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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1999
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ____________ TO ____________
COMMISSION FILE NUMBER: 1-13759
REDWOOD TRUST, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 68-0329422
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
591 REDWOOD HIGHWAY, SUITE 3100
MILL VALLEY, CALIFORNIA 94941
(Address of principal executive offices) (Zip Code)
(415) 389-7373
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: Name of Exchange on Which Registered:
CLASS B 9.74% CUMULATIVE CONVERTIBLE PREFERRED STOCK, NEW YORK STOCK EXCHANGE
PAR VALUE $0.01 PER SHARE
(Title of Class)
COMMON STOCK, PAR VALUE $0.01 PER SHARE NEW YORK STOCK EXCHANGE
(Title of Class)
Securities registered pursuant to Section 12(g) of the Act:
NONE
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 [ ]
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. [ ]
At March 15, 2000 the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $114,259,261.
The number of shares of the Registrant's Common Stock outstanding on March 15,
2000 was 8,789,376.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement issued in connection
with the 2000 Annual Meeting of Stockholders are incorporated by reference into
Part III.
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REDWOOD TRUST, INC.
1999 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
Page
----
PART I
Item 1. BUSINESS......................................................... 3
Item 2. PROPERTIES....................................................... 26
Item 3. LEGAL PROCEEDINGS................................................ 26
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.............. 26
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS.................................. 27
Item 6. SELECTED FINANCIAL DATA.......................................... 28
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS.................... 29
Item 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA......... 47
Item 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE........................... 47
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............... 47
Item 11. EXECUTIVE COMPENSATION........................................... 47
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT............................................ 47
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................... 47
PART IV
Item 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS SCHEDULES AND
REPORTS ON FORM 8-K.............................................. 47
CONSOLIDATED FINANCIAL STATEMENTS.......................................... F-1
2
PART I
ITEM 1. BUSINESS
REDWOOD TRUST
Redwood Trust is a finance company specializing in the mortgage portfolio
lending business. Our primary activity is the acquisition, financing, and
management of high-quality jumbo residential mortgage loans. We fund our loan
portfolio primarily through the issuance of long-term debt. We also own and
manage a portfolio of residential mortgage securities and originate commercial
mortgages for sale to other financial institutions. Our core business of
mortgage portfolio lending is conducted through Redwood Trust, which is a
qualified real estate investment trust ("REIT"). As a result, Redwood Trust does
not pay tax on net mortgage portfolio income or on dividends received from
taxable affiliates so long as Redwood Trust distributes its taxable income as
dividends and meets certain other REIT tests. See "Certain Federal Income Tax
Considerations" commencing on page 20 of this Form 10-K.
We also own a 99% economic interest in a taxable affiliate company, RWT
Holdings, Inc. ("Holdings"). Our investment in Holdings is accounted for under
the equity method. Holdings originates and sells commercial mortgage loans
through its subsidiary, Redwood Commercial Funding, Inc. ("RCF"). RCF typically
originates shorter-term floating-rate commercial mortgage loans to high-quality
borrowers who require more flexible borrowing arrangements than are usually
offered by life insurance companies or commercial mortgage conduit lending
programs.
Holdings had two other businesses, Redwood Financial Services, Inc. ("RFS") and
Redwood Residential Funding, Inc. ("RRF"). Due to a variety of start-up
difficulties with these operations, RFS was closed in the third quarter of 1999
and RRF was closed in the fourth quarter of 1999.
In accordance with the Private Securities Litigation Reform Act of 1995, we can
obtain a "Safe Harbor" for forward-looking statements by identifying those
statements and by accompanying those statements with cautionary statements which
identify factors that could cause actual results to differ from those in the
forward-looking statements. Accordingly, the following information contains or
may contain forward-looking statements: (1) information included in this Annual
Report on Form 10-K, regarding investments in mortgage loans and securities,
interest rate agreements, leverage, interest rates, and statements in Item 7,
Management's Discussion and Analysis of Financial Condition and Results of
Operations, and Item 7A, Quantitative and Qualitative Disclosures about Market
Risk and (2) information included in our future filings with the Securities and
Exchange Commission including, without limitation, statements with respect to
growth, projected revenues, earnings, returns and yields on our portfolio of
mortgage assets, the impact of interest rates, costs, and business strategies
and plans.
For a description of important risk factors, among others, that could affect our
actual results and could cause our actual consolidated results to differ
materially from those expressed in any forward-looking statements made by us,
see "Risk Factors" commencing on page 13 of this Form 10-K.
3
COMPANY BUSINESS AND STRATEGY
The objective of Redwood Trust's mortgage portfolio lending operations is to
generate earnings, dividends, and increases in book value per share (in general,
to create Shareholder Wealth) by acting as a financial intermediary managing
mortgage loans in portfolio funded with AAA-rated callable long-term debt, by
acquiring or creating subordinated mortgage securities or other types of
mortgage equity interests, by managing a portfolio of mortgage securities, and
by otherwise being an efficient investor in mortgage assets. Since Redwood Trust
qualifies as a REIT for tax purposes, we are looking to find those areas of the
mortgage portfolio lending business that are most advantaged by Redwood Trust's
tax status and corporate structure. To achieve our business objective, our
strategy is to focus on the following elements of mortgage portfolio lending
operations.
- Asset Acquisition
- Risk Management
- Capital and Leverage Utilization
The business and strategy of Redwood Trust with respect to the commercial loan
origination operations of our affiliate is discussed below under "RWT Holdings
Business and Strategy" commencing on page 12.
ASSET ACQUISITION
TYPES OF ASSETS
Redwood Trust acquires and manages single-family, multi-family, and commercial
mortgage loans and residential mortgage securities (collectively, "mortgage
assets"). At the end of 1999, 81% of the mortgage assets that we owned bore
adjustable interest rates. Hybrid mortgages assets, with an initial fixed rate
period to the first rate adjustment greater than one year, made up 17% of our
mortgage assets. The remaining 2% of mortgage assets were fixed-rate mortgages.
We may also acquire common stock, preferred stock, and/or debt in other REITs.
Redwood Trust may also acquire its own common or preferred stock, when permitted
by applicable securities and state corporation laws, or other types of assets
under the direction of our Board of Directors.
The majority of our mortgage assets at December 31, 1999 consisted of mortgage
loans and pass-through mortgage securities. We may acquire, without limitations,
other types of mortgage assets, including potentially, structured mortgage
securities that are relatively illiquid and have leveraged risk with respect to
mortgage credit, prepayment and other risks. We generally intend to increase our
credit risk profile by providing credit-enhancement to, and thus retaining some
of the credit risk of, residential and commercial loans produced by Holdings and
others.
We do not plan to acquire or retain any Real Estate Mortgage Investment Conduit
("REMIC") or Collateralized Mortgage Obligation ("CMO") residual interests that
would cause the distribution of excess inclusion income or unrelated business
taxable income to investors. As a result, we qualify as an eligible investment
for tax exempt investors, such as pension plans, profit sharing plans, 401(k)
plans, Keogh plans, and Individual Retirement Accounts. See "Certain Federal
Income Tax Considerations - Taxation of Tax-Exempt Entities."
Our Asset Acquisition/Capital Allocation Policies utilize a return on equity
calculation that includes adjustments for credit risk, borrowing costs, hedging
and the Risk-Adjusted Capital Policy requirements. The relative attractiveness
of various asset types will vary over time. We may acquire our mortgage assets
in the secondary mortgage market or upon origination pursuant to arrangements
with loan originators, other secondary mortgage market participants, or from
Holdings. We may issue purchase commitments to originators and other sellers of
mortgage loans and mortgage securities. These commitments will obligate us to
purchase mortgage assets for a specific period of time, in a specific aggregate
principal amount and at a specified price or margin. In addition, we may issue
commitments to sell mortgage assets to another entity, including Holdings.
PORTFOLIO MANAGEMENT
We only acquire those mortgage assets for which we believe we have the necessary
expertise to evaluate and manage such assets and which are consistent with our
balance sheet guidelines and risk management objectives. Since our intention is
generally to hold our mortgage assets until maturity, we generally do not seek
to acquire
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assets whose prospective investment returns are only attractive in a limited
range of scenarios. We believe that future interest rates and mortgage
prepayment rates are very difficult to predict. Therefore, we seek to acquire
mortgage assets that we believe will provide acceptable returns over a broad
range of interest rate and prepayment scenarios.
Among the asset choices available to us, we acquire those mortgage assets which
we believe will generate the highest returns on capital invested, after
considering (i) the amount and nature of anticipated cash flows from the asset,
(ii) our ability to pledge the asset to secure short-term or long-term
collateralized borrowings, (iii) the increase in our risk-adjusted capital
requirement determined by our Risk-Adjusted Capital Policy resulting from the
purchase and financing of the asset, and (iv) the costs of financing, hedging,
managing, securitizing, and reserving for the asset. Prior to acquisition,
potential returns on capital employed are assessed over the life of the asset
and in a variety of interest rates, yield spread, financing cost, credit loss
and prepayment scenarios.
We also give consideration to balance sheet management and risk diversification
issues. A specific asset which is being evaluated for potential acquisition is
deemed more (or less) valuable to us to the extent it serves to decrease (or
increase) certain interest rate or prepayment risks which may exist in the
balance sheet, to diversify (or concentrate) credit risk, and to meet (or not
meet) the cash flow and liquidity objectives we may establish for the balance
sheet from time to time. Accordingly, an important part of the evaluation
process is a simulation, using our risk management models, of the addition of a
potential asset and its associated borrowings and hedges to the balance sheet
and an assessment of the impact this potential asset acquisition would have on
the risks in and returns generated by our balance sheet as a whole over a
variety of scenarios.
We acquire floating-rate, adjustable-rate, hybrid and fixed-rate mortgage
assets. We generally intend to acquire fixed-rate loans when such loans can meet
our return and other standards when funded on a long-term basis, financed with
equity only, funded on a short-term basis with a comprehensive hedging program,
or funded short-term and unhedged as part of an overall asset-liability
management strategy. Generally it is anticipated that any such long-term
financing or comprehensive hedging program will serve to reduce the risk that
could arise from the funding of fixed-rate assets.
We may also purchase our own common or preferred stock or the debt or the common
or preferred stock of other mortgage REITs or other companies when we believe
that such purchases will yield attractive returns on capital employed. REIT or
other debt securities may be undervalued at points in the economic cycle. When
the stock market valuations of companies are low in relation to the market value
of their assets, stock purchases can be a way for us to acquire an interest in a
pool of mortgage assets or other types of assets at an attractive price. Also,
REITs and other companies may have attractive mortgage finance or other
businesses in which we may want to become a partial owner. We do not, however,
presently intend to invest in the securities of other issuers for the purpose of
exercising control or to underwrite securities of other issuers.
We may seek to acquire and manage other types of assets or to acquire or create
mortgage finance or other businesses when we deem such activities to be in the
best interest of our shareholders.
We intend to acquire new mortgage assets, and will also seek to expand our
capital base in order to further increase our ability to acquire new assets,
when the potential returns from new investments appear attractive relative to
the return expectations of stockholders. We may in the future acquire mortgage
assets by offering our debt or equity securities in exchange for such mortgage
assets.
The REIT provisions of the Internal Revenue Code of 1986, (the "Code") limit, in
certain respects, our ability to sell mortgage assets. See "Certain Federal
Income Tax Considerations - General - Gross Income Tests" and " - Taxation of
Redwood Trust." However, we may decide to sell assets from time to time for a
number of reasons including, without limitation, to dispose of an asset as to
which credit risk concerns have risen beyond levels that we wish to manage, to
reduce interest rate risk, to substitute one type of mortgage asset for another,
to improve yield, to maintain compliance with the 55% requirement under the
Investment Company Act, to effect a change in strategy, or generally to
re-structure the balance sheet when we deem such action advisable. Management
will select any mortgage asset to be sold according to the particular purpose
such sale will serve. The Board of Directors has not adopted a policy that would
restrict management's authority to determine the timing of sales or the
selection of mortgage assets to be sold.
5
As a requirement for maintaining REIT status, we will distribute to stockholders
aggregate dividends equaling at least 95% of our taxable income. See "Certain
Federal Income Tax Considerations - General - Distribution Requirement."
RISK MANAGEMENT
CREDIT RISK MANAGEMENT
We review the credit risk associated with each investment and determine the
appropriate allocation of capital to apply to such investment under our
Risk-Adjusted Capital Policy. In addition, we attempt to diversify our
investment portfolio to avoid undue geographic and other types of
concentrations. Management monitors the overall portfolio risk and determines
appropriate levels of provision for credit loss and provides such information to
the Board of Directors.
With respect to our mortgage securities, we are exposed to various levels of
credit and special hazard risk, depending on the nature of the underlying
mortgages and the nature and level of credit enhancements supporting such
securities. Most of the mortgage securities that we owned at December 31, 1999
had some degree of protection from normal credit losses. At December 31, 1999,
25% of our mortgage assets were mortgage securities covered by credit protection
in the form of a 100% guarantee from a government-sponsored entity ("agency
securities").
An additional 17% of our mortgage assets at December 31, 1999 were
privately-issued securities and represented interests in pools of residential
mortgage loans with the majority of these having some credit enhancement
("private-label securities"). Of this amount, 93% were rated AAA or AA. Credit
loss protection for private-label securities is achieved through the
subordination of other interests in the pool to our interest, through pool
insurance or other means. The degree of credit protection varies substantially
among the private-label securities that we own. While 98% of our private-label
securities had some degree of credit enhancement at December 31, 1999, some of
these credit-enhanced mortgage securities are, in turn, subordinated to other
interests. Therefore, should such a private-label security experience credit
losses, such losses could be greater than our pro rata share of the remaining
mortgage pool, but in no event could exceed our investment in the private-label
security.
We also acquire unsecuritized mortgage loans. At December 31, 1999, 58% of our
mortgage assets were mortgage loans. We have developed a quality control program
to monitor the quality of loan underwriting at the time of acquisition and on an
ongoing basis. We may conduct, or cause to be conducted, a legal document review
of each mortgage loan acquired to verify the accuracy and completeness of the
information contained in the mortgage notes, security instruments and other
pertinent documents in the file. As a condition of purchase, we generally select
a sample of mortgage loans that are targeted to be acquired, focusing on those
mortgage loans with higher risk characteristics, and submit them to a third
party, nationally recognized underwriting review firm for a compliance check of
underwriting and review of income, asset and appraisal information. Our own
employees or Holdings' employees may also perform these functions. In addition,
we, or our agents, will generally underwrite all multifamily and commercial
mortgage loans that we acquire. During the time we hold mortgage loans, we will
be subject to risks of borrower defaults and bankruptcies and special hazard
losses (such as those occurring from earthquakes or floods) that are not covered
by standard hazard insurance. We will generally not obtain credit enhancements
such as mortgage pool or special hazard insurance for our mortgage loans,
although individual loans may be covered by FHA insurance, VA guarantees or
private mortgage insurance and, to the extent securitized into agency
securities, by such government-sponsored entity obligations or guarantees.
ASSET/LIABILITY MANAGEMENT
To the extent consistent with our election to qualify as a REIT, we follow an
interest rate risk management program intended to protect principally against
the effects of substantial increases or decreases in interest rates.
Specifically, our interest rate risk management program is formulated with the
intent to offset the potential adverse effects, including changes in market
value, resulting from interest rate fluctuations, changes in prepayment rates,
differences between earning asset yield and cost of funds of our mortgage assets
and related borrowings, and other market factors. Our interest rate risk
management program encompasses a number of procedures. We attempt to structure
our borrowings to have interest rate adjustment indices and interest rate
6
adjustment periods that, on an aggregate basis, generally correspond to the
interest rate adjustment indices and interest rate adjustment periods of our
adjustable-rate, hybrid and fixed-rate mortgage assets. By doing so, we
generally intend to reduce the differences between interest rate indices and
interest rate adjustment periods of mortgage assets and related borrowings that
may occur.
While our interest rate risk management program intends to address most of the
risks associated with interest rate indices, it does not attempt to address
certain types of basis risk present in our portfolio. For example, to the extent
our six-month LIBOR-based assets are funded with one-month LIBOR-based
liabilities, we incur basis risk. Such risk arises because changes in one-month
LIBOR rates may differ significantly from changes in six-month LIBOR rates.
We purchase and sell, from time to time, interest rate agreements in the form of
interest rate caps, interest rate floors, interest rate swaps, interest rate
futures, options on interest rate futures, mortgage, agency, and Treasury
securities and other cash instruments to attempt to mitigate interest rate and
related risks. We also may use such instruments to modify the characteristics of
any loan issuance or sale or to hedge the anticipated issuance of future
liabilities or the market value of certain assets. In this way, we intend
generally to hedge as much of the interest rate risk as management determines is
in the best interest of our stockholders, given the cost of such hedging
transactions and the need to maintain our status as a REIT. See "Certain Federal
Income Tax Considerations - General - Gross Income Tests." As a result, we may
elect to bear a level of interest rate risk that could otherwise be hedged when
we believe, based on all relevant facts, that bearing such risk is prudent in
light of competing tax and market risks. We utilize financial futures contracts,
options, and forward contracts to the extent consistent with our compliance with
the REIT Gross Income Tests and Maryland law. We obtained no-action relief from
the Commodities Futures Trading Commission permitting us to invest a small
percentage of our total assets in certain financial futures contracts and
options thereon without registering as a commodity pool operator under the
Commodity Exchange Act, provided that we use such instruments solely for bona
fide hedging purposes.
We seek to build a balance sheet and undertake an interest rate risk management
program that is likely, in our view, to enable us to generate positive earnings
and maintain an equity liquidation value sufficient to maintain operations given
a variety of potentially adverse circumstances. Accordingly, the hedging program
addresses both income preservation and capital preservation concerns. To monitor
risks of fluctuations in earnings and in liquidation value of our equity due to
market value changes of balance sheet items, we model the impact of various
economic scenarios on the market value of our mortgage assets, liabilities and
interest rate agreements. We believe that the existing hedging programs will
allow us to maintain operations throughout a wide variety of potentially adverse
circumstances without further action. Nevertheless, in order to further preserve
our capital base during periods when we believe an adverse trend has been
established, we may decide to increase hedging activities and/or sell assets.
Each of these types of actions may lower our earnings in the short term in order
to further the objective of maintaining attractive levels of earnings and
dividends over the long term.
In all of our interest rate risk management transactions, we follow certain
procedures designed to limit credit exposure to counterparties, including
dealing only with counterparties whose financial strength meets our
requirements.
We may participate in the lending business and hedging operations conducted by
Holdings or any similarly structured affiliate. Such affiliates may be subject
to Federal and state income taxes to the extent that they have taxable income
after application of any net operating loss carryforwards ("NOLs") from previous
years. A taxable affiliate may not elect REIT status and may or may not
distribute any net profit after taxes to Redwood Trust and its other
stockholders. Any dividend income that we receive from any such taxable
affiliates (combined with all other income generated from our assets, other than
Qualified REIT Real Estate Assets) must not exceed 25% of our gross income. See
"Certain Federal Income Tax Considerations - General - Gross Income Tests."
At December 31, 1999, our weighted-average assets and liabilities were matched
within a twelve-month period in terms of adjustment frequency and speed of
adjustment to market conditions. Looking at these two factors only (and thus
ignoring periodic and life caps for adjustable-rate mortgage assets and other
risks such as basis, liquidity, market value, and prepayment risk), for any
given change in short-term interest rates our net interest
7
spread should tend to stabilize over time periods greater than twelve months
following that change. The majority of our mortgage assets at December 31, 1999
had coupon rates that adjust to market levels at least every twelve months. The
weighted-average term to reset for the adjustable-rate mortgage assets is
approximately four months. The majority of our borrowings at December 31, 1999
will either mature or adjust to a market interest rate levels within one month
of such date. The short-term borrowings had a weighted-average term to rate
reset of 18 days at December 31, 1999. Our hybrid mortgage loans, which, on
average, have a fixed coupon rate through December 2002, are funded with
borrowings which are also fixed-rate until December 2002. The 2% of our
residential mortgage asset portfolio with fixed-rate coupons is funded with
variable-rate short-term borrowings. We use interest rate agreements to manage
the interest rate risks associated with this portion of our portfolio. Both
changes in coupon rates earned on adjustable-rate assets and in rates paid on
borrowings are expected to be highly correlated over time with changes in LIBOR
and/or Treasury rates (subject to effects of periodic and lifetime caps).
