes, net
Realized gains, net
Total non-interest (loss)
income, net
Direct operating expenses
Benefit from income taxes
Years Ended December 31,
2017
2016
2015
Legacy
Consolidated
VIEs (1)
Other
Total
Legacy
Consolidated
VIEs (1)
Other
Total
Legacy
Consolidated
VIEs (1)
Other
Total
$
19,407
$
581 $
(14,789)
4,618
(39,968)
(39,387)
19,988 $
(54,757)
(34,769)
19,537
$
957 $
(13,103)
6,434
(38,237)
(37,280)
20,494 $
(51,340)
(30,846)
24,814
$
4,763 $
29,577
(15,646)
9,168
(40,346)
(35,583)
(55,992)
(26,415)
—
(8,027)
—
(8,027)
—
—
—
(13)
(752)
—
(8,040)
(752)
(765)
(46,015)
—
(86,167) $
(8,792)
(46,015)
—
(89,576) $
—
(2,062)
(2,062)
—
2,704
(4,200)
—
(4,200)
—
—
2,234
$
(7)
292
(4,207)
292
(1,777)
(55,113)
—
(94,170) $
(5,977)
(55,113)
—
(91,936) $
(1,192)
—
(1,192)
—
—
7,976
$
(76)
—
2,628
(47,055)
5,331
(74,679) $
2,704
(1,268)
—
1,436
(47,055)
5,331
(66,703)
Total
$
(3,409)
$
(1) Legacy consolidated VIEs represent legacy Sequoia entities that are consolidated for GAAP financial reporting purposes. See Note
4
for further discussion on VIEs.
The following table presents supplemental information by segment at December 31, 2017 and December 31, 2016.
Table 21.3 – Supplemental Segment Information
(In Thousands)
December 31, 2017
Residential loans
Real estate securities
Mortgage servicing rights
Total assets
December 31, 2016
Residential loans
Real estate securities
Mortgage servicing rights
Total assets
Investment
Portfolio
Residential
Mortgage Banking
Corporate/
Other
Total
$
3,054,448 $
1,427,945 $
632,817 $
1,476,510
63,598
4,743,873
—
—
—
—
1,453,069
842,880
$
2,261,016 $
835,399 $
791,636 $
1,018,439
118,526
3,615,535
—
—
—
—
866,356
1,001,586
F- 80
5,115,210
1,476,510
63,598
7,039,822
3,888,051
1,018,439
118,526
5,483,477
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 22. Quarterly Financial Data - Unaudited
(In Thousands, except Share Data)
December 31,
September 30,
June 30,
March 31,
Three Months Ended
2017
Operating results:
Interest income
Interest expense
Net interest income
Non-interest income
Operating expenses
Net income
Per share data:
Net income – basic
Net income – diluted
Regular dividends declared per common share
2016
Operating results:
Interest income (1)
Interest expense
Net interest income
Reversal of (provision for) loan losses (2)
Non-interest income (3)
Operating expenses (4)
Net income
Per share data:
Net income – basic
Net income – diluted
Regular dividends declared per common share
$
$
$
$
71,468 $
62,737 $
59,224 $
(36,108)
35,360
10,951
(20,367)
30,933
0.39 $
0.35
0.28
(27,443)
35,294
26,070
(19,922)
36,180
0.46 $
0.41
0.28
(24,234)
34,990
25,297
(18,641)
36,324
0.46 $
0.43
0.28
56,334 $
60,906 $
66,787 $
(20,537)
35,797
—
9,763
(17,824)
25,355
0.32 $
0.31
0.28
(21,597)
39,309
859
33,712
(20,355)
52,553
0.67 $
0.58
0.28
(22,444)
44,343
6,532
10,888
(20,155)
41,281
0.52 $
0.48
0.28
54,628
(21,031)
33,597
27,755
(18,226)
36,969
0.47
0.43
0.28
62,328
(23,950)
38,378
(289)
4,454
(30,452)
12,063
0.15
0.15
0.28
(1)
Interest income from the three-month period ended June 30, 2016 included $5 million of yield maintenance fees from commercial loans that prepaid during the quarter.