In the third quarter of 1998, we adopted mark-to-market accounting for most of
our mortgage securities portfolio and a portion of our mortgage loans. We also
mark-to-market all of our interest rate agreements as a result of designating
them as trading instruments under SFAS 133, Accounting for Derivative
Instruments and Hedging Activities. Relatively small changes in the market value
of mark-to-market assets could have a large effect on our earnings. Our interest
rate hedging activities may partially offset changes in asset market values in
some circumstances. However, market values can change for a wide variety of
reasons, many of which are not linked to interest rate changes or which are
otherwise not hedgeable.
Although we believe we have developed a cost-effective asset/liability
management program to provide a level of protection against interest rate, basis
and prepayment risks, no strategy can completely insulate us from the effect of
interest rate changes, prepayment risks, mortgage credit losses, defaults by
counterparties, or liquidity risk. Further, certain of the Federal income tax
requirements that we must satisfy to qualify as a REIT limit our ability to
fully hedge our interest rate and prepayment risks. We monitor carefully, and
may have to limit, our asset/liability management program to assure that we do
not realize excessive hedging income, or hold hedging assets having excess value
in relation to total assets, which would result in our disqualification as a
REIT or, in case of excess hedging income, the payment of a penalty tax for
failure to satisfy certain REIT income tests under the Code, provided such
failure was for reasonable cause. See "Certain Federal Income Tax Considerations
- - General." In addition, asset/liability management involves transaction costs
that increase dramatically as the period covered by the hedging protection
increases. Therefore, we may be prevented from effectively hedging our interest
rate and prepayment risks over the long-term.
PREPAYMENT RISK MANAGEMENT
We seek to minimize the effects of faster or slower than anticipated prepayment
rates through structuring a diversified portfolio with a variety of prepayment
characteristics, investing in mortgage assets with prepayment prohibitions and
penalties, investing in certain mortgage securities structures which have
prepayment protections, passing on prepayment risk to the buyers of our
mortgage-backed debt and, when possible, balancing mortgage assets purchased at
a premium with mortgage assets purchased at a discount when such types of assets
are available in the marketplace and are otherwise attractive for acquisition.
In certain operating environments, however, it was not possible for us to
acquire attractive assets with a relatively small net balance of discount and
premium. In addition, changes in market values subsequent to acquisition can
effect our premium and discount balances to the extent such market value changes
are reflected in earnings and assets' basis. In these types of circumstances,
net mortgage premium or discount balances may rise and the risk of earnings
variability resulting from changes in prepayment rates may increase. We may
purchase interest-only strips, principal-only strips and/or other financial
assets such as floors, calls, swaptions and futures, as a hedge against
prepayment risks. We may also seek to create and sell interest-only and
principal-only strips from existing assets to help manage prepayment risk.
Management and the Board of Directors monitor prepayment risk through periodic
review of the impact of a variety of prepayment scenarios on our revenues, net
earnings, dividends, cash flow and net balance sheet market value.
We own a variety of non-Agency mortgage securities which are structured so that
for several years they receive either less than or more than a pro rata share of
principal repayments experienced in the underlying mortgage pool as a whole. In
such mortgage securities, one or more classes of senior securities are
ordinarily entitled to
8
receive all principal prepayments on the underlying pool of loans until such
senior securities have been paid down to a specified amount determined by
formula. To illustrate, a mortgage security totaling $100 million of aggregate
principal balance may be structured so that there is (i) $92 million face value
of senior securities, (ii) mezzanine securities with a face value of $2 million
providing credit support for the senior securities, (iii) subordinated
securities, or mortgage equity interests, with a face value of $6 million
providing credit support for the mezzanine securities and the senior securities,
and (iv) the $100 million face value of senior securities, mezzanine securities
and subordinated securities had been issued in this format, the mezzanine
securities or the subordinated securities would receive no principal prepayments
on the underlying loans until the $92 million face value of senior securities
had been paid down to a formula-determined amount, which would normally be
expected to occur within a range of three to ten years depending on the rate of
prepayments and other factors. We own interests that are similar to the senior
securities, mezzanine securities and subordinated securities in this example. We
intend to increase our investment in subordinated securities and other forms of
mortgage equity interests.
During 1999, we received $839 million in principal payments on our mortgage
assets. One commonly used measure of the average annual rate of prepayment of
mortgage principal is the conditional prepayment rate ("CPR"). The CPR for our
mortgage assets averaged 27% for 1999 compared to an average CPR of 30% for
1998. In addition to prepayments, we also receive scheduled mortgage principal
payments (payments representing the normal principal amortization of a 30-year
mortgage loan) and other principal repayments from calls of mortgage securities
and accelerated principal payment structures of securities. Thus, the total
amount of repayments of mortgage principal received each month may exceed a pro
rata level of prepayments. The reported basis of our mortgage assets at December
31, 1999 was equal to 100.31% of the face value of the assets; the net premium
was 0.31% on average. In general, the smaller the level of net discount or
premium, the less risk there is that fluctuations in prepayment rates will
affect net interest income or net asset appreciation income, although the timing
of the amortization of the premium as compared to the timing of the accretion of
the discount could still cause differences, even if the net premium or discount
was relatively small. Our discount and premium mortgage assets may have
different prepayment incentives for their borrowers, or the borrowers may
respond differently to such incentives, or such assets may have different
effective prepayment lock-out features. Thus, the level of our net premium or
discount may not fully reflect the underlying prepayment risk. We may use
interest rate agreements and other means to seek to mitigate the risk that
premium and discount amortization expenses and income and net asset appreciation
income may rise or fall as mortgage prepayments increase or decrease in falling
or rising interest rate environments.
In the third quarter of 1998, we moved to mark-to-market accounting for a
majority of our mortgage securities. For these assets, increases and decreases
in market values will be recorded in income and the basis of the asset will be
adjusted accordingly. As a result, the net mortgage premium or discount balances
on our records will vary with market values, thus affecting future amortization
income and expense. In addition, changes in prepayment rates will cause changes
in the market values of our assets which, in turn, will cause fluctuations in
reported earnings. Relatively small changes in prepayment rates could cause
material changes in our reported earnings.
CAPITAL AND LEVERAGE UTILIZATION
Our goal with respect to capital usage is to utilize our capital in a manner
that yields the highest return to our shareholders over time. In order to
achieve this objective, we examine all potential investments for their overall
return on equity characteristics. Generally, we intend to invest this capital in
earning assets - primarily mortgage assets. At times, however, we may determine
that our capital will yield a higher return through the repurchase of a portion
of our outstanding common stock. Stock repurchases have the effect of reducing
the number of shares outstanding and, to the extent that shares are repurchased
at a level below book value, increasing book value per share. During 1999, we
repurchased 2,483,500 shares of our common stock for an average price of $14.96.
Our book value per share at December 31, 1999 was $20.88 per share. At December
31, 1999, there were 1,000,000 shares authorized for repurchase.
Our goal with respect to leverage is to strike a balance between the
under-utilization of leverage, which reduces potential returns to stockholders,
and the over-utilization of leverage, which could reduce our ability to meet our
obligations or execute our business plan during adverse market conditions. We
have established a Risk-Adjusted
9
Capital Policy which limits our ability to acquire additional assets during
times when our actual capital base is less than a required amount defined in the
policy (subject to certain permitted exceptions when the proceeds of additional
equity issuances must be invested). In this way, the use of balance sheet
leverage is controlled. The actual capital base as defined for the purpose of
the Risk Adjusted Capital Policy is equal to the market value of total assets
funded short-term less the book value of total collateralized short-term
borrowings plus the actual investment on a historical amortized cost basis in
subsidiary trusts ("mortgage equity interests") wherein mortgage assets are
funded with non-recourse, long-term debt less the book value of any parent-level
debt associated with these mortgage equity interests, less any unsecured debt.
At December 31, 1999, 41% of our assets were funded with equity or with
long-term non-recourse debt. Our capital requirement for these assets is
generally equal to 100% of the net equity invested (after taking into account
the issuance of debt), thus equaling the total amount we could potentially lose
in adverse credit circumstances.
Mortgage interests that have some external protection from credit losses but
which are not rated as high as AAA or AA may be leveraged. These interests,
together with mortgage loans not yet securitized and AAA and AA rated mortgage
securities, are typically funded with short-term debt. There are two components
to the capital requirements we establish for short-term funded assets.
The first component of our capital requirements with respect to short-term
funded assets is the current aggregate over-collateralization amount or
"haircut" that lenders require us to hold as capital. The haircut for each such
mortgage asset is determined by the lender and is subject to change when
short-term debt matures and rolls-over. Haircut levels on individual borrowings
range from 2% to 30% on our residential and commercial mortgage assets, and
currently average 4% for our short-funded portfolio as a whole. Should the
market value of the pledged assets decline or haircut requirements increase, we
will be required to deliver additional collateral to the lenders in order to
maintain a constant over-collateralization level on our short-term borrowings.
The second component of our capital requirement with respect to short-term
funded assets is the "liquidity capital cushion." The liquidity capital cushion
is an additional amount of capital, in excess of the haircut, which we maintain
in order to meet the demands for additional collateral by the short-term lenders
should the market value of our short-term funded mortgage assets decline or
haircut levels increase. The aggregate liquidity capital cushion equals the sum
of liquidity cushion amounts assigned under the Risk-Adjusted Capital Policy to
each of our short-term funded mortgage assets. Liquidity capital cushions are
assigned to each short-term funded mortgage asset based on our assessment of
that mortgage asset's market price volatility, credit risk, liquidity and
attractiveness for use as collateral by short-term lenders. The process of
assigning liquidity capital cushions relies on our ability to identify and weigh
the relative importance of these and other factors. Consideration is also given
to hedges associated with the short-term funded mortgage asset and any effect
such hedges may have on reducing net market price volatility, concentration or
diversification of credit and other risks in the balance sheet as a whole and
the net cash flows that can be expected to arise from the interaction of the
various components of our balance sheet. The Board of Directors reviews on a
periodic basis various analyses prepared by management of the risks inherent in
our balance sheet, including an analysis of the effects of various scenarios on
our net cash flow, earnings, dividends, liquidity and net market value. Should
the Board of Directors determine that the minimum required capital base set by
our Risk-Adjusted Capital Policy is either too low or too high, the Board of
Directors may raise or lower the capital requirement accordingly.
We expect that our aggregate minimum capital requirement under the Risk-Adjusted
Capital Policy will approximate 3% to 15% of the market value of our short-term
funded mortgage assets plus the net equity value of our long-term funded
mortgage assets funded with long term debt or equity. This percentage will
fluctuate over time, and may fluctuate out of the expected range, as the
composition of the balance sheet changes, haircut levels required by lenders
change, the market value of short-term funded mortgage assets changes, as
liquidity capital cushions set by the Board of Directors are adjusted over time,
and as the balance of funding between short-term and long-term changes. As of
December 31, 1999, the aggregate Risk-Adjusted Capital Requirement was 8.65% of
total assets. Our actual capital base was 8.68% of total assets at December 31,
1999; thus we were utilizing nearly all of the leverage potential available to
us at that time under our Risk-Adjusted Capital policies.
10
At December 31, 1999, 57% of our borrowings were short-term. Our short-term
borrowings have consisted of collateralized borrowing arrangements of various
types (repurchase agreements, notes payable, committed warehouse facilities and
revolving lines of credit). At December 31, 1999, $1.2 billion of the short-term
borrowings were in repurchase agreements and $0.1 billion was in committed
warehouse facilities. Our long-term borrowings at December 31, 1999 consisted of
non-recourse, floating and fixed rate, collateralized mortgage-backed bonds. In
the future, however, borrowings may also be obtained through loan agreements,
Dollar-Roll Agreements (an agreement to sell a security for delivery on a
specified future date and a simultaneous agreement to repurchase the same or a
substantially similar security on a specified future date) and other credit
facilities with institutional lenders, the issuance of long-term collateralized
debt or similar instruments in the form of collateralized mortgage bonds,
collateralized bond obligations, REMICs, FASITs or other forms, and the issuance
of secured and unsecured debt securities such as commercial paper, medium-term
notes and senior or subordinated notes. We may also seek to fund our current
balance sheet or future growth through the issuance of preferred stock, common
stock or other forms of equity.
In early 1999, we extended the maturity of some of our short-term borrowings out
to the year 2000, and may continue to extend the maturities of some of our
short-term borrowings. We may also seek committed short-term borrowing
facilities. We enter into repurchase agreements primarily with national
broker/dealers, commercial banks and other lenders that typically offer such
financing. We enter into short-term collateralized borrowings only with
financial institutions meeting certain credit standards and we monitor the
financial condition of such institutions on a regular basis.
MORTGAGE LOAN SECURITIZATION TECHNIQUES
We contract with conduits, financial institutions, mortgage bankers, investment
banks, Holdings and others to purchase mortgage loans that they are originating
or holding in their portfolio. We intend to enhance the value and liquidity of
most of the mortgage loans we acquire by securitizing the loans into mortgage
securities or pledging the loans to secure the issuance of long-term,
mortgage-backed debt in the manner which will best meet our needs.
In addition to creating mortgage securities and issuing long-term debt with
mortgage loans in our portfolio, we also may "re-securitize" portions of our
mortgage securities portfolio. In a re-securitization transaction, mortgage
securities rather than mortgage loans are used as collateral to create new
mortgage securities. This would typically be done as the mortgage loans
underlying the mortgage securities improve in credit quality through seasoning,
as values rise on the underlying properties, when the credit quality of junior
classes of mortgage securities improve due to prepayment of more senior classes
or when we desire to replace short-term debt with long-term debt. Such
transactions can result in improved credit ratings, higher market values,
lowered borrowing costs and/or reduced liquidity risk. In December 1997, we
completed our first re-securitization in our "SMFC 97-A Trust".
We may conduct our securitization activities through one or more taxable or
REIT-qualifying subsidiaries formed for such purpose. In 1997, we formed Sequoia
Mortgage Funding Corporation ("Sequoia"), a REIT-qualifying subsidiary, to carry
out securitizations. Since then, Sequoia has completed three securitizations,
issuing non-recourse, mortgage-backed debt with outstanding balances as of
December 31, 1999 of $0.9 billion.
COMPANY POLICIES
The Board of Directors has established the investment policies and strategies
summarized in this report. The Board of Directors has the power to modify or
waive such policies and strategies without the consent of the stockholders to
the extent that the Board of Directors determines that such modification or
waiver is in the best interests of stockholders. Among other factors,
developments in the market which affect the policies and strategies mentioned
herein or which change our assessment of the market may cause the Board of
Directors to revise our policies and strategies.
At all times, we intend to conduct our business so as not to become regulated as
an investment company under the Investment Company Act. Accordingly, we do not
expect to be subject to the restrictive provisions of the Investment Company
Act. The Investment Company Act exempts entities that are "primarily engaged in
the
11
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate" ("Qualifying Interests"). Under the current
interpretation of the staff of the Securities and Exchange Commission, in order
to qualify for this exemption, we must maintain at least 55% of our assets
directly in mortgage loans, qualifying pass-though certificates and certain
other qualifying interests in real estate. In addition, unless certain mortgage
securities represent all the certificates issued with respect to an underlying
pool of mortgages, such mortgage securities may be treated as securities
separate from the underlying mortgage loans and, thus, may not qualify as
Qualifying Interests for purposes of the 55% requirement. Therefore, the
provisions of the Investment Company Act may limit our ownership of certain
mortgage assets.
RWT HOLDINGS, INC. BUSINESS AND STRATEGY
REDWOOD COMMERCIAL FUNDING, INC.
GENERAL
RCF was formed as a subsidiary of Holdings in 1998 to meet the needs of banks
and other investors seeking to acquire commercial mortgage assets. RCF
originates and services high-quality commercial mortgage loans providing funding
to owners of apartment buildings, office buildings, light industrial, mobile
home parks, and retail properties nationwide. RCF originates through commercial
loan brokers or through direct borrower contact. RCF may also acquire portfolios
of commercial mortgage loans. RCF generates revenues from the sale of loans to
its customers and through spread income earned while loans are held in
inventory.
RCF lends to credit-worthy borrowers who nearly always provide personal
guarantees. RCF generally requires that a property be held in a bankruptcy
remote entity and typically requires a loan-to-value ratio of 70% or less and a
debt service coverage ratio of at least 1.20 to 1.00.
COMMERCIAL MORTGAGE LOANS ORIGINATED
Most of the commercial mortgage loans originated by RCF have a principal balance
of $10 million or less, with an average size of approximately $4 million. RCF
may acquire or originate larger loans from time to time. Loans can have fixed
and floating interest rates, or a combination of the two. Floating rate loans
typically adjust quarterly or semi-annually off the corresponding LIBOR index.
Floor rates will typically be the start rate. Fixed rate loans typically have
interest rates 350 to 500 basis points over the 5-year U.S. Treasury rate at
origination.
RCF competes in the commercial loan origination market by offering
responsiveness, reliability, and flexibility. RCF typically structures loan
prepayment penalties to meet the needs of its borrowers and its investors. These
penalties are typically not of the yield maintenance or lock-out variety but
rather may involve a declining percentage of the outstanding balance; for
example, a 5%, 4%, 3%, 2%, 1% penalty structure for years one through five,
respectively of the loan. RCF structures loans to meet special borrower and
investor needs.
SALES PROCESS
RCF sells the loans it originates through whole loan sales to a variety of
institutions, which may include depository institutions, mortgage REITs,
underwriters of commercial mortgage backed securities, and others, through
private placements of loans, participations with investors, or through
securitizations. RCF has not retained interests in these loans to date. RCF may
sell loans or interests in loans to the Redwood Trust portfolio from time to
time.
The length of time between when RCF originates a commercial mortgage loan and it
sells or securitizes such mortgage loan generally ranges from 30 to 180 days.
This period of time may lengthen and has been longer during the start-up phase
of the business. RCF may seek to market individual loans during or after the
origination process. RCF may also seek to make bulk sales, in which case it will
typically build portfolios in the $10 to $25 million range before going to
market. If securitizations or forward sales are contemplated, then larger
portfolios may be assembled.
12
RISK FACTORS
The following is a summary of the factors that we believe are important and that
could cause our actual results to differ from our expectations. These factors
should not be construed as exhaustive. Readers should understand that many
factors govern whether any forward-looking statement will be or can be achieved.
Any one of these risk factors could cause actual results to differ materially
from those projected. We cannot provide any assurance that any important risk
factor will be realized in a manner so as to allow us to achieve our desired or
projected results. Throughout this Form 10-K and other company documents, the
words "believe", "except", "anticipate", "intend", "aim", "expect", "will", and
similar words identify forward-looking statements.
COMPANY OPERATIONS RISKS
Although we generally hedge a portion of our interest rate risk, the results of
our operations are affected by various other factors, many of which are beyond
our control. The results of our operations depend on, among other things, the
level of net interest income generated by our mortgage assets, the market value
of such assets, and the supply of and demand for such mortgage assets and
conditions in the debt markets. Our income and market values can vary as a
result of changes in short-term and long-term interest rates, supply and demand
trends, market liquidity, credit results, borrowing costs and prepayment rates,
the behavior of which involve various risks and uncertainties as set forth
below. Such risks may result in net interest losses or net market value losses
for certain periods. Prepayment rates, interest rates, borrowing costs and
credit losses depend on the nature and terms of the mortgage assets, the
geographic location of the properties securing the mortgage loans included in or
underlying the mortgage assets, conditions in financial markets, the fiscal and
monetary policies of the United States government and the Board of Governors of
the Federal Reserve System, international economic and financial conditions,
competition and other factors, none of which can be predicted with any
certainty. Because changes in interest and prepayment rates may significantly
affect our activities, our operating results depend, in large part, upon our
ability to effectively manage our interest rate and prepayment risks while
maintaining our status as a REIT.
We employ substantial leverage and face potential net interest and operating
losses in connection with borrowings.
We intend to continue to employ our financing strategy of borrowing a
substantial portion of the market value or, in the case of certain forms of
long-term debt, face value of our mortgage assets. The portion borrowed may vary
depending upon the mix of the mortgage assets in our portfolio and the
application of the risk-adjusted capital policy requirements to such mix of
mortgage assets. We expect generally to maintain a ratio of our total capital
base to book value of total mortgage assets of between 3% and 15%, although the
percentage may vary from time to time depending upon the market conditions and
other factors deemed relevant by management. The capital base is the book value
of capital accounts, retained earnings, and subordinated debt deemed by
management to qualify as capital for this purpose, taking into account market
value adjustments. However, we are not limited under our bylaws in respect of
the amount of our borrowings, whether secured or unsecured. Also, the aggregate
percentage of total equity capital could at times be outside the range of our
borrowings. We may experience net income losses if the returns on the mortgage
assets purchased with borrowed funds fail to cover the cost of the borrowings.
In addition, we may not be able to achieve the degree of leverage we believe to
be optimal. Increases in haircuts, decreases in the market value of our mortgage
assets, increases in interest rate volatility, availability of financing in the
market, and rating agency and bond insurer requirements for long-term financing
and circumstances then applicable in the lending market are some of the factors
that would prevent us from achieving the optimal degree of leverage. If we are
not able to achieve the degree of leverage we believe to be optimal, the results
of our operations may be less profitable than they might be otherwise.
Failure to refinance outstanding borrowings may adversely affect our ability to
achieve our investment objectives.
Our ability to achieve our investment objectives depends not only on our ability
to borrow money in sufficient amounts and on favorable terms but also on our
ability to renew or replace on a continuous basis our maturing short-term
borrowings. At December 31, 1999, we relied on short-term borrowings and equity
to fund 59% of our mortgage assets. We have utilized short-term borrowings to
fund adjustable-rate, hybrid and fixed-rate
13
mortgage assets. In the event we are not able to renew or replace maturing
borrowings, we could be required to sell mortgage assets and related interest
rate agreements under adverse market conditions and could incur losses as a
result. An event or a development such as a sharp increase or decrease in
interest rates or increasing market concern about the value or liquidity of a
type or types of mortgage loans or mortgage securities which are short-term
funded will reduce the market value of the mortgage assets. This would likely
cause lenders to require additional collateral. At the same time, the market
value of the unpledged collateral kept on hand to meet calls for additional
collateral pledges may have decreased. A number of such factors in combination
may cause us difficulties, including a possible liquidation of a major portion
of our mortgage assets at disadvantageous prices with consequent losses. This
could have a materially adverse effect on us and our solvency.
Decline in market value of mortgage assets may limit our ability to borrow,
result in lenders initiating margin calls, and require us to sell mortgage
assets in adverse market conditions.
Some of our mortgage assets may be cross-collateralized to secure our multiple
borrowing obligations from a single lender. A decline in the market value of our
portfolio of mortgage assets may limit our ability to borrow or result in
lenders initiating margin calls. A lender's margin call requires a pledge of
cash or additional mortgage assets to re-establish the ratio of the amount of
the borrowing to the value of the collateral. We may acquire fixed-rate or
hybrid mortgage assets pursuant to our asset acquisition/capital allocation
policies. Such fixed-rate mortgage assets, if funded with short-term debt, may
be more susceptible to margin calls because increases in interest rates tend to
more negatively affect the market value of fixed-rate or hybrid mortgage assets
than adjustable-rate mortgage assets. This remains true despite effective
hedging against such fluctuations because the hedging instruments may not be
part of the collateral securing the collateralized borrowings.
Additionally, it may be difficult to realize the full value of the hedging
instrument when desired for liquidity purposes due to the applicable REIT
provisions of the Code. We could be required to sell mortgage assets under
adverse market conditions in order to maintain liquidity. Management may effect
such sales when deemed by it to be necessary in order to preserve our capital
base. If these sales were made at prices lower than the basis of the mortgage
assets, we would experience losses.
A default by us under our short-term or long-term collateralized borrowings
could also result in a liquidation of the collateral, including any
cross-collateralized assets, and a resulting loss of the difference between the
value of the collateral and the amount borrowed.
Additionally, in the event of our bankruptcy, most reverse repurchase agreements
will qualify for special treatment under the bankruptcy laws. This will allow
the creditors under such agreements to avoid the automatic stay provisions of
the bankruptcy laws and to liquidate the collateral under such agreements
without delay. Conversely, in the event of the bankruptcy of a party with whom
we had a reverse repurchase agreement, we might experience difficulty recovering
the collateral subject to such agreement. In addition, our claims against
creditors could be subject to significant delay. Recoveries, if and when
received, may be substantially less than the damages we actually suffered.
To the extent that we are compelled to liquidate mortgage assets that are
qualified REIT real estate assets to repay borrowings, we may be unable to
comply with the REIT provisions of the Code regarding assets and sources of
income requirements. This would ultimately jeopardize our status as a REIT.
Failure to maintain REIT status would eliminate our competitive advantage over
non-REIT competitors and subject us to federal taxation.
Interest rate fluctuations may result in a decrease in net interest income
and/or may result in a decline in the market value of mortgage assets.
We cannot perfectly match the maturities and interest rate adjustment
frequencies of our assets and liabilities. We cannot hedge away all such
mis-matches. We may not choose to match or hedge assets and liabilities to the
full extent possible. Thus, the spread between interest income and interest
expense will vary, and may go negative, as interest rates fluctuate. In
addition, since earnings also consist of appreciation and depreciation of
14
market values of assets as well as interest income, overall earnings may be
volatile as compared to our cost of funds.
Changes in prepayment characteristics of mortgage assets may result in a
decrease in net interest income and/or may result in a decline in the market
value of mortgage assets.
Mortgage asset prepayment rates vary from time to time and may cause changes in
the amount of our net interest income and asset appreciation income. Prepayments
of adjustable-rate, fixed rate, and hybrid mortgage loans and mortgage
securities backed by adjustable-rate, fixed-rate, and hybrid mortgage loans
usually can be expected to increase when mortgage interest rates fall below the
then-current interest rates on such assets and decrease when mortgage interest
rates exceed the then-current interest rate on the assets, although such effects
are not fully predictable. Prepayment experience may also be affected by changes
in consumer behavior, the geographic location of the property securing the
mortgage loans, the assumability of the mortgage loans, advances in technology
and reduction of costs with respect to refinancing mortgages, conditions in the
housing and financial markets, general economic conditions, and other factors.
Mortgage securities backed by single family mortgage loans are often structured
so that certain classes are provided protection from prepayments for a period of
time. However, in a period of extremely rapid prepayments, during which
earlier-paying classes may be retired faster than expected, the protected
classes may receive unscheduled payments of principal earlier than expected and
would have average lives that, while longer than the average lives of the
earlier-paying classes, would be shorter than originally expected. Commercial
mortgages and some residential mortgages are structured with prepayment
penalties. However, these loans can still prepay, and the cost to us of such
prepayment may exceed the penalties received. We seek to minimize prepayment
risk through a variety of means, which may include, to the extent capable of
being implemented at reasonable cost at various points in time, structuring a
diversified portfolio with a variety of prepayment characteristics, investing in
mortgage assets with prepayment prohibitions and penalties, investing in certain
mortgage securities structures which have prepayment protection, balancing
assets purchased at a premium with mortgage assets purchased at a discount, and
prepayment hedging. In many operating environments, however, it is not be
possible for us to acquire assets with a relatively small net balance of
discount and premium. Our discount and premium mortgage assets may have
different prepayment incentives for their borrowers, or the borrowers may
respond differently to such incentives, or such assets may have different
effective prepayment lock-out features. Thus, the level of our net premium or
discount may not fully reflect the underlying prepayment risk. Even if we do
have low levels of net mortgage premium or discount, changes in prepayment rates
can affect earnings by affecting the market values of assets. We may choose not
to hedge prepayment risk, and any such hedges we do make may not be effective.
In such circumstances, the risk of earning variability resulting from changes in
prepayment rates may rise. In addition, we have purchased and/or created
interest-only and principal-only strips. These securities are leveraged with
respect to prepayment risk although they may also serve as prepayment hedges. No
strategy can completely insulate us from prepayment risks arising from the
effects of interest rate changes while simultaneously meeting returns acceptable
to shareholders.
Changes in anticipated prepayment rates of mortgage assets could affect us in
several adverse ways. The faster than anticipated prepayment of any adjustable-,
hybrid, or fixed-rate mortgage asset that we purchased at a premium would
generally result in higher premium amortization expense. In addition, increased
prepayments may be a disadvantage to us in environments where we can only
acquire assets with lower returns than our existing assets. Slower than
anticipated prepayment rates will decrease discount amortization income for
discount mortgage assets and will reduce our ability to invest in new mortgage
assets with higher yields when such assets are available. In addition, depending
on asset type or characteristics, slowing or increasing mortgage prepayment
rates may reduce market values and thus reduce or eliminate any asset
appreciation income or cause reported losses.
Failing to hedge against interest rate changes effectively may adversely affect
results of operations.
Our operating strategy subjects us to interest rate risks. We follow an
asset/liability management program intended to partially protect against
interest rate changes and prepayments. Nevertheless, developing an effective
asset/liability management strategy is complex and no strategy can completely
insulate us from risks associated with interest rate changes and prepayments.
Also, we do not attempt to hedge all such risks. In addition, there is no
assurance that our hedging activities will have the desired beneficial impact on
our operating results or financial condition. Hedging typically involves costs,
including transaction costs, which increase dramatically as the period covered
by the hedge increases and which also increase during periods of rising and
volatile interest rates. We may
15
increase our hedging activity, and thus increase our hedging costs, during such
periods when interest rates are volatile or rising and/or when hedging costs
have increased. Moreover, federal tax laws applicable to REITs may substantially
limit our ability to engage in asset/liability management transactions. Such
federal tax laws may prevent us from effectively implementing hedging strategies
that we determine, absent such restrictions, would best insulate us from the
risks associated with changing interest rates and prepayments.
We use mark-to-market accounting for all of our interest rate agreements,
whereas, not all of our hedged assets and liabilities are marked-to-market in a
similar manner. As a result of the use of different accounting treatments
between assets, liabilities, and their hedges, earnings volatility may result.
We purchase and sell from time to time interest rate caps, interest rate swaps,
interest rate futures, and similar instruments to attempt to mitigate the risk
of the spread between the yield on earning assets and the cost of funds
narrowing as interest rates change. We also attempt to hedge, to some degree,
the market values of balance sheet items. Also, we purchase and sell interest
rate caps, interest rate swaps, interest rate futures, and similar instruments
to attempt to modify the characteristics of any fixed-rate loan issuance, or to
hedge the anticipated issuance of future liabilities or the market value of
certain assets. We may also buy or sell US Treasury securities, mortgage
securities, agency securities, or other cash instruments as part of our hedging
strategy. In this way, we intend generally to hedge as much of the interest rate
risk and prepayment risk as management determines is in our best interests given
the cost of such hedging transactions and the need to maintain our status as a
REIT. The amount of income we may earn from our interest rate caps and other
hedging instruments is subject to substantial limitations under the REIT
provisions of the Code. In particular, when we earn income under such
instruments, we will seek advice from tax counsel as to whether such income
constitutes qualifying income for purposes of the 95% gross income test and as
to the proper characterization of such arrangements for purposes of the REIT
asset tests. This determination may result in our electing to bear a level of
interest rate risk that could otherwise be hedged when management believes,
based on all relevant facts, that bearing such risk is advisable.
Hedging poses a credit risk.
In the event that we purchase interest rate caps or floors or enter into other
contractual interest rate agreements to hedge against lifetime and periodic rate
or payment caps, and the provider of interest rate agreements becomes
financially unsound or insolvent, we may be forced to unwind our interest rate
agreements with such provider and may take a loss on such interest rate
agreements. There is no assurance that we can avoid such third party risks.
Difference in performance between the hedging instrument and hedged items may
adversely affect results of operations.
We also accept basis risk in entering into interest rate swap and cap agreements
and other hedges. Basis risk occurs as the performance of hedged items and/or
hedging instruments vary from expectations and differ in performance from each
other. For instance, we hedge our liabilities to mitigate interest rate risk of
mortgage assets that are fixed or reprice at different times or are based on
different indices. Although the hedging item may reduce interest rate risk,
mortgage borrowers may prepay at speeds that vary from initial expectation. We
could have a hedging instrument in place without an underlying hedged liability.
We also, to a partial degree, may seek to hedge changes in asset market values.
Basis risk arises because asset market values can change for many other reasons
than are hedgeable. Any differences from original expectations in basis,
prepayment rates, market values or other factors may have a material adverse
effect on results of our operations.
We face credit loss exposure on mortgage assets.
A substantial portion of our portfolio at December 31, 1999 consisted of
single-family mortgage loans or mortgage assets evidencing interests in
single-family mortgage loans. At December 31, 1999, 58% of the mortgage assets
we owned were single-family mortgage loans and 41% were single-family mortgage
securities. Commercial mortgage loans totaled $8 million, or 0.4% of assets. We
bear the risk of credit loss on any residential or commercial mortgage assets we
purchase in the secondary mortgage market or through our mortgage lending
business. To the extent third parties have been contracted to provide the credit
enhancement, we are dependent in part upon the credit worthiness and
claims-paying ability of the insurer and the timeliness of reimbursement in the
event of a default on the underlying obligations. Furthermore, the insurance
coverage for various types of losses is limited in amount and losses in excess
of the limitation would be borne us.
16
Prior to securitization, we generally do not intend to obtain credit
enhancements such as mortgage pool or special hazard insurance for our
residential and commercial mortgage loans, other than FHA insurance, VA
guarantees, and private mortgage insurance, in each case relating only to
individual residential mortgage loans. Accordingly, during the time we hold such
mortgage loans for which third party insurance or other credit enhancements are
not obtained, we will be subject to risks of borrower defaults and bankruptcies
and special hazard losses that are not covered by standard hazard insurance,
such as those occurring from earthquakes or floods. In the event of a default on
any mortgage loan held by us, including, without limitation, resulting from
higher default levels as a result of declining property values and worsening
economic conditions, among other factors, we would bear the risk of loss of
principal to the extent of any deficiency between the value of the related real
property, plus any payments from an insurer or guarantor, and the amount owing
on the mortgage loan. Defaulted mortgage loans would also cease to be eligible
collateral for short-term borrowings and, to the extent not funded with
long-term non-recourse debt, would have to be financed by us out of other funds
or funded with equity until ultimately liquidated, resulting in increased
financing costs and reduced net income or a net loss.
We expect to pool mortgage loans funded short-term and securitize them to obtain
long-term financing. In doing so we may continue to bear the risk of loss on the
underlying mortgage loans because we may not obtain third party credit
enhancements and we may retain the subordinated securities of the resulting
structure. In addition, we intend to continue to purchase subordinated mortgage
securities issued by others wherein the risk of credit loss in our interest is
based on the underlying mortgage loans in the entire pool. In these cases, our
credit loss exposure is based on a larger pool of assets than may appear on our
balance sheet, although our potential losses are limited to our investment in
such subordinated pieces.
A dramatic increase in short-term interest rates may adversely affect our
results of operations.
Our liabilities generally reset monthly while our assets reset monthly,
semi-annually or annually. Thus, a dramatic increase in short-term rates would
result in an increase in our cost of funds sooner than the coupon rates would
reset on our assets. Furthermore, most of our assets have periodic caps and life
caps that may limit the amount by which the coupon rates reset whereas there
generally are no limitations as to how fast or how far our cost of funds might
rise. As a result of these factors, should short-term interest rates rise very
quickly and dramatically, our interest expense for our borrowings may exceed the
interest income earned on our assets for a period of time. In such a
circumstance, not only would our net interest income be reduced or eliminated,
but also the market values of our assets would likely decline. Such declines
could materially effect our reported earnings and our liquidity. We attempt to
mitigate such risk through our hedging programs, but there can be no assurance
that such hedge strategies will fully cover this risk.
Inability to acquire attractively priced and underwritten mortgage assets may
adversely affect our ability to achieve our investment objectives.
Since our assets pay down through scheduled principal repayments and through
prepayments, we must reinvest our capital in new assets to keep our capital
fully employed and meet our objectives. There can be no assurance that we will
be able to acquire sufficient mortgage assets at spreads above our cost of
funds. Our net income depends, in large part, on our ability to acquire mortgage
assets at favorable spreads to our borrowing costs. In acquiring mortgage
assets, we compete with other REITs, investment banking firms, savings and loan
associations, banks, mortgage bankers, insurance companies, mutual funds, other
lenders, and other entities purchasing mortgage assets, many of which have
greater financial resources than we have.
In addition, in fluctuating interest rate environments, cost to the borrower on
new adjustable-rate and hybrid mortgage loans may increase relative to the cost
to the borrower on new fixed-rated mortgage loans. Under such conditions,
borrowers tend to favor fixed-rate mortgage loans, thereby decreasing the supply
of adjustable- rate and hybrid loans available for us to purchase. In addition,
an increase in refinancings from adjustable-rate and hybrid loans to fixed-rate
loans may occur, thus increasing the prepayment rates experienced by our
portfolio and increasing our asset purchase requirements. In addition, the
relative availability of adjustable-rate and hybrid mortgage loans may also be
diminished by a number of other market and regulatory considerations. In these
circumstances, we may be required to change our investment strategies to
emphasize different asset
17
types, may pay higher prices for relatively scarce adjustable-rate and hybrid
loans, and/or may operate with a reduced asset size. Each of these strategies
may reduce our earnings.
A flattening or inversion of the yield curve between short and long-term
interest rates may adversely affect our results of operations.
The shape of the yield curve will affect the results of our operations.
Generally, a flat yield curve between one month and one year interest rates will
tend to reduce our spread between our yield on assets and our cost of funds,
thereby reducing net interest income. Lower short-term rates reduce the yields
on both our assets and our cost of funds but may have the overall effect of
lowering net interest income over time as the yield on our assets funded with
equity would tend to decline.
The shape of the yield curve between short-term and long-term interest rates
generally affects the prepayment behavior of our mortgage assets. Lower
long-term rates generally result in faster prepayments that increase our
amortization expense, lower the market value of our assets, and may reduce net
income.
We lack voting control of our taxable affiliates.
We formed Holdings to serve as a holding company for our taxable affiliates to
legally separate lines of business from the REIT entity. This was done for
regulatory, tax, risk management, and other reasons. George E. Bull III and
Douglas B. Hansen, executive officers of Redwood Trust, Inc., own 100% of the
voting common stock of Holdings while we own 100% of Holdings' nonvoting
preferred stock. The common stock is entitled to one percent of dividend
distributions of Holdings and the preferred stock is entitled to 99% of such
distributions. Holdings wholly owns RCF and other subsidiaries. Without voting
control of Holdings and its subsidiaries, we cannot be assured that their
business activities and policies may not differ from those that would be
followed if we did have voting control. In addition, while Holdings and Messrs.
Bull and Hansen have entered into an agreement of shareholders which contains
certain management and control provisions and restrictions on transfer of the
common stock of Holdings, we cannot be assured that the agreement will be
enforced in a timely manner against the individuals, their heirs or
representatives. We are obligated to pay preferred dividends before common
dividends, and certain restriction are imposed on us by the preferred
stockholders.
HOLDINGS OPERATIONS RISKS
Holdings operations will have an impact on our overall performance. There are
many risks associated with the business conducted at Holdings, and its operating
results are difficult to ascertain. To the extent Holdings or its subsidiaries
engage in portfolio lending, they face many of the risks discussed above. In
addition, RCF is subject to operations risks including the following:
RCF faces the risks of a recently formed enterprise.
RCF is a recently formed enterprise. We cannot assure you that RCF will achieve
or maintain profitability. RCF plans to expand and develop its business. There
can be no assurance that such activities will be effective.
RCF may be adversely impacted by credit losses.
RCF faces risk of loss on its commercial mortgage loans due to default of the
borrowers for credit or other reasons. Commercial mortgage loans of the type
originated by RCF are generally subject to higher levels of credit and other
risks compared to residential mortgage loans in our portfolio. In the event of
default, the collateral securing such loans may not be adequate to fully
discharge the amounts due. RCF bears directly the risk of loss on loans being
held by it for sale to investors. RCF relies on being able to originate and
acquire commercial loans at prices lower than its investors will buy these
loans. Credit concerns from delinquent or defaulted loans, as well as other
factors such as interest rate variations, failure to hedge effectively, supply
and demand considerations in the market place, and the like, can reduce or
eliminate RCF's ability to realize a gain on sale. Although RCF generally does
not make representations and warranties to its investors upon sale of its loans,
if the loans sold by RCF perform poorly, RCF's ability to continue to sell loans
to investors could be significantly diminished and cause RCF to curtail or
suspend its lending activities.
RCF may be adversely impacted by market risk.
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RCF maintains inventory positions in commercial mortgage loans. In addition, RCF
may enter into commitments to sell mortgage loans and may hold loans on a
temporary basis pending resale. As such, RCF is exposed to market risk. Market
risk includes the risk of decrease in market value of the inventoried assets due
to interest rate changes, a downturn in the commercial real estate market, or
other factors and the risk of reduced net interest income or losses from
prepayment levels higher than anticipated or increased funding costs. In
addition, counterparties to loan sale commitments may not be able or willing to
complete transactions, thus potentially exposing RCF to loss.
RCF is dependent on the availability of borrowings.
In order to facilitate its loan originations, RCF will rely on short-term
collateralized borrowing arrangements. The cost and availability of such funding
may affect RCF's profitability and ability to maximize returns on the
opportunities it creates. There is no assurance that RCF will be able to obtain
or retain such borrowing arrangements.