(2) During the second quarter of 2016, we recorded a reversal of provision for loan losses of $7 million as a result of the transfer of most of our commercial mezzanine loans
from held-for-investment to held-for sale.
(3) Non-interest income for the three-month period ended September 30, 2016 included $5 million of realized gains from the sale of the majority of our commercial mezzanine
loan portfolio.
(4) During the first quarter of 2016, we recorded restructuring charges totaling $10 million associated with the restructuring of our conforming and commercial mortgage
banking operations.
F- 81
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2017
Note 23. Subsequent Events
In February 2018, our Board of Directors approved an authorization for the repurchase of an additional $39 million of our common stock, increasing the total
amount authorized for repurchases of common stock to $100 million , and also authorized the repurchase of outstanding debt securities, including convertible and
exchangeable debt. This authorization increased the previous share repurchase authorization approved in February 2016 and has no expiration date. This
repurchase authorization does not obligate us to acquire any specific number of shares or securities. Under this authorization, shares or securities may be
repurchased in privately negotiated and/or open market transactions, including under plans complying with Rule 10b5-1 under the Securities Exchange Act of
1934, as amended.
F- 82
REDWOOD TRUST, INC. AND SUBSIDIARIES
SCHEDULE IV - MORTGAGE LOANS ON REAL ESTATE
December 31, 2017
(In Thousands)
Description
Residential Loans Held-for-Investment
At Redwood:
Hybrid ARM loans
Fixed loans
At Legacy Sequoia:
ARM loans
Hybrid ARM loans
At Sequoia Choice:
Fixed loans
Total Residential Loans Held-for-Investment
Residential Loans Held-for-Sale:
ARM loans
Hybrid ARM loans
Fixed loans
Total Residential Loans Held-for-Sale
Number of
Loans
Interest
Rate
Maturity
Date
Carrying
Amount (1)
Principal Amount
Subject to Delinquent
Principal or Interest
259
3,033
3,145
33
806
3
93
1,917
2.63% to 6.00%
2040-09 - 2047-11
$
204,771 $
2.75% to 6.75%
2022-10 - 2048-01
1.00% to 5.63%
2019-02 - 2036-05
2.63% to 3.75%
2033-07 - 2034-12
2.75% to 6.50%
2037-02 - 2047-11
1.50% to 3.00%
2032-11 - 2033-10
2.88% to 4.00%
2044-08 - 2048-01
2.88% to 6.25%
2029-05 - 2048-01
2,229,616
619,777
13,039
620,062
3,687,265 $
298 $
79,347
1,348,300
1,427,945
$
$
$
$
—
—
24,816
641
—
25,457
—
—
459
459
(1) The aggregate cost for Federal income tax purposes of our mortgage loans held at Redwood approximates the carrying values, as disclosed in the schedule. For our held-for-
investment loans at consolidated Legacy Sequoia and Sequoia Choice entities, the aggregate cost for Federal income tax purposes at December 31, 2017 was zero, as the
transfers of these loans into Sequoia securitizations were treated as sales for tax purposes.
F- 83
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTE TO SCHEDULE IV - RECONCILIATION OF MORTGAGE LOANS ON REAL ESTATE
December 31, 2017
The following table summarizes the changes in the carrying amount of mortgage loans on real estate during the years ended December 31, 2017, 2016, and
2015.
(In Thousands)
Balance at beginning of period
ASU 2014-13 election adjustment
Adjusted beginning balance
Additions during period:
Originations/acquisitions
Net discount accretion
Deductions during period:
Sales
Principal repayments
Reversal of provision for loan losses
Transfers to REO
Deconsolidation adjustments
Changes in fair value, net
Balance at end of period
Years Ended December 31,
2017
2016
2015
$
3,890,751 $
4,331,450 $
—
—
3,890,751
4,331,450
3,965,500
(103,649)
3,861,851
5,741,427
4,983,049
11,115,486
—
330
747
(3,982,683)
(576,620)
—
(4,219)
—
46,554
(4,509,644)
(879,188)
7,102
(11,566)
(6,871)
(23,911)
(10,071,061)
(582,187)
355
(5,792)
—
12,051
$
5,115,210 $
3,890,751 $
4,331,450
F- 84
SECOND AMENDMENT TO LEASE
EXHIBIT 10.30
THIS SECOND AMENDMENT TO LEASE is executed effective December 27, 2017 by and between AG‑SKB Belvedere
Owner, L.P. (“Landlord”), and Redwood Trust, Inc. (“Tenant”).