OTHER RISKS
We depend on key personnel for successful operations.
Both our operations and those of Holdings and its affiliates depend
significantly upon the contributions of their respective executive officers.
Many of such executive officers would be difficult to replace. The loss of any
key person could materially adversely affect business and operating results.
Capital stock price volatility may negatively impact liquidity of our common
stock and may cause investors in our common stock to experience losses.
Capital stock price volatility may adversely affect the market price of our
common stock. With respect to the public market for our common stock, it is
likely that the market price of the common stock will be influenced by earnings
volatility and by the market's perception of our ability to achieve earnings
growth. Our earnings resulting from activities at Redwood Trust and Holdings are
dependent on revenues, which consist primarily of net asset appreciation, net
gain on sale and interest income, exceeding expenses, consisting primarily of
interest expense, hedging expenses, credit expenses, operating expenses and, in
the case of Holdings, taxes. All of these elements can be volatile with respect
to a variety of internal and external factors. Liquidity and capital issues can
have large effects. Our dividend, and practices with respect to paying a
dividend, may also effect the stock price. In addition, if the market price of
other REIT or financial stocks decline for any reason, or if there is a
broad-based decline in real estate values or in the value of our mortgage assets
and the market price of our common stock has been adversely affected due to any
of the foregoing reasons, the liquidity of our common stock may be negatively
affected and investors who may desire or be required to sell shares of common
stock may experience losses.
COMPETITION
REDWOOD TRUST
We believe that our principal competition in the business of acquiring,
managing, credit-enhancing and financing mortgage assets and issuing
mortgage-backed debt to investors are financial institutions such as banks,
savings and loans, life insurance companies, bond insurance companies, mortgage
insurance companies, Fannie Mae, Freddie Mac, Federal Home Loan Banks,
institutional investors such as mutual, pension and hedge funds, and certain
other mortgage REITs. While most of these entities have significantly greater
resources than us, we anticipate that we will be able to compete effectively and
generate relatively attractive rates of return for our stockholders due to our
relatively low level of operating costs, relative freedom to securitize our
assets, our ability to utilize prudent amounts of leverage through accessing the
wholesale market for collateralized borrowings, freedom from certain forms of
regulation and the tax advantages of its REIT status. The existence of these
competitive entities, as well as the possibility of additional entities forming
in the future, may increase the competition for the acquisition of mortgage
assets resulting in higher prices and lower yields on such mortgage assets. We
believe we are and plan to continue to be a "low cost producer" compared to most
of our competitors in the business of holding, credit-enhancing and financing
mortgage assets.
19
RWT HOLDINGS, INC.
Holdings' business unit, RCF, competes in the business of originating,
purchasing, and selling commercial mortgage loans with established mortgage
correspondent programs, investment banking firms, securities broker-dealers,
savings and loan associations, banks, finance companies, mortgage bankers,
mortgage brokers, insurance companies, other lenders, and other entities
originating and selling commercial mortgage assets. Many of the institutions
with which RCF competes in these operations have significantly greater financial
resources than RCF and Holdings. Fluctuations in the volume and cost of
acquiring mortgage assets resulting from competition from other prospective
originators of mortgage assets could adversely affect the profitability of RCF
and Holdings operations.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
The following discussion summarizes certain Federal income tax considerations to
Redwood Trust and its stockholders. This discussion is based on existing Federal
income tax law, which is subject to change, possibly retroactively. This
discussion does not address all aspects of Federal income taxation that may be
relevant to a particular stockholder in light of its personal investment
circumstances or to certain types of investors subject to special treatment
under the Federal income tax laws (including financial institutions, insurance
companies, broker-dealers and, except to the extent discussed below, tax-exempt
entities and foreign taxpayers) and it does not discuss any aspects of state,
local or foreign tax law. This discussion assumes that stockholders will hold
their Common Stock as a "capital asset" (generally, property held for
investment) under the Code. Stockholders are advised to consult their tax
advisors as to the specific tax consequences to them of purchasing, holding and
disposing of the Common Stock, including the application and effect of Federal,
state, local and foreign income and other tax laws.
GENERAL
Redwood Trust has elected to become subject to tax as a REIT, for Federal income
tax purposes, commencing with the taxable year ending December 31, 1994.
Management currently expects that Redwood Trust will continue to operate in a
manner that will permit Redwood Trust to maintain its qualifications as a REIT.
This treatment will permit Redwood Trust to deduct dividend distributions to its
stockholders for Federal income tax purposes, thus effectively eliminating the
"double taxation" that generally results when a corporation earns income and
distributes that income to its stockholders.
There can be no assurance that Redwood Trust will continue to qualify as a REIT
in any particular taxable year, given the highly complex nature of the rules
governing REITs, the ongoing importance of factual determinations and the
possibility of future changes in the circumstances of Redwood Trust. If Redwood
Trust failed to qualify as a REIT in any particular year, it would be subject to
Federal income tax as a regular, domestic corporation, and its stockholders
would be subject to tax in the same manner as stockholders of such corporation.
In this event, Redwood Trust could be subject to potentially substantial income
tax liability in respect of each taxable year that it fails to qualify as a REIT
and the amount of earnings and cash available for distribution to its
stockholders could be significantly reduced or eliminated.
The following is a brief summary of certain technical requirements that Redwood
Trust must meet on an ongoing basis in order to qualify, and remain qualified,
as a REIT under the Code.
STOCK OWNERSHIP TESTS
The capital stock of Redwood Trust must be held by at least 100 persons and no
more than 50% of the value of such capital stock may be owned, directly or
indirectly, by five or fewer individuals at all times during the last half of
the taxable year. Under the Code, most tax-exempt entities including employee
benefit trusts and charitable trusts (but excluding trusts described in 401(a)
and exempt under 501(a)) are generally treated as individuals for these
purposes. Redwood Trust must satisfy these stock ownership requirements each
taxable year. Redwood Trust must solicit information from certain of its
shareholders to verify ownership levels and its Articles of Incorporation
provide restrictions regarding the transfer of Redwood Trust's shares in order
to aid in meeting the stock ownership requirements. If Redwood Trust were to
fail either of the stock ownership tests, it would generally be disqualified
from REIT status, unless, in the case of the "five or fewer" requirement, the
"good faith" exemption is available.
20
ASSET TESTS
Redwood Trust must generally meet the following asset tests (the "REIT Asset
Tests") at the close of each quarter of each taxable year:
(a) at least 75% of the value of Redwood Trust's total assets must consist
of Qualified REIT Real Estate Assets, government securities, cash, and cash
items (the "75% Asset Test"); and
(b) the value of securities held by Redwood Trust but not taken into
account for purposes of the 75% Asset Test must not exceed either (i) 5% of
the value of Redwood Trust's total assets in the case of securities of any
one non-government issuer, or (ii) 10% of the outstanding voting securities
of any such issuer.
Redwood Trust expects that substantially all of its assets will be Qualified
REIT Real Estate Assets. In addition, Redwood Trust does not expect that the
value of any non-qualifying security of any one entity, including interests in
taxable affiliates, would ever exceed 5% of Redwood Trust's total assets, and
Redwood Trust does not expect to own more than 10% of any one issuer's voting
securities.
Redwood Trust intends to monitor closely the purchase, holding and disposition
of its assets in order to comply with the REIT Asset Tests. In particular,
Redwood Trust intends to limit and diversify its ownership of any assets not
qualifying as Qualified REIT Real Estate Assets to less than 25% of the value of
Redwood Trust's assets and to less than 5%, by value, of any single issuer. If
it is anticipated that these limits would be exceeded, Redwood Trust intends to
take appropriate measures, including the disposition of non-qualifying assets,
to avoid exceeding such limits.
GROSS INCOME TESTS
Redwood Trust must generally meet the following gross income tests (the "REIT
Gross Income Tests") for each taxable year:
(a) at least 75% of Redwood Trust's gross income must be derived from
certain specified real estate sources including interest income and gain
from the disposition of Qualified REIT Real Estate Assets or "qualified
temporary investment income" (i.e., income derived from "new capital"
within one year of the receipt of such capital) (the "75% Gross Income
Test");
(b) at least 95% of Redwood Trust's gross income for each taxable year must
be derived from sources of income qualifying for the 75% Gross Income Test,
or from dividends, interest, and gains from the sale of stock or other
securities (including certain interest rate swap and cap agreements,
options, futures and forward contracts entered into to hedge variable rate
debt incurred to acquire Qualified REIT Real Estate Assets) not held for
sale in the ordinary course of business (the "95% Gross Income Test"); and
Redwood Trust intends to maintain its REIT status by carefully monitoring its
income, including income from hedging transactions and sales of mortgage assets,
to comply with the REIT Gross Income Tests. In accordance with the code, Redwood
Trust will treat income generated by its interest rate caps and other hedging
instruments as qualifying income for purposes of the 95% Gross Income Tests to
the extent the interest rate cap or other hedging instrument was acquired to
reduce the interest rate risks with respect to any indebtedness incurred or to
be incurred by Redwood Trust to acquire or carry real estate assets. In
addition, Redwood Trust will treat income generated by other hedging instruments
as qualifying or non-qualifying income for purposes of the 95% Gross Income Test
depending on whether the income constitutes gains from the sale of securities as
defined by the Investment Company Act of 1940. Under certain circumstances, for
example, (i) the sale of a substantial amount of mortgage assets to repay
borrowings in the event that other credit is unavailable or (ii) unanticipated
decrease in the qualifying income of Redwood Trust which may result in the
non-qualifying income exceeding 5% of gross income, Redwood Trust may be unable
to comply with certain of the REIT Gross Income Tests. See " - Taxation of
Redwood Trust" below for a discussion of the tax consequences of failure to
comply with the REIT Provisions of the Code.
DISTRIBUTION REQUIREMENT
Redwood Trust must generally distribute to its stockholders an amount equal to
at least 95% of Redwood Trust's REIT taxable income before deductions of
dividends paid and excluding net capital gain. (See recently enacted tax
legislation section below describing changes to the current distribution
requirement.)
21
The IRS has ruled that if a REIT's dividend reinvestment plan allows
stockholders of the REIT to elect to have cash distributions reinvested in
shares of the REIT at a purchase price equal to at least 95% of the fair market
value of such shares on the distribution date, then such distributions qualify
under the 95% distribution requirement. Redwood Trust maintains a Dividend
Reinvestment and Stock Purchase Plan ("DRP") and intends that the terms of its
DRP will comply with this ruling.
QUALIFIED REIT SUBSIDIARIES
Redwood Trust currently holds some of its assets through Sequoia Mortgage
Funding Corporation, a wholly-owned subsidiary, which is treated as a "Qualified
REIT Subsidiary". As such its assets, liabilities and income are generally
treated as assets, liabilities and income of Redwood Trust for purposes of each
of the above REIT qualification tests.
TAXATION OF REDWOOD TRUST
In any year in which Redwood Trust qualifies as a REIT, Redwood Trust will
generally not be subject to Federal income tax on that portion of its REIT
taxable income or capital gain that is distributed to its stockholders. Redwood
Trust will, however, be subject to Federal income tax at normal corporate income
tax rates upon any undistributed taxable income or capital gain.
Notwithstanding its qualification as a REIT, Redwood Trust may also be subject
to tax in certain other circumstances. If Redwood Trust fails to satisfy either
the 75% or the 95% Gross Income Test, but nonetheless maintains its
qualification as a REIT because certain other requirements are met, it will
generally be subject to a 100% tax on the greater of the amount by which Redwood
Trust fails either the 75% or the 95% Gross Income Test. Redwood Trust will also
be subject to a tax of 100% on net income derived from any "prohibited
transaction" (which includes dispositions of property classified as "dealer"
property) and if Redwood Trust has (i) net income from the sale or other
disposition of "foreclosure property" which is held primarily for sale to
customers in the ordinary course of business or (ii) other non-qualifying income
from foreclosure property, it will be subject to Federal income tax on such
income at the highest corporate income tax rate. In addition, if Redwood Trust
fails to distribute during each calendar year at least the sum of (i) 85% of its
REIT ordinary income for such year and (ii) 95% of its REIT capital gain net
income for such year, Redwood Trust would be subject to a 4% Federal excise tax
on the excess of such required distribution over the amounts actually
distributed during the taxable year, plus any undistributed amount of ordinary
and capital gain net income from the preceding taxable year. Redwood Trust may
also be subject to the corporate alternative minimum tax, as well as other taxes
in certain situations not presently contemplated.
If Redwood Trust fails to qualify as a REIT in any taxable year and certain
relief provisions of the Code do not apply, Redwood Trust would be subject to
Federal income tax (including any applicable alternative minimum tax) on its
taxable income at the regular corporate income tax rates. Distributions to
stockholders in any year in which Redwood Trust fails to qualify as a REIT would
not be deductible by Redwood Trust, nor would they generally be required to be
made under the Code. Further, unless entitled to relief under certain other
provisions of the Code, Redwood Trust would also be disqualified from
re-electing REIT status for the four taxable years following the year in which
it became disqualified.
Redwood Trust intends to monitor on an ongoing basis its compliance with the
REIT requirements described above. In order to maintain its REIT status, Redwood
Trust will be required to limit the types of assets that Redwood Trust might
otherwise acquire, or hold certain assets at times when Redwood Trust might
otherwise have determined that the sale or other disposition of such assets
would have been more prudent.
TAXABLE SUBSIDIARIES
Redwood Trust intends to undertake certain hedging activities and the creation
of mortgage securities through securitization through its taxable affiliates. In
order to ensure that Redwood Trust does not violate the more than 10% voting
stock of a single issuer limitation described above, Redwood Trust owns (or will
own) only nonvoting preferred, nonvoting common stock or 10% or less of the
voting common stock and the other persons own (or will own) all of the remaining
voting common stock of such taxable affiliates. The value of Redwood Trust's
investment in such taxable affiliates must also be limited to less than 5% of
the value of Redwood Trust's total assets at the end of each calendar quarter so
that Redwood Trust can also comply with the 5% of value, single issuer asset
limitation described above under " - General - Asset Tests." The taxable
affiliates do
22
not elect REIT status and distribute only net after-tax profits to their
stockholders, including Redwood Trust. Before Redwood Trust engages in any
hedging or securitization activities or uses any such taxable affiliates,
Redwood Trust will obtain an opinion of counsel to the effect that such
activities or the formation and contemplated method of operation of such
corporation will not cause Redwood Trust to fail to satisfy the REIT Asset and
REIT Gross Income Tests.
TAXATION OF STOCKHOLDERS
Distributions (including constructive distributions) made to holders of Common
Stock other than tax-exempt entities (and not designated as capital gain
dividends) will generally be subject to tax as ordinary income to the extent of
Redwood Trust's current and accumulated earnings and profits as determined for
Federal income tax purposes. If the amount distributed exceeds a stockholder's
allocable share of such earnings and profits, the excess will be treated as a
return of capital to the extent of the stockholder's adjusted basis in the
Common Stock, which will not be subject to tax, and thereafter as a taxable gain
from the sale or exchange of a capital asset.
Distributions designated by Redwood Trust as capital gain dividends will
generally be subject to tax as long-term capital gain to stockholders, to the
extent that the distribution does not exceed Redwood Trust's actual net capital
gain for the taxable year. Distributions by Redwood Trust, whether characterized
as ordinary income or as capital gain, are not eligible for the corporate
dividends received deduction. In the event that Redwood Trust realizes a loss
for the taxable year, stockholders will not be permitted to deduct any share of
that loss. Further, if Redwood Trust (or a portion of its assets) were to be
treated as a taxable mortgage pool, any "excess inclusion income" that is
allocated to a stockholder would not be allowed to be offset by a net operating
loss of such stockholder. Future Treasury Department regulations may require
that the stockholders take into account, for purposes of computing their
individual alternative minimum tax liability, certain tax preference items of
Redwood Trust.
Dividends declared during the last quarter of a taxable year and actually paid
during January of the following taxable year are generally treated as if
received by the stockholder on the record date of the dividend payment and not
on the date actually received. In addition, Redwood Trust may elect to treat
certain other dividends distributed after the close of the taxable year as
having been paid during such taxable year, but stockholders will be treated as
having received such dividend in the taxable year in which the distribution is
made.
Upon a sale or other disposition of the Common Stock, a stockholder will
generally recognize a capital gain or loss in an amount equal to the difference
between the amount realized and the stockholder's adjusted basis in such stock,
which gain or loss generally will be long-term if the stock was held for more
than twelve months. Any loss on the sale or exchange of Common Stock held by a
stockholder for six months or less will generally be treated as a long-term
capital loss to the extent of designated capital gain dividends received by such
stockholder.
DRP participants will generally be treated as having received a dividend
distribution, subject to tax as ordinary income, in an amount equal to the fair
value of the Common Stock purchased with the reinvested dividends generally on
the date Redwood Trust credits such Common Stock to the DRP participant's
account.
Redwood Trust is required under Treasury Department regulations to demand annual
written statements from the record holders of designated percentages of its
Capital Stock disclosing the actual and constructive ownership of such stock and
to maintain permanent records showing the information it has received as to the
actual and constructive ownership of such stock and a list of those persons
failing or refusing to comply with such demand.
In any year in which Redwood Trust does not qualify as a REIT, distributions
made to its stockholders would be taxable in the same manner discussed above,
except that no distributions could be designated as capital gain dividends,
distributions would be eligible for the corporate dividends received deduction,
the excess inclusion income rules would not apply, and stockholders would not
receive any share of Redwood Trust's tax preference items. In such event,
however, Redwood Trust would be subject to potentially substantial Federal
income tax liability, and the amount of earnings and cash available for
distribution to its stockholders could be significantly reduced or eliminated.
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TAXATION OF TAX-EXEMPT ENTITIES
Subject to the discussion below regarding a "pension-held REIT," a tax-exempt
stockholder is generally not subject to tax on distributions from Redwood Trust
or gain realized on the sale of the Securities, provided that such stockholder
has not incurred indebtedness to purchase or hold its Securities, that its
shares are not otherwise used in an unrelated trade or business of such
stockholder, and that Redwood Trust, consistent with its present intent, does
not hold a residual interest in a REMIC that gives rise to "excess inclusion"
income as defined under section 860E of the Code. However, if Redwood Trust was
to hold residual interests in a REMIC, or if a pool of its assets were to be
treated as a "taxable mortgage pool," a portion of the dividends paid to a
tax-exempt stockholder may be subject to tax as unrelated business taxable
income ("UBTI"). Although Redwood Trust does not believe that Redwood Trust, or
any portion of its assets, will be treated as a taxable mortgage pool, no
assurance can be given that the IRS might not successfully maintain that such a
taxable mortgage pool exists.
If a qualified pension trust (i.e., any pension or other retirement trust that
qualifies under Section 401 (a) of the Code) holds more than 10% by value of the
interests in a "pension-held REIT" at any time during a taxable year, a
substantial portion of the dividends paid to the qualified pension trust by such
REIT may constitute UBTI. For these purposes, a "pension-held REIT" is a REIT
(i) that would not have qualified as a REIT but for the provisions of the Code
which look through qualified pension trust stockholders in determining ownership
of stock of the REIT and (ii) in which at least one qualified pension trust
holds more than 25% by value of the interest of such REIT or one or more
qualified pension trusts (each owning more than a 10% interest by value in the
REIT) hold in the aggregate more than 50% by value of the interests in such
REIT. Assuming compliance with the Ownership Limit provisions in Redwood Trust's
Articles of Incorporation it is unlikely that pension plans will accumulate
sufficient stock to cause Redwood Trust to be treated as a pension-held REIT.
Distributions to certain types of tax-exempt stockholders exempt from Federal
income taxation under Sections 501 (c)(7), (c)(9), (c)(17), and (c)(20) of the
Code may also constitute UBTI, and such prospective investors should consult
their tax advisors concerning the applicable "set aside" and reserve
requirements.
STATE AND LOCAL TAXES
Redwood Trust and its stockholders may be subject to state or local taxation in
various jurisdictions, including those in which it or they transact business or
reside. The state and local tax treatment of Redwood Trust and its stockholders
may not conform to the Federal income tax consequences discussed above.
Consequently, prospective stockholders should consult their own tax advisors
regarding the effect of state and local tax laws on an investment in the Common
Stock.
CERTAIN UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS APPLICABLE TO FOREIGN
HOLDERS
The following discussion summarizes certain United States Federal tax
consequences of the acquisition, ownership and disposition of Common Stock or
Preferred Stock by an initial purchaser that, for United States Federal income
tax purposes, is a "Non-United States Holder". Non-United States Holder means:
not a citizen or resident of the United States; not a corporation, partnership,
or other entity created or organized in the United States or under the laws of
the United States or of any political subdivision thereof; or not an estate or
trust whose income is includible in gross income for United States Federal
income tax purposes regardless of its source. This discussion does not consider
any specific facts or circumstances that may apply to particular non-United
States Federal tax consequences of acquiring, holding and disposing of Common
Stock or Preferred Stock, as well as any tax consequences that may arise under
the laws of any foreign, state, local or other taxing jurisdiction.
DIVIDENDS
Dividends paid by Redwood Trust out of earnings and profits, as determined for
United States Federal income tax purposes, to a Non-United States Holder will
generally be subject to withholding of United States Federal income tax at the
rate of 30%, unless reduced or eliminated by an applicable tax treaty or unless
such dividends are treated as effectively connected with a United States trade
or business. Distributions paid by Redwood Trust in excess of its earnings and
profits will be treated as a tax-free return of capital to the extent of the
holder's adjusted basis in his shares, and thereafter as gain from the sale or
exchange of a capital asset as described below. If it cannot be determined at
the time a distribution is made whether such distribution will exceed the
earnings and profits of Redwood Trust, the distribution will be subject to
withholding at the same rate as
24
dividends. Amounts so withheld, however, will be refundable or creditable
against the Non-United States Holder's United States Federal tax liability if it
is subsequently determined that such distribution was, in fact, in excess of the
earnings and profits of Redwood Trust. If the receipt of the dividend is treated
as being effectively connected with the conduct of a trade or business within
the United States by a Non-United States Holder, the dividend received by such
holder will be subject to the United States Federal income tax on net income
that applies to United States persons generally (and, with respect to corporate
holders and under certain circumstances, the branch profits tax).
For any year in which Redwood Trust qualifies as a REIT, distributions to a
Non-United States Holder that are attributable to gain from the sales or
exchanges by Redwood Trust of "United States real property interests" will be
treated as if such gain were effectively connected with a United States business
and will thus be subject to tax at the normal capital gain rates applicable to
United States stockholders (subject to applicable alternative minimum tax) under
the provisions of the Foreign Investment in Real Property Tax Act of 1980
("FIRPTA"). Also, distributions subject to FIRPTA may be subject to a 30% branch
profits tax in the hands of a foreign corporate stockholder not entitled to a
treaty exemption. Redwood Trust is required to withhold 35% of any distribution
that could be designated by Redwood Trust as a capital gains dividend. This
amount may be credited against the Non-United States Holder's FIRPTA tax
liability. It should be noted that mortgage loans without substantial equity or
shared appreciation features generally would not be classified as "United States
real property interests."
GAIN ON DISPOSITION
A Non-United States Holder will generally not be subject to United States
Federal income tax on gain recognized on a sale or other disposition of its
shares of either Common or Preferred Stock unless (i) the gain is effectively
connected with the conduct of a trade or business within the United States by
the Non-United States Holder, (ii) in the case of a Non-United Stated Holder who
is a nonresident alien individual and holds such shares as a capital asset, such
holder is present in the United States for 183 or more days in the taxable year
and certain other requirements are met, or (iii) the Non-United States Holder is
subject to tax under the FIRPTA rules discussed below. Gain that is effectively
connected with the conduct of a United States Holder will be subject to the
United States Federal income tax on net income that applies to United States
persons generally (and, with respect to corporate holders and under certain
circumstances, the branch profits tax) but will not be subject to withholding.
Non-United States Holders should consult applicable treaties, which may provide
for different rules.
Gain recognized by a Non-United States Holder upon a sale of either Common Stock
or Preferred Stock will generally not be subject to tax under FIRPTA if Redwood
Trust is a "domestically-controlled REIT," which is defined generally as a REIT
in which at all times during a specified testing period less than 50% in value
of its shares were held directly or indirectly by non-United States persons.
Because only a minority of Redwood Trust's stockholders is expected to be
Non-United States Holders, Redwood Trust anticipates that it will qualify as a
"domestically-controlled REIT." Accordingly, a Non-United States Holder should
not be subject to United States Federal income tax from gains recognized upon
disposition of its shares.
INFORMATION REPORTING AND BACKUP WITHHOLDING
Redwood Trust will report to its U.S. shareholders and the Internal Revenue
Service the amount of distributions paid during each calendar year, and the
amount of tax withheld, if any. Under the backup withholding rules, a
shareholder may be subject to backup withholding at the rate of 31% with respect
to distributions paid unless such holder (a) is a corporation or comes within
certain other exempt categories and, when required, demonstrates that fact; or
(b) provides a taxpayer identification number, certifies as to no loss of
exemption from backup withholding, and otherwise complies with applicable
requirements of the backup withholding rules. A shareholders that does not
provide Redwood Trust with its correct taxpayer identification number may also
be subject to penalties imposed by the Internal Revenue Service. Any amount paid
as backup withholding will be creditable against the shareholder's income tax
liability. In addition, Redwood Trust may be required to withhold a portion of
dividends and capital gain distributions to any shareholders that do not certify
under penalties of perjury their non-foreign status to Redwood Trust.
25
RECENTLY ENACTED TAX LEGISLATION
Recently enacted tax legislation (HR 1180) changes the requirement for years
beginning after December 31, 2000 that a REIT not own more than 10% of the
voting power of a corporation (other than a "REIT Subsidiary") to a requirement
based on a 10% of vote or value limit, except in the case of certain taxable
REIT subsidiaries ("TRS") engaged in specific types of activities. The combined
value of all TRS's, however, would be limited to no more than 20% of the total
value of a REIT's assets. In addition, significant other limitations would apply
with respect to transactions between the REIT and the TRS.
In addition, the current REIT 95% distribution requirement (see above) will
decrease to 90% for tax years beginning after December 31, 2000. Several other
REIT provision changes not discussed here were made as part of the recently
enacted tax legislation and are generally effective for years beginning after
December 31, 2000.
Generally, a dividend distribution of earnings from a REIT is considered for
estimated tax purposes only when the dividend is made. However, recently enacted
legislation, effective December 15, 1999, requires any person owning at least
10% of the vote or value of a closely-held REIT to accelerate recognition of
year-end dividends received from the REIT in computing estimated tax payments.
EMPLOYEES
As of March 15, 2000, we employed twenty-five people, RCF employed fourteen
people, and RRF employed nine people.
ITEM 2. PROPERTIES
Redwood Trust and Holdings lease space for their executive and administrative
offices at 591 Redwood Highway, Suites 3100, 3120 and 3140, Mill Valley,
California 94941, telephone (415) 389-7373.
RCF leases space for its commercial origination operations at 6548 South
McCarran Blvd., Suite A, Reno, Nevada 89509, telephone (775) 448-9200.
Additionally, RCF leases three offices, all located in California, for use by
its loan production officers.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 1999, there were no pending legal proceedings to which Redwood
Trust was a party or of which any of its property was subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of Redwood Trust's shareholders during the
fourth quarter of 1999.
26
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Effective January 28, 1998, Redwood Trust's Common Stock was listed and traded
on the New York Stock Exchange under the symbol RWT. Prior to that date, Redwood
Trust's Common Stock was traded on the over-the-counter market and was quoted on
the Nasdaq National Market under the symbol RWTI. Redwood Trust's Common Stock
was held by approximately 350 holders of record on March 15, 2000 and the total
number of beneficial shareholders holding stock through depository companies was
approximately 3,000. The high and low closing sales prices of shares of the
Common Stock as reported on the New York Stock Exchange or the Nasdaq National
Market composite tape and the cash dividends declared on the Common Stock for
the periods indicated below were as follows:
Common Dividends Declared
---------------------------------
Stock Prices Record Payable Per
High Low Date Date Share
-------------------------------------------------------------
Year Ended
December 31, 2000
First Quarter (through
March 15, 2000) $13 9/16 $11 15/16 3/31/00 4/21/00 $0.35
Year Ended
December 31, 1999
First Quarter $17 3/8 $13 1/2 -- -- --
Second Quarter $17 9/16 $14 1/2 -- -- --
Third Quarter $17 1/2 $12 3/4 11/8/99 11/22/99 $0.15
Fourth Quarter $13 1/4 $11 5/16 12/31/99 1/21/00 $0.25
Year Ended
December 31, 1998
First Quarter $23 1/2 $18 5/8 5/7/98 5/21/98 $0.27
Second Quarter $25 5/8 $17 9/16 8/6/98 8/21/98 $0.01
Third Quarter $17 5/8 $12 3/4 -- -- --
Fourth Quarter $16 1/16 $11 1/16 -- -- --
Redwood Trust intends to pay quarterly dividends so long as the minimum REIT
distribution rules require it. Redwood Trust intends to make distributions to
its stockholders of all or substantially all of its taxable income each year
(subject to certain adjustments) so as to qualify for the tax benefits accorded
to a REIT under the Code. All distributions will be made by Redwood Trust at the
discretion of the Board of Directors and will depend on the taxable earnings of
Redwood Trust, financial condition of Redwood Trust, maintenance of REIT status
and such other factors as the Board of Directors may deem relevant from time to
time. No dividends may be paid on the Common Stock unless full cumulative
dividends have been paid on the Preferred Stock. As of December 31, 1999, the
full cumulative dividends have been paid on the Preferred Stock.
27
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data is for the years ended December 31, 1999,
1998, 1997, 1996 and 1995. It is qualified in its 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 Form 10-K.
- --------------------------------------------------------------------------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,
1999 1998 1997 1996 1995
----------- ------------ ------------ ------------ -----------
STATEMENT OF OPERATIONS DATA:
Interest income $ 147,310 $ 222,804 $ 198,604 $ 67,284 $ 15,726
Interest expense (117,162) (196,124) (160,277) (49,191) (10,608)
Interest rate agreement expense (2,065) (3,514) (3,741) (1,158) (339)
Net interest income 28,083 23,166 34,586 16,935 4,779
Provision for credit losses (1,346) (1,120) (2,930) (1,696) (493)
Equity in earnings (losses) of RWT Holdings, Inc. (21,633) (4,676) -- -- --
Operating expenses(a) (3,835) (4,656) (4,658) (2,554) (1,131)
Net unrealized/realized market value gains (losses) 284 (38,943) 563 -- --
Net income (loss) before change in acctg principle (1,013) (30,057) $ 24,746 $ 11,537 $ 3,155
Net income (loss) available to common stockholders $ (1,013) $ (40,118) $ 24,746 $ 11,537 $ 3,155
Average common shares - "diluted" 9,768,345 13,199,819 13,680,410 8,744,184 3,703,803
Diluted net income (loss) per share
before change in accounting principle $ (0.10) $ (2.28) $ 1.81 $ 1.32 $ 0.85
Diluted net income (loss) per share $ (0.10) $ (3.04) $ 1.81 $ 1.32 $ 0.85
Net taxable income $ 7,812 $ 2,859 $ 29,964 $ 15,168 $ 3,832
Net taxable income available to common stockholders $ 5,071 $ 112 $ 27,149 $ 14,020 $ 3,832
Cash Dividends declared per Class A preferred share -- -- -- -- $ 0.500
Cash Dividends declared per Class B preferred share $ 3.020 $ 3.020 $ 3.020 $ 1.141 N/A
Cash Dividends declared per common share $ 0.400 $ 0.280 $ 2.150 $ 1.670 $ 0.460
BALANCE SHEET DATA:
Mortgage assets $ 2,367,405 $ 2,670,863 $ 3,366,622 $ 2,153,428 $ 432,244
Total assets $ 2,419,928 $ 2,832,448 $ 3,444,197 $ 2,184,197 $ 441,557
Short-term debt $ 1,253,565 $ 1,257,570 $ 1,914,525 $ 1,953,103 $ 370,316
Long-term debt $ 945,270 $ 1,305,560 $ 1,172,801 -- --
Total liabilities $ 2,209,993 $ 2,577,658 $ 3,109,660 $ 1,973,192 $ 373,267
Total stockholders' equity $ 209,935 $ 254,790 $ 334,537 $ 211,005 $ 68,290
Number of Class B preferred shares outstanding 902,068 909,518 909,518 1,006,250 --
Number of common shares outstanding (EOP) 8,783,341 11,251,556 14,284,657 10,996,572 5,517,299
Reported book value per common share $ 20.88 $ 20.27 $ 21.55 $ 16.50 $ 12.38
OTHER DATA:
Average assets $ 2,293,238 $ 3,571,889 $ 3,036,725 $ 999,762 $ 220,616
Average borrowings $ 2,046,132 $ 3,250,914 $ 2,709,208 $ 861,316 $ 174,926
Average equity $ 237,858 $ 307,076 $ 307,029 $ 131,315 $ 43,349
Interest rate spread 0.82% 0.34% 0.68% 1.09% 1.11%
Net interest margin 1.22% 0.65% 1.14% 1.69% 2.17%
Operating expenses as a % of net interest income(a) 13.66% 20.09% 13.47% 15.08% 23.66%
Operating expenses as a % of average assets(a) 0.17% 0.13% 0.15% 0.26% 0.51%
Operating expenses as a % of average equity(a) 1.61% 1.52% 1.52% 1.94% 2.61%
Return on average assets 0.08% (1.05)% 0.91% 1.27% 1.43%
Average assets/average equity 9.64x 11.63x 9.89x 7.61x 5.09x
Return on average equity 0.73% (12.17)% 8.98% 9.66% 7.28%
Credit reserves $ 5,954 $ 4,973 $ 4,931 $ 2,180 $ 490
Actual credit losses $ (317) $ (1,079) $ (179) $ (6) $ (4)
(a) Excludes one-time termination expense of $1.2 million for 1998.
28
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the Consolidated
Financial Statements and Notes.
SAFE HARBOR STATEMENT
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995: Statements in this discussion regarding Redwood Trust, Inc., or "Redwood
Trust", and our business which are not historical facts are "forward-looking
statements" that involve risks and uncertainties. For a discussion of such risks
and uncertainties, which could cause actual results to differ from those
contained in the forward-looking statements, we refer you to "Company Business
and Strategy" beginning on Page 4 and "Risk Factors" commencing on Page 13 of
this 1999 Form 10-K.
OVERVIEW
Redwood Trust is a finance company specializing in the mortgage portfolio
lending business. Our primary activity is the acquisition, financing, and
management of high-quality jumbo residential mortgage loans. We fund our loans
chiefly through the issuance of long-term debt. We also manage a portfolio of
jumbo residential mortgage securities and originate commercial mortgage loans
for sale to other financial institutions.
Our core business of mortgage finance is conducted through Redwood Trust, Inc.,
which is a qualified real estate investment trust ("REIT"). In general, our REIT
status allows us to avoid corporate income taxes by distributing to our
shareholders an amount equal to at least 95% of taxable income.
We also own a 99% economic interest in a taxable affiliate company, RWT
Holdings, Inc. ("Holdings"). Our investment in Holdings is accounted for under
the equity method. Holdings originates commercial mortgage loans for sale to
institutional investors through its Redwood Commercial Funding, Inc. ("RCF")
subsidiary. RCF typically originates shorter-term floating-rate commercial
mortgage loans to high-quality borrowers who require more flexible borrowing
arrangements than are usually offered by life insurance companies or commercial
mortgage conduit lending programs.
Holdings had two other operating businesses, Redwood Financial Services, Inc.
("RFS") and Redwood Residential Funding ("RRF"). Due to a variety of start-up
difficulties with these operations, RFS was closed in the third quarter of 1999
and RRF was closed in the fourth quarter of 1999. These closures resulted in
restructuring charges of $8.4 million during the year ended December 31, 1999,
and a significant reduction in the headcount and ongoing operating expenses at
Holdings.
For more information, please visit our Web site at: http://www.redwoodtrust.com.
FINANCIAL CONDITION
Our balance sheet presents our mortgage finance assets and liabilities. It also
includes, as one line item, our net investment in Holdings. Holdings' balance
sheet and financial condition are presented separately with discussion and
analysis beginning on Page 39.
At December 31, 1999, we owned $1.4 billion mortgage loans and $1.0 billion
mortgage securities. We financed these mortgage assets with $1.3 billion of
short-term debt, $0.9 billion of long-term debt, and $210 million of equity.
Our exposure to credit loss from our mortgage loans is limited, to some degree,
by the method we use to finance a portion of these loans. The long-term debt we
issue is non-recourse to us; as a result, our credit exposure to our
29
long-term debt financed loans is limited to our net investment remaining after
the issuance of such debt. A total of $0.9 billion of non-recourse assets and
liabilities are owned by trusts created by our special-purpose finance
subsidiary, Sequoia Mortgage Funding Corporation ("Sequoia"). The trusts are
"bankruptcy-remote" with respect to Redwood Trust. Although the net earnings of
the trusts accrue to Redwood Trust, Redwood Trust is not responsible for the
repayment of Sequoia debt and Sequoia has no call on the liquidity of Redwood
Trust. Our recourse exposure to Sequoia's mortgage assets is limited to our
equity investments in these trusts. At December 31, 1999, these equity
investments had a reported net value of $32 million.
At December 31, 1998, the portion of our balance sheet that was subject to
recourse was $1.5 billion of assets, $1.3 billion of borrowings, and $0.2
billion of equity. The ratio of equity-to-recourse-assets was 14.8%. The ratio
of recourse-debt-to-equity was 6.0 to 1.0.
At December 31, 1998, we reported $2.8 billion in assets, of which $1.5 billion
were recourse, and $2.6 billion of liabilities, of which $1.3 billion were
recourse. Equity capital was $0.3 billion. The ratio of
equity-to-recourse-assets was 16.7% and the ratio of recourse-debt-to-equity was
4.9 to 1.0.
EARNING ASSETS
At December 31, 1999, we owned $2.4 billion of earning assets. At December 31,
1998, we owned $2.7 billion of earning assets. During the year ended December
31, 1999, we reduced the amount of our earning assets, in part, as a result of
using $37 million of our equity capital to repurchase our common stock. Our
earning assets at December 31, 1999 and 1998 included the following:
MORTGAGE LOANS
At December 31, 1999, $993 million carrying value, or 42% of our total mortgage
asset portfolio, were high-quality residential mortgage loans with
adjustable-rate coupons with a face value of $981 million. Our carrying value of
these loans, after $2.8 million of credit reserves, was 101.21% of the face or
principal value of the loans. At December 31, 1998, we owned $822 million
carrying value of these loans, or 31% of our portfolio, at a carrying value of
101.52% of the $810 million face value (net of a $2.0 million credit reserve).
Seriously delinquent loans in this portion of our portfolio were $3.4 million at
December 31, 1999 and $3.2 million at December 31, 1998.
At December 31, 1999, $391 million carrying value, or 17% of our total mortgage
asset portfolio, were high-quality residential mortgage loans with hybrid
coupons with a face value of $392 million. Our hybrid mortgage loans have an
initial fixed coupon rate for three to ten years followed by annual adjustments.
Our carrying value of these loans, after $2.3 million of credit reserves, was
99.84% of face value. At December 31, 1998, we owned $575 million carrying value
of these loans, or 22% of our portfolio, at a carrying value of 100.03% of the
$575 million face value (net of a $1.7 million credit reserve). Seriously
delinquent loans in this portion of our portfolio were $1.3 million at December
31, 1999 and $0.7 million at December 31, 1998.
At December 31, 1999, $8.4 million carrying value, or 0.4% of our total mortgage
asset portfolio, were commercial mortgage loans originated by RCF. Our carrying
value of these loans was 99.85% of total face value of $8.4 million. At December
31, 1998, we owned $8.3 million carrying value of these loans, or 0.3% of our
portfolio, at a carrying value of 99.56% of face value of $8.3 million. All of
these loans were current at December 31, 1999 and December 31, 1998.
We own mortgage loans on real estate properties located throughout the United
States. At December 31, 1999, the geographic distribution of our mortgage loan
portfolio was as follows: California 26%; Florida 9%; New York 8%; New Jersey
5%; Texas 5%; Georgia 5%. The remaining 42% of our investments were in states
located throughout the country, with no one state greater than 5%. At December
31, 1998, 32% of our loan portfolio was secured by properties located in
California, 8% were located in Florida, 6% were in New York, 5% were in New
Jersey, and the remaining 49% of our portfolio was secured by properties
throughout the United States, with no one state greater than 5%.
30
For presentation purposes, the $1.0 billion at December 31, 1999 and the $1.1
billion at December 31, 1998 of mortgage loans that are financed with long-term
debt in Sequoia trusts are classified as "Mortgage Loans: held-for investment"
on our balance sheets and are carried at amortized cost. The remaining mortgage
loans that are funded with short-term debt and equity are classified as
"Mortgage Loans: held-for-sale" on our balance sheets and are carried at the
lower-of-cost-or-market, with any related market value adjustments recorded
through the income statement.