RECITALS
A.
Landlord and Tenant are parties to that certain Lease dated June 1, 2012, as amended by First Amendment
dated May 25, 2017 (collectively, the “Lease”), pursuant to which Tenant leases from Landlord certain Premises located at
One Belvedere Place in Mill Valley, California. The defined, capitalized terms used in the Lease shall have the same
meanings when used herein.
B.
Landlord and Tenant desire to amend the Lease as set forth in this Amendment.
NOW, THEREFORE, it is agreed as follows.
1.
Temporary Space . The Temporary Space is Suite 300 on the 3 rd Floor of Two Belvedere Place, which is
depicted on Exhibit A and is agreed to contain 8,237 rentable square feet. Commencing January 1, 2018, Tenant shall be
allowed to use the Temporary Space, on the terms set forth in this Amendment.
of the terms of the Lease that apply to use of the Premises.
(a)
Tenant shall use the Temporary Space only for general office purposes. Such use shall be upon all
Tenant shall not be required to pay Basic Rent, Operating Expenses or any security deposit with
respect to the Temporary Space. Tenant shall pay, within ten (10) days of each request, the cost of utilities used in the Temporary
Space and the cost of routine janitorial service to the Temporary Space.
(b)
all insurance required under the Lease (but with the same being applicable to the Temporary Space) and deliver proof of the same to
Landlord.
(c)
Prior to entry into the Temporary Space and as a condition to use of the same, Tenant shall obtain
(d)
The Temporary Space is delivered “AS IS”. Tenant shall bring to the Temporary Space the furniture
owned by Landlord (as conveyed by Tenant under the Lease by Bill of Sale) (the “Landlord’s Furniture”). Tenant may install
cabling and work stations in the Temporary Space; Tenant shall not otherwise alter the Temporary Space. On or before the
Expiration Date set forth below, Tenant, at its cost, shall remove its cabling, work stations and other property, shall remove and
dispose of all of the Landlord’s Furniture, shall remove all of its property, and shall surrender the Temporary Space in the condition
it was received.
(e)
In the event of any casualty or condemnation affecting the Temporary Space, Landlord shall have
the right to terminate Tenant’s right to use the same; Landlord has no obligation to restore the Temporary Space. No casualty,
condemnation, or utility interruption that affects the Temporary Space shall have any effect on the leasing of the Premises under the
Lease.
(f)
No expansion, renewal, or early termination rights in the Lease apply to the Temporary Space.
Space.
(g)
(h)
(i)
All obligations and liabilities of Tenant related to the Premises shall apply also to the Temporary
Tenant shall not sublease all or any part of the Temporary Space.
Tenant shall have no right to holdover in the Temporary Space beyond the last day allowed by this
Amendment. If Tenant does so, then Tenant shall pay, as additional rent, the sum of $41,185.00 per month, prorated daily;
acceptance of this rent is not a waiver of this provision nor of any other right or remedy for such failure by Tenant. Further, Tenant
shall defend and indemnify Landlord for, from, against and regarding any claim or loss arising from Tenant’s failure to vacate the
Temporary Space as and when required hereunder.
2.
Expiration . Tenant shall cease use of the Temporary Space and shall vacate the same on or before July 31,
2018 (the “Expiration Date”). Tenant shall, at the time of vacating the Temporary Space, have the Temporary Space
professionally cleaned, otherwise Landlord shall have the right to do so and Tenant shall reimburse Landlord’s cost of such
work. Tenant shall surrender the Temporary Space in the same condition as it was delivered.
3.
Construction . Tenant acknowledges that construction work will occur to demise the Temporary Space from
adjacent space and to improve such adjacent space. Tenant agrees that such work will cause noise, disruption and
interference with use of the Temporary Space, and Tenant will make no claim against Landlord, any contractor, or the
property manager based on the same. Tenant will comply with the directives of the contractor and/or property manager
issued in connection with such work.
4.