MORTGAGE SECURITIES
At December 31, 1999, 24% of our total mortgage asset portfolio, or $575 million
carrying value with a face value of $565 million, consisted of residential
mortgage securities issued and credit-enhanced by Fannie Mae or Freddie Mac and
effectively rated "AAA". The majority of these securities, $565 million or 98%,
were adjustable-rate securities with the remaining 2% fixed-rate securities. The
carrying value of these securities was 101.73% of face value. At December 31,
1998, we owned $601 million carrying value of these securities, or 22% of our
portfolio, at a carrying value of 101.28% of the $593 million face value.
At December 31, 1999, 12% of our total mortgage asset portfolio, or $291 million
carrying and face value, consisted of adjustable-rate residential mortgage
securities issued by private-label security issuers. These securities were
credit-enhanced through subordination or other means and were rated "AAA" or
"AA". The carrying value of these securities was 99.86% of face value. At
December 31, 1998, we owned $551 million carrying value of these securities, or
21% of our portfolio, at a carrying value of 100.16% of the $551 million face
value.
At December 31, 1999, 2% of our total mortgage asset portfolio, or $47 million
carrying value with a face value of $48 million, consisted of residential
floating-rate mortgage securities rated "AAA" or "AA" which were backed by home
equity loans, or "HEL". The carrying value of these securities was 98.79% of
face value. At December 31, 1998, we owned $57 million carrying value of these
securities, or 2% of our portfolio, at a carrying value of 97.62% of the $59
million face value.
At December 31, 1999, 1% of our mortgage asset portfolio, or $28 million
carrying value with a face value of $49 million, consisted of lower-rated,
residential mortgage securities issued by private-label security issuers. These
securities bore some degree of credit risk and were rated "A" or below. The
carrying value of these securities, after $0.8 million of credit reserves, was
57.85% of face value. At December 31, 1998, we owned $8 million carrying value
of these securities, or 0.3% of our portfolio, at a carrying value, after credit
reserves, of 44.60% of the $17 million face value. We intend to increase our
investment in lower-rated, residential mortgage securities in the future.
At December 31, 1999, 1% of our mortgage asset portfolio, or $16 million
carrying and face value, consisted of fixed-rate, private-label mortgage
securities. These are commonly called "CMOs". They were rated "AAA" or "AA" and
had average lives of 1 to 2 years. The carrying value of these securities was
97.28% of face value. At December 31, 1998, we owned $19 million carrying value
of these securities, or 1% of our portfolio, at a carrying value of 100.59% of
the $19 million face value.
At December 31, 1999, 0.5% of our mortgage asset portfolio, or $12 million
carrying value with a face value of $13 million, consisted of fixed-rate,
credit-enhanced private-label mortgage securities rated "AA" and backed by
residential mortgage loans with loan-to-value ratios in excess of 100%. The
carrying value of these securities was 91.00% of face value. At December 31,
1998, we owned $12 million carrying value of these securities, or 0.5% of our
portfolio, at a carrying value of 95.09% of the $13 million face value.
At December 31, 1999, 0.3% of our total mortgage asset portfolio, or $6 million
carrying and face value, consisted of floating-rate CMO mortgage securities
issued by Fannie Mae or Freddie Mac and effectively rated "AAA". The carrying
value of these securities was 99.88% of face value. At December 31, 1998, we
owned $17 million carrying value of these securities, or 0.6% of our portfolio,
at a carrying value of 100.18% of the $17 million face value.
31
At December 31, 1999, 0.01% of our mortgage asset portfolio, or $0.1 million
carrying value with no face value, consisted of interest-only mortgage
securities rated "AAA" or "AA". At December 31, 1998, we owned $0.4 million
carrying value of these securities, or 0.01% of our portfolio.
For presentation purposes, all of the mortgage securities except for the
lower-rated securities are classified as "Mortgage Securities - trading" on our
balance sheets and are carried at their estimated fair market value, with any
related market value adjustments recorded through the income statement. The $28
million at December 31, 1999 and $8 million at December 31, 1998, of lower-rated
mortgage securities are classified as "Mortgage Securities - available-for-sale"
on our balance sheets and are also carried at their estimated fair market value.
Market value adjustments on these securities, however, are not recorded through
the income statement but are included in "accumulated other comprehensive
income" in the equity portion of the balance sheet.
U.S. TREASURY SECURITIES
At December 31, 1998, we owned $48 million of ten-year U.S. Treasury securities
as part of our asset/liability management and hedging program. We sold our
ten-year U.S. Treasury securities in the first half of 1999.
CASH
We had $20 million of unrestricted cash at December 31, 1999 and $56 million at
year-end 1998.
Sequoia owned cash totaling $5 million at December 31, 1999 and $13 million at
year-end 1998. In consolidating Sequoia assets on our balance sheet, we reflect
this cash as "Restricted Cash" since it will be used for the specific purpose of
making payments to Sequoia bondholders and is not available for general
corporate purposes.
INTEREST RATE AGREEMENTS
Our interest rate agreements are carried on our balance sheet at estimated
market value, which was $2.0 million at December 31, 1999 and $2.5 million at
December 31, 1998. Please see "Note 2. Summary of Significant Accounting
Policies", "Note 7. Interest Rate Agreements" and "Note 10. Fair Value of
Financial Instruments" in the Notes to Consolidated Financial Statements for
more information.
INVESTMENT IN RWT HOLDINGS, INC.
We do not consolidate the assets and liabilities of Holdings on our balance
sheet. We reflect the net book value of our investment in one line item on our
balance sheet labeled "Investment in RWT Holdings, Inc." We refer you to
Holdings' "Consolidated Financial Statements and Notes" and Holdings'
"Management's Discussion and Analysis" below for more information on Holdings.
Through December 31, 1999, we had invested $29.7 million in the preferred stock
of Holdings. Our share of the operating losses at Holdings has reduced the
carrying value of this investment. The carrying value was $3.4 million at
December 31, 1999 and $15.1 million at December 31, 1998.
At December 31, 1999, our assets also included loans to Holdings of $6.5 million
and a receivable from Holdings of $0.5 million. We expect to collect the full
amount of these receivables during the year 2000. We expect that we will
continue to provide liquidity to Holdings, when necessary, during the year 2000.
At December 31, 1998, loans to Holdings totaled $6.5 million and receivables
from Holdings were $0.4 million.
OTHER ASSETS
Our other assets include accrued interest receivables, other receivables, fixed
assets, leasehold improvements and prepaid expenses. These totaled $14.9 million
at December 31, 1999 and $20.5 million at December 31, 1998.
SHORT-TERM DEBT
Short-term borrowings totaled $1.3 billion at December 31, 1999, or 57% of our
total debt. At December 31, 1998, short-term borrowings were $1.3 billion, or
49% of our total debt. We pledge a portion of our mortgage securities portfolio,
mortgage loan portfolio, and other investments to secure this debt. Maturities
on this debt typically range from one month to one year. The interest rate on
most of this debt adjusts monthly to a spread
32
over or under the one-month LIBOR interest rate, with some of it adjusting daily
based on the Fed Funds interest rate.
LONG-TERM DEBT
At December 31, 1999, we owned $1.0 billion of residential mortgage loans that
were financed with long-term debt through trusts owned by our financing
subsidiary, Sequoia Mortgage Funding Corporation ("Sequoia"). The amount of
outstanding Sequoia long-term debt amortizes as the underlying mortgages pay
down. As the equity owner of these trusts, we are entitled to distributions of
the net earnings of the trusts, which principally consist of the interest income
earned from mortgages in each trust less the interest expense of the debt of
each trust. Sequoia debt is non-recourse to Redwood Trust. The debt is
consolidated on our balance sheet and is reflected as long-term debt, which is
carried at historical amortized cost. The original scheduled maturity of this
debt was approximately thirty years. Since these debt balances are retired over
time as principal payments are received on the underlying mortgages, the
expected average life of this debt is two to six years.
At December 31, 1999, 43% of our total debt, or $945 million, was long-term
mortgage-backed debt. Of this long-term debt, $563 million had a floating-rate
and $382 million was fixed-rate until December 2002, and floating-rate
thereafter.
At December 31, 1998, 51% of our total debt, or $1.3 billion, was long-term
mortgage-backed debt. Of this long-term debt, $776 million had a floating-rate
and $530 million had a fixed-rate until December 2002, at which time it becomes
floating-rate debt.
OTHER LIABILITIES
Our other liabilities include accrued interest payable, accrued expenses, and
dividends payable. The net balance of these accounts totaled $11.2 million at
December 31, 1999 and $14.5 million at December 31, 1998.
STOCKHOLDERS' EQUITY
At December 31, 1999, total equity capital was $210 million, preferred stock
equity was $27 million, and reported common equity totaled $183 million, or
$20.88 per common share outstanding.
In reporting equity, we mark-to-market all earning assets and interest rate
agreements except mortgage loans that were financed to maturity (Sequoia). In
accordance with Generally Accepted Accounting Principles ("GAAP"), no
liabilities were marked-to-market.
If we had marked-to-market all of our assets and liabilities, total equity
capital would have been reported as $213 million at December 31, 1999. After
subtracting out the preference value of the preferred stock, common equity on a
full mark-to-market basis was $185 million and the net mark-to-market value per
common share was $21.07.
At December 31, 1998, reported equity capital was $255 million, preferred stock
equity was $27 million, and reported common equity was $228 million, or $20.27
per common share outstanding. Mark-to-market common equity was $220 million, or
$19.53 per common share.
During 1999, total equity fell from $255 million to $210 million primarily as a
result of $37 million of stock repurchases. The book value per share increased
from $20.27 to $20.88, a 3% increase; the mark-to-market common equity per share
increased from $19.53 to $21.07 per share, an increase of 8% or $1.54 per share,
during 1999. This increase was due to net asset appreciation and the effects of
our stock repurchase program. We acquired 2,483,500 shares, or 22%, of our
common stock during the year ended December 31, 1999 at an average price of
$14.96 per share.
33
RESULTS OF OPERATIONS
Our operating results include all of the reported income of our mortgage finance
operations plus, as one line item on our income statement, our share of the
after-tax results of operations at Holdings. Detailed results at Holdings are
discussed separately below. Please see "RWT Holdings, Inc. - Management
Discussion and Analysis of Financial Condition and Results of Operations"
commencing on page 38 of this 1999 Form 10-K for further discussion of Holdings'
financial position and performance.
INTEREST INCOME
For the year ended December 31, 1999, interest income, or total revenues,
generated by our mortgage finance operations was $147 million. Our portfolio had
average earning assets of $2.2 billion and earned an average yield of 6.65%.
During this year, the average coupon rate, or the cash-earning rate on mortgage
principal, was 6.93%. The average value of assets included a net unamortized
premium of 0.62% of mortgage principal totaling $13 million. We write off this
net premium balance as an expense over the life of our assets. Net premium
amortization expense for the year for assets was $5 million, which reduced the
earning asset yield by 0.22%. The prepayment rate on our mortgage assets, which
drives the rate at which we write off net premium balances, was 27% Conditional
Prepayment Rate ("CPR") during the year. Other factors reduced the earning asset
yield by 0.06%.
For the year ended December 31, 1998, interest income was $223 million. Our
portfolio had average earning assets of $3.5 billion and earned an average yield
of 6.48%. The average coupon rate was 7.42%. The average reported value of
assets included a 1.47% net premium, or $49 million. Net premium amortization
expense was $28 million, which reduced earning asset yield by 0.82%. Prepayments
during the year were 30% CPR. Other factors reduced the earning asset yield by
0.12%.
For the year ended December 31, 1997, interest income was $199 million. Our
portfolio had average earning assets of $3.0 billion and earned an average yield
of 6.74%. The average coupon rate was 7.72%. The reported value of assets
included a 2.13% net premium, or $61 million. Net premium amortization expense
was $23 million, which reduced earning asset yield by 0.81%. Prepayments during
the year were 25% CPR. Other factors reduced the earning asset yield by 0.17%.
During 1999, we reduced our earning asset balances in order to free capital to
fund the start-up operations at Holdings and fund our stock repurchases. In the
third quarter of 1998, we began reporting many of our assets at market value for
income statement purposes. This served to decrease our outstanding premium
balance, thereby reducing the effect that prepayments had on our earning asset
yields. As a result, our earning asset yield increased slightly in 1999 from
1998, despite a lower average coupon rate. The increase in yield is due to
reduced premium amortization expenses caused by a combination of lower net
premium balances and slower prepayment speeds during the later half of 1999.
In the fourth quarter of 1999, interest income was $35 million. Our portfolio
had average earning assets of $2.0 billion and earned an average yield of 6.88%.
The average coupon rate was 7.01%. The reported value of assets included a 0.33%
net premium, or $7 million. Net premium amortization expense was $0.5 million,
which reduced earning asset yield by 0.10%. Prepayments during the quarter were
19% CPR. Other factors reduced the earning asset yield by 0.03%.
For the quarter ended December 31, 1998, interest income was $54 million. Our
portfolio had average earning assets of $3.1 billion and earned an average yield
of 6.87%. The coupon rate was 7.17%. The reported value of assets included a
0.63% net premium, or $19 million. Net premium amortization expense was $1.8
million, which reduced earning asset yield by 0.23%. Prepayments during the
quarter were 32% CPR. Other factors reduced the earning asset yield by 0.07%.
INTEREST EXPENSE
Interest expense for the year ended December 31, 1999 was $117 million. We
funded our mortgage portfolio and other assets with an average of $238 million
of equity and $2.0 billion of borrowings. We paid an average cost of
34
funds of 5.73% for these borrowings. Short-term debt averaged 47% of total debt
and cost us 5.35%. Long-term debt averaged 53% of total debt and cost us 6.03%.
Interest expense for the year ended December 31, 1998 was $196 million. We
funded our mortgage portfolio and other assets with an average of $307 million
of equity and $3.3 billion of borrowings. We paid an average cost of funds of
6.03% for these borrowings. Short-term debt averaged 61% of total debt and cost
us 5.81%. Long-term debt averaged 39% of total debt and cost us 6.38%.
Interest expense for the year ended December 31, 1997 was $160 million. We
funded our mortgage portfolio and other assets with an average of $307 million
of equity and $2.7 billion of borrowings. We paid an average cost of funds of
5.92% for these borrowings. Short-term debt averaged 88% of total debt and cost
us 5.86%. Long-term debt averaged 12% of total debt and cost us 6.31%.
Total interest expense was lower in 1999 due to a reduction in the size of the
portfolio. The cost of funds decreased as short-term interest rates fell, on
average, from their 1998 levels. Our borrowing costs did not fall by the full
amount of the decrease in short-term interest rates during this period, as we
utilized an increasing percentage of more expensive long-term debt and we
incurred costs in order to secure committed short-term financing.
In the fourth quarter of 1999, interest expense was $28 million. We funded our
mortgage portfolio with an average of $222 million of equity and $1.8 billion of
borrowings. We paid an average cost of funds of 5.89% for these borrowings.
Short-term debt averaged 47% of total debt and cost us 5.78%. Long-term debt
averaged 53% of total debt and cost us 6.13%.
For the quarter ended December 31, 1998, interest expense was $44 million. We
funded our mortgage portfolio with an average of $253 million of equity and $3.0
billion of borrowings. We paid an average cost of funds of 5.89% for these
borrowings. Short-term debt averaged 53% of total debt and cost us 5.59%.
Long-term debt averaged 47% of total debt and cost us 6.23%.
INTEREST RATE AGREEMENTS EXPENSE
We use interest rate agreements in order to strengthen our balance sheet,
increase liquidity, and dampen potential earnings volatility. In the third
quarter of 1998, as a result of early adopting SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities, we elected to classify all of our
interest rate agreements as trading instruments. As a result of this
designation, we marked-to-market our interest rate agreements which resulted in
a write-down of the basis of these agreements. This market value adjustment had
the effect of reducing interest rate agreements amortization expense on an
on-going basis. Total interest rate agreement expense may change over time as
the mix of our assets and liabilities changes. We refer you to "Note 7. Interest
Rate Agreements" in the Notes to Consolidated Financial Statements for
additional details.
Net interest rate agreements expense, [before any market value adjustments which
are reflected in the Statement of Operations line item "Realized and Unrealized
Market Value Gains (Losses)"], was $2.1 million for the year ended December 31,
1999, $3.5 million for the year ended December 31, 1998, and $3.7 million for
the year ended December 31, 1997. As a percent of average borrowings, net
interest rate agreements expense was 0.10% during 1999, 0.11% during 1998, and
0.14% during 1997.
Net interest rate agreements expense was $0.5 million for the fourth quarter of
1999 and $0.3 million for fourth quarter of 1998. As a percent of average
borrowings, net interest rate agreements expense was 0.11% during the fourth
quarter of 1999 and 0.04% during the fourth quarter of 1998.
NET INTEREST INCOME
Net interest income, which equals interest income less interest expense less
interest rate agreements expense, was $28 million for the year ended December
31, 1999. Our interest rate spread, which equals the yield on earning assets
less the cost of funds and hedging, was 0.82%. Our net interest margin, which
equals net interest income divided by average assets, was 1.22% during this
year. Our net interest income as a percent of average equity
35
was 11.8% during this year. For the year ended December 31, 1998, net interest
income was $23 million, the interest rate spread was 0.34%, and the net interest
margin was 0.65%. Our net interest income as a percent of average equity was
7.5% during this year. For the year ended December 31, 1997, net interest income
was $35 million, the interest rate spread was 0.68%, and the net interest margin
was 1.14%. Our net interest income as a percent of average equity was 11.3%
during this year.
Net interest income increased from 1998 to 1999 despite a decrease in our
average portfolio size. Our interest rate spread (the difference between our
asset yield and our cost of funds) increased from 0.34% to 0.82% during this
period. The yield on our assets increased due to a reduction in premium
amortization expenses while our cost of funds declined due to falling interest
rates.
For the fourth quarter of 1999, net interest income was $7 million, the interest
rate spread was 0.88%, and the net interest margin was 1.28%. Net interest
income as a percent of average equity was 12.0% for this quarter. For the
quarter ended December 31, 1998, net interest income was $10 million, the
interest rate spread was 0.94%, and the net interest margin was 1.19%. Net
interest income as a percent of average equity was 15.2% for this quarter.
NET UNREALIZED AND REALIZED MARKET VALUE GAINS AND LOSSES
During the year ended December 31, 1999, our portfolio of assets that were
marked-to-market for income statement purposes increased in estimated market
value by $0.3 million. This net gain consisted of $1.6 million market value
gains on mortgage assets, $3.3 million realized losses on U.S. Treasury
securities, and $2.0 million market value gains on interest rate agreements.
Market values for our mortgage assets rose as anticipated prepayment speeds
fell. The losses on the U.S. Treasury securities and the gains on our interest
rate agreements were a function of rising interest rates and rising volatility.
In 1998, the net market value loss on our portfolio of assets that was
marked-to-market was $49 million. This net loss consisted of $33 million market
value losses on mortgage assets and $16 million market value losses on interest
rate agreements. In the third quarter of 1998, we adopted mark-to-market
accounting and SFAS No. 133. Due to faster prepayment speeds and other factors,
the value of our mortgage assets had been declining since the second half of
1997. The market value losses that we recognized in income in 1998 as a result
of the adoption of new accounting methodologies represented the cumulative
market value losses on mortgage assets and interest rate agreements incurred
over a period of several years. Please see "Note 2. Summary of Significant
Accounting Policies", "Note 3. Mortgage Assets", and "Note 7. Interest Rate
Agreements" in the Notes to Consolidated Financial Statements for more
information regarding these changes in accounting methodologies.
Total net realized gains on assets during the year ended December 31, 1997 were
$0.6 million. This net gain consisted of $0.7 million realized gains on mortgage
assets and $0.2 million realized losses on interest rate agreements.
The net loss on our portfolio of assets that were marked-to-market in the fourth
quarter of 1999 was $1.2 million. This net loss consisted of $1.1 million market
value loss on mortgage assets and $0.1 million market value loss on interest
rate agreements. During the fourth quarter of 1998, our portfolio experienced a
net gain of $2.0 million. This net gain consisted of $1.5 million market value
gain on mortgage assets and $0.5 million market value gain on interest rate
agreements.