Building Planning . If Landlord enters into a letter of intent to lease all of the Temporary Space to a
prospective new Tenant for a period of not less than three (3) years, then upon written notice given at least thirty (30) days in
advance (the “Relocation Notice”), Landlord shall have the right to require Tenant to relocate from the Temporary Space to
other space or spaces in the Project (the “Relocation Space”). The Relocation Notice shall identify the Relocation Space and
the date of the relocation. If the Relocation Space is not comparable to the Temporary Space in size or quality, then Tenant
may terminate this Amendment, as of the relocation date specified in the Relocation Notice, by written notice given to
Landlord within five (5) days of the Relocation Notice, in which event the Expiration Date shall be the relocation date set
forth in Landlord’s notice rather than July 31, 2018. If this Amendment is not so terminated, then Tenant shall relocate from
the Temporary Space to the Relocation Space on the date set forth in the Relocation Notice, at Tenant’s expense, and this
Amendment shall remain in full force and effect on its same terms except that the Relocation Space shall be the “Temporary
Space” for all purposes hereunder.
5.
Allowance .
(a)
The outside date for use of the Allowance set forth in Section 2.2 of the Work Letter attached to the
First Amendment as Exhibit B (the “Work Letter”) is hereby extended from May 31, 2018 to December 31, 2018. Notwithstanding
the other provisions of the Work Letter, in order to use the Allowance Tenant shall first finally complete all Alterations and then
shall submit to Landlord, in addition to all items listed in Section 2.1 of the Work Letter, a complete set of “as built” plans and
specifications, in both hard copy and CAD form, showing fully and in detail all Alterations.
6.
7.
8.
of the Allowance not used to pay Costs prior to August 31, 2018 shall be retained by Landlord without credit to Tenant and shall not
be available to Tenant for any purpose.
(b)
Section 2.3 of the Work Letter and all references to such Section 2.3, are hereby deleted. Any part
and timely performed each and all of their obligations under the Lease.
Acknowledgment . Tenant acknowledges and agrees that Landlord and all predecessor lessors have fully
Effect of Amendment . Submission of this Amendment for review does not constitute an offer by Landlord
to Tenant. This document may not be relied upon, nor may any claim for reliance or estoppel be made based upon this
document, unless and until this document is fully executed and delivered by each party.
Representations . Tenant hereby represents and warrants to Landlord that (a) this Amendment constitutes
the binding obligation of Tenant and is enforceable against the Tenant in accordance with its terms, (b) Tenant has not made
any assignment, sublease, transfer, conveyance or other disposition of its interest in the Lease or in the Premises (including
assignments for security purposes), (c) no consent of any third party is necessary for Tenant to execute, deliver and perform
this Amendment, and (d) Tenant has engaged with no broker regarding this Amendment. The person executing this
Amendment on behalf of Tenant warrants his or her authority to do so.
9.
Disclosure . For purposes of Section 1938 of the California Civil Code, Landlord hereby discloses to
Tenant, and Tenant hereby acknowledges, that the Temporary Space has not undergone inspection by a Certified Access
Specialist (CASp). A Certified Access Specialist (CASp) can inspect the subject premises and determine whether the subject
premises comply with all of the applicable construction-related accessibility standards under state law. Although state law
does not require a CASp inspection of the subject premises, the commercial property owner or lessor may not prohibit the
lessee or tenant from obtaining a CASp inspection of the subject premises for the occupancy or potential occupancy of the
lessee or tenant, if requested by the lessee or tenant. The parties shall mutually agree on the arrangements for the time and
manner of the CASp inspection, the payment of the fee for the CASp inspection, and the cost of making any repairs
necessary to correct violations of construction-related accessibility standards within the premises. Landlord has no obligation
to make or to pay for the inspection or to make or to pay for any repairs.
10.
pdf is sufficient.
Counterparts . This Amendment may be executed and delivered in counterparts; delivery by facsimile or
11.
Status of Lease . Except as expressly amended hereby the Lease remains in full force and effect and is
hereby ratified and confirmed.
IN WITNESS WHEREOF, this Amendment has been executed as of the date first above written.