PROVISION FOR CREDIT LOSSES
We take credit provision expenses on our mortgage loans held for investment,
which are those loans financed with long-term debt and accounted for on an
amortized cost basis. During the year ended December 31, 1999, credit provisions
were $1.3 million. In 1998, credit provisions totaled $1.1 million. Credit
provision expenses increased from 1998 to 1999 due to an increase in the average
size of the mortgage loan portfolio. For the year ended December 31, 1997,
credit provisions totaled $2.9 million. Prior to 1998, we also expensed credit
provisions on a portfolio of subordinated mortgage securities. We stopped taking
credit provisions on this pool of securities in December 1997 when we
restructured our credit risk on these securities through a resecuritization
transaction ("SMFC re-Remic securities"). We believe the existing reserve for
the SMFC re-Remic securities of
36
$0.8 million at December 31, 1999 will be sufficient to cover likely future
credit losses. Actual realized taxable credit losses for the whole company were
$0.3 million in 1999, $1.1 million in 1998, and $0.2 million in 1997.
In the quarter ended December 31, 1999, credit provisions were $0.2 million and
there were no actual credit losses. For the fourth quarter of 1998, credit
provisions were $0.4 million and there were no actual credit losses.
We have recently purchased, and intend to continue to purchase, mortgage-backed
securities that have risk of credit loss. In acquiring such assets, we project
cash flows and resulting yields under a variety of potential loss scenarios as
well as other factors (e.g., interest rates, prepayment speeds.) These
securities are purchased at a discount, in part because of the credit risk
inherent in these assets. We anticipate a yield on such assets after factoring
in anticipated losses. Thus, we do not plan to build a credit reserve for such
assets, as such losses are already imbedded in the price paid and resulting
yields on such assets. The amount of discount amortized into income is based on
the projected future cash flows, after credit losses, on such asset. Once
acquired, we continue to review the projected losses on each asset. Should
projected credit losses change (which can occur for a variety of reasons), the
effective yield earned over the remaining life of the asset will change
accordingly.
OPERATING EXPENSES
Total operating expenses for our mortgage finance operations were $3.8 million
for the year ended December 31, 1999, $5.9 million for the year ended December
31, 1998, and $4.7 million for the year ended December 31, 1996. Total operating
expenses for 1998 include $1.2 million of one-time termination expenses incurred
in the fourth quarter. On-going operating expenses in 1998 were $4.7 million.
On-going operating expenses as a percentage of average assets were 0.17% in
1999, 0.13% in 1998, and 0.15% in 1997. Operating expenses as a percentage of
average equity were 1.61% in 1999, 1.52% in 1998, and 1.52% in 1997. These
ratios have increased over time as we have decreased the size of our portfolio
and reduced our equity through the repurchase of stock.
Total on-going operating expenses for the mortgage finance operations were $1.2
million for the fourth quarter of 1999 and $1.1 million for the fourth quarter
of 1998 (excluding the $1.2 million one-time termination charge). On-going
operating expenses as a percentage of average assets were 0.23% for the fourth
quarter of 1999 and 0.14% for the fourth quarter of 1998. Operating expenses as
a percentage of average equity were 2.19% for the quarter ended December 31,
1999 and 1.75% for the quarter ended December 31, 1998.
We share many operating expenses of Holdings, including personnel and related
expenses. Holdings' share is subject to full reimbursement by Holdings. We
incurred reimbursable operating expenses for Holdings of $3.0 million during
1999 and $2.3 million in 1998. For the quarter ended December 31, 1999,
reimbursable operating expenses were $0.3 million. For the quarter ended
December 31, 1998, reimbursable operating expenses were $0.6 million. As
Holdings reduces the scope of its operations, a greater percentage of the
combined operating expenses of the two companies will be recognized and reported
at Redwood Trust. We also expect to report significantly higher operating
expenses at Redwood Trust in 2000 due to an expected increase in Dividend
Equivalent Right expenses and bonus expenses assuming Redwood's dividends and
profitability rates increase.
NET EARNINGS FROM MORTGAGE FINANCE OPERATIONS
Net earnings from mortgage finance operations include all revenue and expense
items except for the losses from Holdings and preferred dividends. For the year
ended December 31, 1999, net earnings from mortgage finance operations were
$23.4 million, or $2.39 per share. Net losses from mortgage finance operations
were $32.7 million for the year ended December 31, 1998, or negative $2.48 per
share. For the year ended December 31, 1997, net earnings were $27.6 million, or
$2.01 per share.
In the fourth quarter of 1999, net earnings from mortgage finance operations
totaled $4.1 million, or $0.46 per share. In the fourth quarter of 1998, net
earnings from mortgage finance operations were $9.0 million, $0.79 per share.
37
EQUITY IN EARNINGS (LOSSES) OF RWT HOLDINGS, INC.
Our share of the losses generated by start-up operations at Holdings was $21.6
million for the year ended December 31, 1999. This included $8.4 million of
restructuring charges at RFS and RRF as a result of ceasing their operations.
During 1998, we recognized losses from Holdings of $4.7 million.
In the fourth quarter of 1999, we recognized losses from Holdings of $9 million,
which included $6 million of restructuring charges at RRF. In the fourth quarter
of 1998, we recognized losses from Holdings of $3 million.
We refer you to Holdings' "Consolidated Financial Statements and Notes" and
Holdings' "Management's Discussion and Analysis" below for more information on
Holdings.
NET INCOME
For the year ended December 31, 1999, net income for all of our operations was
$1.7 million. After preferred dividends of $2.7 million, net income available to
common stockholders was negative $1.0 million. For the year ended December 31,
1998, net losses for all of our operations were $37.3 million. After preferred
dividends of $2.7 million, net income available to common stockholders was
negative $40.0 million. For the year ended December 31, 1997, net income for all
of our operations was $27.6 million. After preferred dividends of $2.8 million,
net income available to common stockholders was $24.7 million.
In the fourth quarter of 1999, net losses for all of our operations were $4.9
million. After preferred dividends of $0.7 million, net income available to
common stockholders was negative $5.6 million. For the quarter ended December
31, 1998, net income for all of our operations was $6.5 million. After preferred
dividends of $0.7 million, net income available to common stockholders was $5.8
million.
EARNINGS PER SHARE
Average diluted common shares outstanding were 9.8 million for the year ended
December 31, 1999, 13.2 million for 1998, and 13.7 million for 1997. Diluted
earnings per share were negative $0.10 for the year ended December 31, 1999,
negative $3.04 for 1998, and positive $1.81 for 1997. Diluted earnings per share
include losses from Holdings of $2.21 per share in 1999 and $0.35 per share in
1998.
Average diluted common shares outstanding were 8.8 million for the quarter ended
December 31, 1999 and 11.4 million for the fourth quarter of 1998. Diluted
earnings per share were negative $0.64 for the quarter ended December 31, 1999
and positive $0.51 for the fourth quarter of 1998. Diluted earnings per share
include losses from Holdings of $1.03 per share for the quarter ended December
31, 1999 and $0.22 per share for the quarter ended December 31, 1998.
Shares outstanding declined as a result of our common stock repurchase program.
We repurchased 2.5 million shares during 1999 and 3.1 million shares during
1998.
DIVIDENDS
We declared common stock dividends of $0.40 per share for the year ended
December 31, 1999, $0.28 per share for 1998, and $2.15 per share for 1997.
For the quarter ended December 31, 1999, we declared common stock dividends of
$0.25 per share. We did not declare a common stock dividend for the fourth
quarter of 1998.
For the first quarter of 2000, we declared a $0.35 per share common stock
dividend.
RISK MANAGEMENT
Our market risks include changes in market valuations, changes in net interest
income, liquidity risk, prepayment risk, credit risk, and others. Management's
discussion and selected information on these risks is included in "Item 7(a)
Quantitative and Qualitative Disclosures About Market Risk" in this Form 10-K,
beginning on page 41.
38
RWT HOLDINGS, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
OVERVIEW
RWT Holdings, Inc. ("Holdings") was incorporated in Delaware in February 1998
and commenced operations on April 1, 1998. Holdings' start-up operations have
been funded by Redwood Trust, which has a significant investment in Holdings
through the ownership of all of Holdings' non-voting preferred stock, and by
Redwood Trust's senior management, who own Holding's voting common stock. We
refer you to "Note 1. The Company" in the Notes to the Consolidated Financial
Statements of RWT Holdings, Inc. and Subsidiaries for additional information on
Holdings' initial capitalization.
Holdings originates commercial mortgage loans for sale to institutional
investors through its Redwood Commercial Funding, Inc. ("RCF") subsidiary. RCF
originated $42 million of commercial mortgage loans in 1999. At December 31,
1999, commercial mortgage loans originated or acquired by RCF totaled $38
million, of which $8 million were held by Redwood Trust and $30 million were
held at Holdings. These loans are all held for future sale.
RCF recorded net revenue for 1999 of $0.2 million. Loan sales were minimal, and
net interest income at RCF was low as most of the commercial loans originated by
RCF were held by Redwood Trust for most of the year. For the year ended December
31, 1999, direct RCF operating expenses were $1.5 million. RCF expects to
recognize sale revenues upon the sale of the commercial loan portfolio.
Holdings had two other operating businesses, Redwood Financial Services, Inc.
("RFS") and Redwood Residential Funding ("RRF"). Due to a variety of start-up
difficulties with these units, operations were closed at RFS in the third
quarter of 1999 and at RRF in the fourth quarter of 1999. These closures
resulted in restructuring charges of $8.4 million during the year ended December
31, 1999, and a significant reduction in the headcount and ongoing operating
expenses at Holdings.
Holdings and its subsidiaries share operating expenses with Redwood Trust.
Operating expenses paid by Redwood Trust and reimbursable by Holdings were $3.0
million during 1999.
In 2000, we will continue to develop RCF's operations and seek to increase its
profitability and value as a business.
FINANCIAL CONDITION
On a consolidated basis, at December 31, 1999, Holdings owned $4 million of
residential mortgage loans and $30 million of commercial mortgage loans.
Holdings also had $2 million in cash, $2 million of accrued interest receivable,
and $1 million in other assets, for total assets of $39 million. Holdings had
commitments to acquire $8 million of commercial mortgage loans and $16 million
of residential mortgage loans from Redwood Trust for settlement during the first
half of 2000. The residential loans were purchased by RRF and RFS prior to their
closures. Holdings intends to sell these loans in 2000.
The loans owned by Holdings were funded with short-term borrowings and equity.
Short-term debt was $22 million, loans from Redwood Trust were $7 million,
accrued restructuring charges were $4 million, and other liabilities totaled $3
million, for total liabilities of $36 million. The majority of the accrued
restructuring charges are expected to be paid in the first quarter of 2000.
Redwood Trust expects to continue to provide liquidity to Holdings, when
necessary, during the year 2000. Total equity at December 31, 1999 was $3
million.
39
At December 31, 1998, Holdings owned $12 million of residential mortgage loans,
$10 million in cash, and $1 million in other assets, for total assets of $23
million. Loans from Redwood Trust totaled $7 million and other liabilities were
$1 million. Equity at this time totaled $15 million.
RESULTS OF OPERATIONS
For the year ended December 31, 1999, net interest income on a consolidated
basis was $1.1 million, including interest income of $4.8 million and interest
expense of $3.7 million. Holdings also had net losses as a result of mortgage
asset sales and market value adjustments of $0.7 million during 1999, resulting
in net revenues of $0.4 million. Operating expenses at Holdings totaled $13.8
million for 1999, including Holdings' share of operating expenses from Redwood
Trust. Restructuring charges related to the closures of RFS and RRF totaled $8.4
million. Holdings' net loss for the year ended December 31, 1999 was $21.9
million.
For the period from April 1, 1998 (commencement of operations) through December
31, 1998, net interest income on a consolidated basis was $0.5 million,
including interest income of $3.2 million and interest expense of $2.7 million.
Holdings also had small net gains as a result of mortgage asset sales and market
value adjustments during 1998, resulting in net revenues of $0.5 million.
Operating expenses at Holdings totaled $5.2 million for 1998. Holdings' net loss
for the period ended December 31, 1999 was $4.7 million.
Holdings' continued to experience losses during 1999, primarily due to the
increase in operating expenses as a result of the ramping up of operations
though the first nine months of the year. The closures of RFS and RRF also
contributed significantly to the overall losses at Holdings. The restructuring
charges recognized as a result of these closures reflect the majority of costs
necessary to exit the businesses of RFS and RRF. The restructuring resulted in a
significant reduction in the headcount and ongoing operating expenses at
Holdings. The restructuring accrual includes costs associated with existing
contractual and lease arrangements at both subsidiaries which have no future
value. In addition, as a result of the closure of the two subsidiaries, certain
assets utilized in these businesses were determined to have little or no
realizable value, resulting in impairment losses. These assets included software
developed for use at RRF and certain fixed assets at both subsidiaries.
Restructuring charges were determined in accordance with the provisions of Staff
Accounting Bulletin No. 100 "Restructuring and Impairment Charges", Emerging
Issues Task Force No. 94-3 "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity", and other relevant
accounting guidance. Holdings expects to incur some additional costs during
2000, approximately $1.0 million, in connection with the closure of RRF.
For the quarter ended December 31, 1999, net interest income on a consolidated
basis was $0.3 million, including interest income of $2.1 million and interest
expenses of $1.8 million. Holdings also had net losses as a result of mortgage
asset sales and market value adjustments of $0.9 million during the fourth
quarter of 1999, resulting in net revenues of negative $0.6 million. Operating
expenses at Holdings totaled $2.3 million for this quarter. Restructuring
charges related to the closure of RRF totaled $6.2 million. Holdings' net loss
for the quarter ended December 31, 1999 was $9.1 million.
For the quarter ended December 31, 1998, net interest income on a consolidated
basis was $0.2 million, including interest income of $.2 million and minimal
interest expenses. Holdings also had minor net losses as a result of market
value adjustments during the fourth quarter of 1998, resulting in net revenues
of $0.2 million. Operating expenses at Holdings totaled $2.7 million for this
quarter. Holdings' net loss for the quarter ended December 31, 1998 was $2.5
million.
At December 31, 1999, Holdings had net operating loss carryforwards of
approximately $21 million for federal tax purposes and $11 million for state
income tax purposes. The federal carryforwards expire through 2018 and the state
carryforwards expire through 2004. Due to the start-up nature of its operations,
Holdings has not been able to record a tax benefit relating to its net operating
losses for GAAP at this time.
40
ITEM 7(a). QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We seek to manage the interest rate, market value, liquidity, prepayment and
credit risks inherent in all financial institutions in a prudent manner designed
to insure our longevity. At the same time, we endeavor to provide our
shareholders an opportunity to realize an attractive total rate of return
through Redwood Trust stock ownership. We do not seek to avoid all risks. We do
seek, to the best of our ability, to assume risk that can be quantified from
historical experience, to actively manage such risk, to earn sufficient
compensation to justify the taking of such risks, and to maintain capital levels
consistent with the risks we do undertake.
Our strategy for managing some of these risks includes the use of derivative
interest rate agreements. Please see "Note 2. Summary of Significant Accounting
Policies" for additional discussions on our use of interest rate agreements and
their designation as "trading" instruments.
QUALITATIVE INFORMATION ABOUT MARKET RISK
MARKET VALUE RISK
The market value of our assets can fluctuate due to changes in interest rates,
prepayment rates, liquidity, financing, supply and demand, credit, and other
factors. These fluctuations affect our earnings.
At December 31, 1999, we owned mortgage securities and loans totaling $946
billion that we account for on a mark-to-market basis or, in the case of
mortgage loans, on a lower-of-cost-or-market basis, for purposes of determining
reported earnings. Of these assets, 96% had adjustable-rate coupons and 4% had
fixed-rate coupons.
Our interest rate agreements hedging program may offset some asset market value
fluctuations due to interest rate changes. All of our $3.8 billion in notional
amounts of interest rate agreements are marked-to-market for income statement
purposes.
Market value fluctuations of assets and interest rate agreements, especially to
the extent assets are funded with short-term borrowings, can also affect our
access to liquidity.
INTEREST RATE RISK
At December 31, 1999, we, including Sequoia, owned $2.4 billion of assets and
had $2.2 billion of liabilities. The majority of the assets were
adjustable-rate, as were a majority of the liabilities.
Fixed-rate mortgage assets and hybrid mortgage assets (with fixed-rate coupons
for 3 to 7 years and adjustable-rate coupons thereafter) totaled $0.4 billion,
or 19% of total assets. We had debt with interest rate reset characteristics
matched to the hybrid mortgages totaling $0.4 billion.
On average, our cost of funds has the ability to rise or fall more quickly as a
result of changes in short-term interest rates than does the earning rate on our
assets. In the case of a large increase in short-term interest rates, periodic
and lifetime caps for a portion of our assets could limit increases in interest
income. The risk of reduced earnings in a rising interest rate environment is
mitigated to some extent by our interest rate agreement hedging program and by
any concurrent slowing of mortgage prepayment rates that may occur.
Our net income may vary somewhat as the yield curve between one-month interest
rates and six- and twelve-month interest rates vary. At December 31, 1999, we
effectively owned $0.7 billion of adjustable-rate mortgage assets with interest
rates that adjust every six or twelve months as a function of interest rates of
the same maturity funded with $0.7 billion of debt that had an interest rate
that adjusts monthly as a function of one-month LIBOR interest rates.
At December 31, 1999, we owned $0.6 billion of adjustable-rate mortgage assets
that adjust monthly as a function of one-month interest rates, funded with $0.6
million of debt that also adjusts monthly as a function of one-month LIBOR
interest rates.
41
Adjustable-rate assets with earnings rates dependent on U.S. Treasury rates
totaled $0.6 billion at December 31, 1999. Liabilities with a cost of funds
dependent on U.S. Treasury rates totaled $0.3 billion at that time. As part of
our hedging program, we also had $0.3 billion notional amount of basis swaps
that, in effect, increased our U.S. Treasury-based liabilities to $0.6 billion.
Thus, at December 31, 1999, our U.S. Treasury-based assets equaled our U.S.
Treasury-based liabilities. These basis swaps all matured in early 2000. To the
extent our Treasury-based assets are not funded with Treasury-based liabilities
(or effectively funded with Treasury-based liabilities through the use of
interest rate agreements), we incur basis risk. Such risk arises because changes
in Treasury rates may differ significantly from changes in the Fed Funds, LIBOR,
or Euro-dollar interest rates.
Interest rates and related factors can affect our spread income and our mark to
market results. Changes in interest rates also affect prepayment rates (see
below) and influence other factors that may affect our results.
LIQUIDITY RISK
Our primary liquidity risk arises from financing long-maturity mortgage assets
with short-term debt. Even if the interest rate adjustments of these assets and
liabilities are well matched, maturities may not be matched. In addition, trends
in the liquidity of the U.S. capital markets in general may affect our ability
to rollover short-term debt.
The assets that we pledge to secure short-term borrowings are generally
high-quality, liquid assets. As a result, we have not had difficulty refinancing
our short-term debt as it matures, even during the financial market liquidity
crisis in late 1998. Still, changes in the market values of our assets, in our
perceived credit worthiness, in lender over-collateralization requirements, and
in the capital markets, can impact our access to liquidity.
At December 31, 1999, we had $71 million of highly liquid assets which were
unpledged and available to meet margin calls on short-term debt that could be
caused by asset value declines or changes in lender over-collateralization
requirements. These assets consisted of unrestricted cash and unpledged "AAA"
rated mortgage securities. Total available liquidity, including unrestricted
cash, equaled 6% of our short-term debt balances.
We paid commitment fees in 1999 to secure two committed lines of short-term
financing. There are certain restrictions regarding the collateral for which
these lines can be used, but they generally allow us to fund whole loan
acquisitions for the term of the commitments. There is no assurance that we will
be able to renew or wish to renew such lines upon expiration.
PREPAYMENT RISK
As we receive repayments of mortgage principal, we amortize into income our
mortgage premium balances as an expense and our mortgage discount balances as
income. Mortgage premium balances arise when we acquire mortgage assets at a
price in excess of the principal value of the mortgages. Premium balances are
also created when an asset appreciates and is marked-to-market at a price above
par. Mortgage discount balances arise when we acquire mortgage assets at a price
below the principal value of the mortgages, or when an asset depreciates in
market value and is marked-to-market at a price below par. At December 31, 1999,
mortgage premium balances were $27.6 million and mortgage discount balances were
$20.3 million. Net mortgage premium was $7.3 million. Since the prepayment
characteristics of our premium and discount mortgage assets may vary, gross
premium levels, net premium levels, and other factors may influence our
earnings.
Sequoia's long-term debt has associated deferred bond issuance costs. These
capitalized costs are amortized as an expense as the bonds are paid off with
mortgage principal receipts. These deferred costs totaled $2.8 million at
December 31, 1999. In addition, premium received from the issuance of bonds at
prices over principal value is amortized as income as the bond issues pay down.