LANDLORD:
TENANT:
AG-SKB Belvedere Owner, L.P.,
a Delaware limited partnership
Redwood Trust, Inc.,
a Maryland corporation
By:
Its:
AG-SKB Belvedere GP, L.L.C.,
a Delaware limited liability company
General Partner
By:
Name:
Title:
/s/ Steven G. White
Steven G. White
Vice President
By:
Name:
Title:
/s/ Bo Stern
Bo Stern
Chief Investment Officer
STATEMENT OF COMPUTATION OF RATIO OF EARNINGS TO FIXED CHARGES (1)
EXHIBIT 12
Our ratio of earnings to fixed charges for the each of the years ended December 31, 2017 , 2016 , 2015 , 2014 , and 2013 were as follows:
(In Thousands, Except Ratios)
2017
2016
2015
2014
2013
Net income before provision for income taxes
$
152,158 $
134,960 $
91,742 $
101,313 $
184,194
Interest expense on asset-backed securities
Interest expense on long-term debt
Interest expense on convertible debt maturing in less than one year
19,108
52,857
8,836
14,735
51,506
—
21,469
43,842
—
31,227
30,246
—
39,716
23,819
—
Earnings available to cover fixed charges
$
232,959 $
201,201 $
157,053 $
162,786 $
247,729
Years Ended December 31,
Fixed charges:
Interest expense on asset-backed securities
$
19,108 $
14,735 $
21,469 $
31,227 $
Interest expense on long-term debt
Interest expense on convertible debt maturing in less than one year
52,857
8,836
51,506
43,842
30,246
—
—
—
39,716
23,819
—
Total fixed charges
Ratio of Earnings to Fixed Charges
$
80,801 $
66,241 $
65,311 $
61,473 $
63,535
2.88
3.04
2.40
2.65
3.90
(1) The ratio of earnings to fixed charges represents the number of times “fixed charges” are covered by “earnings.” “Fixed charges” consist of interest on
outstanding long-term debt, convertible notes with a maturity of less than one year, and asset-backed securities issued, as well as associated amortization of
debt discount and deferred issuance costs. The proportion deemed representative of the interest factor of operating lease expense has not been deducted as the
total operating lease expense in itself was de minimis and did not affect the ratios in a material way. “Earnings” consist of consolidated income before income
taxes and fixed charges.
LIST OF SUBSIDIARIES
OF REDWOOD TRUST, INC.
Subsidiaries*
Redwood Asset Management, Inc.**
Redwood Capital Trust I
Redwood Residential Acquisition Corporation
Redwood Subsidiary Holdings, LLC
RWT Holdings, Inc.***
RWT Securities, LLC
Sequoia Mortgage Funding Corporation****
Sequoia Residential Funding, Inc.*****
RWT Financial, LLC
EXHIBIT 21
Jurisdiction of
Incorporation or
Organization
Delaware
Delaware
Delaware
Delaware
Delaware
Delaware
Delaware
Delaware
Delaware
*
**
***
****
*****
In accordance with Item 601(b)(21)(ii) of Regulation S-K the names of certain subsidiaries have been omitted.
Redwood Asset Management, Inc. is the collateral manager of the following Acacia securitization entities: Acacia CDO 5, Ltd., Acacia CDO 7, Ltd.,
Acacia CDO 8, Ltd., Acacia CDO CRE 1, Ltd., Acacia CDO 9, Ltd., Acacia CDO 10, Ltd., Acacia CDO 11, Ltd., and Acacia CDO 12, Ltd. These
Acacia CDO entities were organized in the Cayman Islands.
The following special purpose entities, each of which is organized in Delaware, are associated with residential risk sharing arrangements with Fannie
Mae and Freddie Mac: RRAC SPV-FN Trust; RRAC SPV-FN2 Trust; and RRAC SPV-FRE Trust. The equity interests in each such entity are held
by RWT Holdings, Inc.
Sequoia Mortgage Funding Corporation is the depositor with respect to four Sequoia securitization trusts that are not listed in this exhibit, but we are
required to consolidate the assets and liabilities of two of these trusts under GAAP for financial reporting purposes.
Sequoia Residential Funding, Inc. is the depositor with respect to more than 30 Sequoia securitization trusts that are not listed in this exhibit, but we
are required to consolidate the assets and liabilities of certain of these trusts under GAAP for financial reporting purposes.
CONSENT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
EXHIBIT 23
We have issued our reports dated February 28, 2018 , with respect to the consolidated financial statements and internal control over financial reporting,
included in the Annual Report of Redwood Trust, Inc. on Form 10-K for the year ended December 31, 2017 . We consent to the incorporation by reference to said
reports in the Registration Statements of Redwood Trust, Inc. on Form S-3 (File No. 333-211267, effective May 10, 2016) and on Forms S-8 (File Nos. 333-89302,
effective May 29, 2002; 333-89300, effective May 29, 2002; 333-90592, effective June 17, 2002; 333-116395, effective June 10, 2004; 333-136497, effective
August 10, 2006; 333-155154, effective November 6, 2008; 333-162893, effective November 5, 2009; 333-176102, effective August 5, 2011; 333-183114,
effective August 7, 2012; 333-183116, effective August 7, 2012; 333-190529, effective August 9, 2013; 333-190530, effective August 9, 2013; 333-196247,
effective May 23, 2014, 333-197990, effective August 8, 2014).
/s/ GRANT THORNTON LLP
Newport Beach, CA
February 28, 2018
CHIEF EXECUTIVE OFFICER CERTIFICATION PURSUANT TO SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
I, Martin S. Hughes, certify that:
1. I have reviewed this Annual Report on Form 10-K of Redwood Trust, Inc.;
EXHIBIT 31.1
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this
report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over the financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-
15(f)) for the registrant and we have:
a)
b)
c)
d)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the period in which this report is being prepared;
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under
our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles;
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most
recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably
likely to materially affect, the registrant’s internal control over financial reporting; and
5.
The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the
registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
a)
b)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s
internal control over financial reporting.
Date: February 28, 2018
/s/ MARTIN S. HUGHES
Martin S. Hughes
Chief Executive Officer
CHIEF FINANCIAL OFFICER CERTIFICATION PURSUANT TO SECTION 302 OF
THE SARBANES-OXLEY ACT OF 2002
I, Collin L. Cochrane, certify that:
1. I have reviewed this Annual Report on Form 10-K of Redwood Trust, Inc.;
EXHIBIT 31.2
2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the
statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this
report;
3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over the financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-
15(f)) for the registrant and we have:
a)
b)
c)
d)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the period in which this report is being prepared;
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under
our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial
statements for external purposes in accordance with generally accepted accounting principles;
Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the
effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most
recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably
likely to materially affect, the registrant’s internal control over financial reporting; and
5.
The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the
registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):
a)
b)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are
reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s
internal control over financial reporting.
Date: February 28, 2018
/s/ COLLIN L. COCHRANE
Collin L. Cochrane
Chief Financial Officer
CERTIFICATION
EXHIBIT 32.1
Pursuant to 18 U.S.C. §1350, the undersigned officer of Redwood Trust, Inc. (the “Registrant”) hereby certifies that the Registrant’s Annual Report on
Form 10-K for the year ended December 31, 2017 (the “Annual Report”) fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the
Securities Exchange Act of 1934 and that the information contained in the Annual Report fairly presents, in all material respects, the financial condition and results
of operations of the Registrant.
Date: February 28, 2018
/s/ MARTIN S. HUGHES
Martin S. Hughes
Chief Executive Officer
The foregoing certification is being furnished solely pursuant to 18 U.S.C. §1350 and is not being filed as part of the Annual Report or as a separate
disclosure document.
CERTIFICATION
EXHIBIT 32.2
Pursuant to 18 U.S.C. §1350, the undersigned officer of Redwood Trust, Inc. (the “Registrant”) hereby certifies that the Registrant’s Annual Report on
Form 10-K for the year ended December 31, 2017 (the “Annual Report”) fully complies with the requirements of Section 13(a) or 15(d), as applicable, of the
Securities Exchange Act of 1934 and that the information contained in the Annual Report fairly presents, in all material respects, the financial condition and results
of operations of the Registrant.
Date: February 28, 2018
/s/ COLLIN L. COCHRANE
Collin L. Cochrane
Chief Financial Officer
The foregoing certification is being furnished solely pursuant to 18 U.S.C. §1350 and is not being filed as part of the Annual Report or as a separate
disclosure document.