These balances totaled $3.8 million at December 31, 1999. The combined effect of
these two items was to reduce our effective mortgage-related premium by $1.0
million.
Our net premium at December 31, 1999 for assets and liabilities affected by the
rate of mortgage principal receipts was $6.3 million. This net premium equaled
3.4% of common equity. Amortization expense and income will vary as prepayment
rates on mortgage assets vary. In addition, changes in prepayment rates will
effect the
42
market value of our assets and our earnings. Changes in the value of our assets,
to the extent they are incorporated into the basis of our assets, will also
affect future amortization expense.
CREDIT RISK
Our principal credit risk comes from mortgage loans owned by Sequoia, mortgage
loans held in portfolio, and our lower-rated mortgage securities. We also have
credit risk with counter-parties with whom we do business.
Not including mortgage loans owned by Sequoia, we owned $416 million in
residential mortgage loans at December 31, 1999. Of these, $0.5 million were
seriously delinquent (delinquent over 90 days, in foreclosure, in bankruptcy, or
real estate owned). We also owned $8 million in commercial mortgage loans. These
commercial mortgage loans were all current at December 31, 1999.
The three Sequoia trusts owned $1.0 billion in residential mortgage loans at
December 31, 1999. Our total credit risk from these trusts is limited to our
equity investment in these trusts. These equity investments had a reported value
of $32 million, net of related credit reserves, at December 31, 1999. At that
time, $4.1 million of the underlying loans, or 0.42%, were seriously delinquent.
At December 31, 1999, we had $5.1 million of credit reserves to provide for
potential future credit losses from our mortgage loans. The reserve is based
upon our assessment of various factors affecting our mortgage loans, including
current and projected economic conditions, delinquency status, and credit
protection. Total seriously delinquent loans had a loan balance of $4.6 million.
To date, our realized credit losses from defaulted residential mortgage loans
have averaged 9% of the loan balance of the defaulted loans. Loss severity may
increase in the future, however, particularly if real estate values decline. We
believe our current level of reserve and credit provision policy is reasonable.
At December 31, 1999, we also had $0.8 million credit reserves for our SMFC
re-REMIC securities. Our total potential credit exposure from these securities
(after this credit reserve) is our net cost basis of $6.7 million. At this time,
we believe the credit reserve is sufficient to cover currently foreseen credit
losses from these assets.
CAPITAL RISK
Our capital levels, and thus our access to borrowings and liquidity, may be
tested, particularly if the market value of our assets securing short-term
borrowings declines.
Through our risk-adjusted capital policy, we assign a guideline capital adequacy
amount, expressed as a guideline equity-to-assets ratio, to each of our mortgage
assets. For short-term funded assets, this ratio will fluctuate over time, based
on changes in that asset's credit quality, liquidity characteristics, potential
for market value fluctuation, interest rate risk, prepayment risk, and the
over-collateralization requirements for that asset set by our collateralized
short-term lenders. Capital requirements for equity interests in Sequoia trusts
and for lower-rated mortgage securities generally equal our net investment. The
sum of the capital adequacy amounts for all of our mortgage assets is our
aggregate guideline capital adequacy amount.
The total guideline equity-to-assets ratio capital amount has declined over the
last few years as we have eliminated some of the risks of short-term debt
funding through issuing long-term debt. In the most recent quarters, however,
the total guideline ratio has increased as we have acquired new types of assets
such as commercial mortgage loans and lower-rated mortgage securities.
We do not expect that our actual capital levels will always exceed the guideline
amount. If interest rates were to rise in a significant manner, our capital
guideline amount may rise, as the potential interest rate risk of our mortgages
would increase, at least on a temporary basis, due to periodic and life caps and
slowing prepayment rates. We measure all of our mortgage assets funded with
short-term debt at estimated market value for the purpose of making
risk-adjusted capital calculations. Our actual capital levels, as determined for
the risk-adjusted capital policy, would likely fall as rates increase as the
market values of our mortgages, net of mark-to-market gains on hedges,
decreased. (Such market value declines may be temporary as well, as future
coupon adjustments on adjustable-rate mortgage loans may help to restore some of
the lost market value.)
43
In this circumstance, or any other circumstance in which our actual capital
levels decreased below our capital adequacy guideline amount, we would generally
cease the acquisition of new mortgage assets until capital balance was restored
through prepayments, interest rate changes, or other means. In certain cases
prior to a planned equity offering or other circumstances, the Board of
Directors has authorized management to acquire mortgage assets in a limited
amount beyond the usual constraints of our risk-adjusted capital policy.
Growth in assets and earnings may be limited when our access to new equity
capital is limited. Holdings can benefit over time from the re-investment of
retained earnings at Holdings. Our mortgage finance operation, however, is
generally required to distribute at least 95% of taxable income as dividends.
INFLATION RISK
Virtually all of our assets and liabilities are financial in nature. As a
result, interest rates, changes in interest rates and other factors drive our
performance far more than does inflation. Changes in interest rates do not
necessarily correlate with inflation rates or changes in inflation rates.
Our financial statements are prepared in accordance with Generally Accepted
Accounting Principles and our dividends must equal at least 95% of our net
income as calculated for tax purposes. In each case, our activities and balance
sheet are measured with reference to historical cost or fair market value
without considering inflation.
QUANTITATIVE INFORMATION ABOUT MARKET RISK
The information presented in the table below includes all of our interest rate
sensitive assets and liabilities. We acquire interest-rate sensitive assets,
fund them with interest-rate sensitive liabilities and also utilize
interest-rate sensitive derivative financial instruments. We designate some of
these assets as "trading" and others as "non-trading." The designation of an
asset as "trading" does not necessarily imply that we have a short-term intended
holding period for that asset.
The table below includes information about the possible future repayments and
interest rates of our assets and liabilities and constitutes a "forward-looking
statement." There are many assumptions used to generate this information and
there can be no assurance that assumed events will occur as assumed. Other
events will occur and will affect the outcomes. Furthermore, future sales,
acquisitions, calls, and restructurings could materially change our interest
rate risk profile.
For interest-rate sensitive assets, the table presents principal cash flows and
related average interest rates by year of maturity. The forward curve (future
interest rates as implied by the yield structure of markets) as of December 31,
1999 was used to project the average interest rates for each year, based on the
existing characteristics of the portfolio. The maturity of cash flows includes
assumptions on the prepayment speeds of these assets based on their recent
prepayment performance; actual prepayment speeds will vary.
As of December 31, 1999, all short-term interest-rate sensitive liabilities were
scheduled to mature in 2000. The balance of long-term interest-rate sensitive
liabilities is amortized with the receipt of principal payments from the
mortgages securing such debt. Thus, long-term liability maturities are presented
based on the principal maturities of the underlying mortgages at assumed
prepayment rates. Weighted average interest rates for the year are based on the
forward curve and the characteristics of such debt.
Information presented on derivative financial instruments includes the notional
amounts of such instruments by maturity date and the effective strike, pay or
receive rates by the year in which instruments mature. The information includes
all of our derivative instruments owned as of December 31, 1999, regardless of
whether they were effective at December 31, 1999 or were scheduled to become
effective at a later date.
44
QUANTITATIVE INFORMATION ABOUT MARKET RISK
(All Dollars in Thousands)
PRINCIPAL EST. MARKET
PRINCIPAL AMOUNTS MATURING AND EFFECTIVE RATES DURING PERIOD VALUE AT VALUE AT
DEC. 31, DEC. 31,
2000 2001 2002 2003 2004 THEREAFTER 1999 1999
------------------------------------------------------------ ----------------------
"NON-TRADING" ASSETS, LIABILITIES AND DERIVATIVE FINANCIAL INSTRUMENTS
INTEREST-RATE SENSITIVE ASSETS
Adjustable-Rate Residential Mortgage Loans
Sequoia 1 Loans Principal Value 37,300 25,728 17,806 12,326 8,522 18,735 120,417 120,298
Interest Rate 8.09% 8.93% 9.14% 9.16% 9.18% 9.98% 99.90%
Sequoia 2 Loans Principal Value 67,271 57,180 51,165 45,596 38,417 188,841 448,470 451,951
Interest Rate 8.09% 8.71% 8.80% 8.80% 8.81% 9.16% 100.78%
Redwood Trust Loans Principal Value 126,742 87,771 60,929 42,283 29,318 65,413 412,456 415,880
Interest Rate 7.92% 8.52% 8.61% 8.62% 8.62% 8.92% 100.83%
Adjustable-rate Commercial
Mortgage Loans
Commercial Loans Principal Value 43 45 50 53 52 8,208 8,450 8,437
Interest Rate 9.85% 10.68% 10.75% 10.87% 11.29% 11.82% 99.85%
Hybrid Residential
Mortgage Loans
Sequoia 3 Loans Principal Value 62,902 53,095 44,793 36,874 31,116 163,260 392,040 383,404
Interest Rate 6.76% 6.76% 6.76% 8.93% 9.15% 10.17% 97.80%
Adjustable-rate Residential
Mortgage Securities
SMFC 97-A Principal 163 163 177 195 215 14,822 15,736 6,623
Interest Rate 7.95% 8.61% 8.81% 8.82% 8.84% 9.63% 42.09%
INTEREST-RATE SENSITIVE LIABILITIES
SHORT-TERM DEBT
Reverse Repurchase
Agreements and Bank Principal 1,253,565 0 0 0 0 0 1,253,565 1,253,565
Warehouse Facilities Interest Rate 6.31% N/a N/a N/a N/a N/a 100.00%
LONG-TERM DEBT
Sequoia 1 Debt Principal 37,300 25,728 17,806 12,326 8,522 18,775 120,458 120,458
Interest Rate 7.04% 7.59% 7.68% 7.69% 7.69% 7.99% 100.00%
Sequoia 2 Debt Principal 67,271 57,180 51,165 45,596 38,417 181,273 440,902 437,231
Interest Rate 6.81% 7.53% 7.73% 7.74% 7.76% 8.62% 99.17%
Sequoia 3 Debt Principal 62,902 53,095 44,793 36,874 31,116 154,085 382,865 370,759
Interest Rate 6.40% 6.35% 6.35% 7.56% 7.59% 8.12% 96.84%
------------------------------------------------------------ ----------------------
"TRADING" ASSETS, LIABILITIES AND DERIVATIVE FINANCIAL INSTRUMENTS
INTEREST-RATE SENSITIVE ASSETS
Adjustable-Rate Residential
Mortgage Securities
Agency Securities Principal Value 149,077 109,855 81,202 60,045 44,330 120,430 564,941 574,847
Interest Rate 7.95% 8.61% 8.81% 8.82% 8.84% 9.63% 101.75%
Privately-issued Securities Principal 120,672 78,820 51,604 33,771 22,072 41,005 347,944 345,651
Interest Rate 7.96% 8.64% 8.77% 8.78% 8.79% 9.19% 99.34%
Fixed-rate Residential
Mortgage Securities
Agency and Privately-
issued Securities Principal 3,887 3,487 3,126 2,802 2,511 19,427 35,240 33,666
Rated AAA and AA Interest Rate 7.15% 7.15% 7.15% 7.15% 7.15% 7.15% 95.53%
Privately-issued
Securities Rated Principal 2,617 2,346 2,102 1,883 1,686 13,075 23,710 13,593
A and Below Interest Rate 6.60% 6.60% 6.60% 6.60% 6.60% 6.60% 57.33%
------------------------------------------------------------ ----------------------
45
QUANTITATIVE INFORMATION ABOUT MARKET RISK
(All Dollars in Thousands)
(Continued)
Notional Est. Market
Notional Amounts Maturing and Effective Rates During Period Value At Value At
DEC. 31, DEC. 31,
2000 2001 2002 2003 2004 THEREAFTER 1999 1999
----------------------------------------------------------- -----------------------
INTEREST-RATE SENSITIVE DERIVATIVE FINANCIAL INSTRUMENTS
(Interest Rate Agreements Which Represent Mirroring Transactions are Not Included in This Table.)
Interest Rate Caps -
(See Below for Details) Notional 381,000 520,000 310,000 0 64,000 82,400 2,357,400 2,161
(PURCHASED) Strike Rate 7.31% 9.71% 10.30% n/a 6.58% 8.33% 0.09%
Floors Notional 0 0 5,000 2,000 1,000 3,000 11,000 31
(PURCHASED) Strike Rate n/a n/a 5.33% 5.33% 5.33% 5.33% 0.28%
Basis Swaps: Libor vs.
Treasury Notional 250,000 0 0 0 0 0 250,000 122
(PURCHASED) Pay Rate 6.03% n/a n/a n/a n/a n/a 0.05%
Receive Rate 6.08% n/a n/a n/a n/a n/a
Put Swaptions Notional 67,000 0 0 0 0 0 67,000 14
(PURCHASED) Strike Rate 6.36% n/a n/a n/a n/a n/a 0.02%
Treasury Call Options Notional 11,000 0 0 0 0 0 11,000 0
(PURCHASED) Strike Rate 5.10% n/a n/a n/a n/a n/a 0.00%
Treasury Call Option Spreads Notional 32,000 0 0 0 0 0 32,000 (644)
(PURCHASED) Strike Rate 5.46% n/a n/a n/a n/a n/a -2.01%
Stopout Rate 4.96% n/a n/a n/a n/a n/a
Treasury Put Option Spreads Notional 21,000 0 0 0 0 0 21,000 0
(SOLD) Strike Rate 5.46% n/a n/a n/a n/a n/a 0.00%
Stopout Rate 5.91% n/a n/a n/a n/a n/a
Eurodollar Futures Notional 180,000 60,000 45,000 60,000 120,000 150,000 615,000 211
(SOLD) Sale Price 93.61% 93.39% 93.27% 93.06% 92.88% 92.65% 0.03%
Put Options on Eurodollar
Futures Notional 475,000 0 0 0 0 0 475,000 22
(PURCHASED) Strike Price 93.44% n/a n/a n/a n/a n/a 0.00%
FNMA MBS Forward Sales Notional 15,000 0 0 0 0 0 15,000 115
(SOLD) Sale Price 99.55% n/a n/a n/a n/a n/a 0.77%
Call Options on FNMA MBS
Forwards Notional 7,500 0 0 0 0 0 7,500 6
(PURCHASED) Strike Price 100.55% n/a n/a n/a n/a n/a 0.08%
----------------------------------------------------------- -----------------------
DETAIL OF INTEREST RATE CAPS
(totaled above)
with Strike Rates <6% Notional 555,000 0 0 0 0 0 555,000 404
Strike Rate 5.70% n/a n/a n/a n/a n/a 0.07%
with Strike Rates of
6% to 7% Notional 200,000 0 5,000 0 54,000 2,000 261,000 765
Strike Rate 6.42% n/a 6.25% n/a 6.32% 6.63% 0.29%
with Strike Rates of
7% to 8% Notional 25,000 20,000 0 0 0 10,000 55,000 415
Strike Rate 7.00% 7.13% n/a n/a n/a 7.50% 0.75%
with Strike Rates of
8% to 9% Notional 406,000 0 5,000 0 10,000 54,000 475,000 348
Strike Rate 8.60% n/a 8.60% n/a 8.00% 8.34% 0.07%
with Strike Rates of
9% to 10% Notional 125,000 200,000 0 0 0 16,400 341,400 103
Strike Rate 9.40% 9.53% n/a n/a n/a 9.00% 0.03%
with Strike Rates of
10% to 11% Notional 20,000 300,000 200,000 0 0 0 520,000 121
Strike Rate 10.00% 10.00% 10.10% n/a n/a n/a 0.02%
with Strike Rates >11% Notional 50,000 0 100,000 0 0 0 150,000 5
Strike Rate 12.00% n/a 11.00% n/a n/a n/a 0.00%
----------------------------------------------------------- -----------------------
46
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements of the Company and Holdings and the
related Notes, together with the Reports of Independent Accountants thereon, are
set forth on pages F-1 through F-36 of this Form 10-K and incorporated herein by
reference.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 as to directors and executive officers of
the Company is incorporated herein by reference to the definitive Proxy
Statement to be filed pursuant to Regulation 14A under the headings "Election of
Directors" and "Management of the Company."
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference to the
definitive Proxy Statement to be filed pursuant to Regulation 14A under the
heading "Executive Compensation."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated herein by reference to the
definitive Proxy Statement to be filed pursuant to Regulation 14A under the
heading "Security Ownership of Certain Beneficial Owners and Management."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated herein by reference to the
definitive Proxy Statement to be filed pursuant to Regulation 14A under the
heading "Executive Compensation - Certain Relationships and Related
Transactions."
PART IV
ITEM 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS SCHEDULES AND REPORTS ON
FORM 8-K
(a) Documents filed as part of this report:
(1) Consolidated Financial Statements
(2) Schedules to Consolidated Financial Statements: All
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.
47
(3) Exhibits:
Exhibit
Number Exhibit
------- -------
3.1 Articles of Amendment and Restatement of the Registrant(a)
3.1.1 Certified Certificate of Amendment of the Charter of
Registrant(l)
3.2 Articles Supplementary of the Registrant(a)
3.3 Amended and Restated Bylaws of the Registrant(b)
3.3.1 Amended and Restated Bylaws, amended December 13, 1996(g)
3.4 Articles Supplementary of the Registrant, dated August 14,
1995(d)
3.4.1 Articles Supplementary of the Registrant relating to the Class
B 9.74% Cumulative Convertible Preferred Stock, filed August 9,
1996(f)
4.2 Specimen Common Stock Certificate(a)
4.3 Specimen Class B 9.74% Cumulative Convertible Preferred Stock
Certificate(f)
4.4 In May 1999, the Bonds issued pursuant to the Indenture, dated
as of June 1, 1997, between Sequoia Mortgage Trust 1 and First
Union National Bank, as Trustee, were redeemed, restructured,
and contributed to Sequoia Mortgage Trust 1A, interests in
which were then privately placed with investors(i)
4.4.1 Indenture dated as of October 1, 1997 between Sequoia Mortgage
Trust 2 (a wholly-owned, consolidated subsidiary of the
Registrant) and Norwest Bank Minnesota, N.A., as Trustee(j)
4.4.2 Sequoia Mortgage Trust 1A Trust Agreement, dated as of May 4,
1999 between Sequoia Mortgage Trust 1 and First Union National
Bank(m)
10.1 Purchase Terms Agreement, dated August 18, 1994, between the
Registrant and Montgomery Securities(a)
10.2 Registration Rights Agreement, dated August 19, 1994, between
the Registrant and Montgomery Securities(a)
10.3 [Reserved]
10.4 Founders Rights Agreement, dated August 19, 1994, between the
Registrant and the original holders of Common Stock of the
Registrant(a)
10.5 Form of Reverse Repurchase Agreement for use with Agency
Certificates, Privately-Issued Certificates and
Privately-Issued CMOs(a)
10.5.1 Form of Reverse Repurchase Agreement for use with Mortgage
Loans(d)
10.6.1 [Reserved]
10.7 [Reserved]
10.8 Forms of Interest Rate Cap Agreements(a)
10.9 [Reserved]
10.9.2 Clearance Agreement, dated December 1, 1996, between the
Registrant and Bankers Trust Company(d)
10.10 Employment Agreement, dated August 19, 1994, between the
Registrant and George E. Bull(a)
10.11 Employment Agreement, dated August 19, 1994, between the
Registrant and Douglas B. Hansen(a)
10.12 [Reserved]
10.13 [Reserved]
10.14 1994 Amended and Restated Executive and Non-Employee Director
Stock Option Plan(c)
10.14.1 1994 Amended and Restated Executive and Non-Employee Director
Stock Option Plan, amended March 6, 1996(d)
10.14.2 Amended and Restated 1994 Executive and Non-Employee Director
Stock Option Plan, amended December 13, 1996(h)
10.14.3 Amended and Restated Executive and Non-Employee Director Stock
Option Plan, amended March 4, 1999
10.27 [Reserved]
10.29 Form of Dividend Reinvestment Plan(b)
10.29.1 Form of Dividend Reinvestment and Stock Purchase Plan(g)
48
10.30 Office Building Lease(d)
10.30.1 Amendment to Office Building Lease(k)
10.31 RWT Holdings, Inc. Series A Preferred Stock Purchase Agreement,
dated March 1, 1998 (n) 10.32 Administrative Personnel and
Facilities Agreement dated as of April 1, 1998, between Redwood
Trust, Inc. and RWT Holdings, Inc.(n)
10.32.1 First Amendment to Administrative Personnel and Facilities
Agreement dated as of April 1, 1998, between Redwood Trust,
Inc. and RWT Holdings, Inc.(n)
10.33 Lending and Credit Support Agreement dated as of April 1, 1998,
between RWT Holdings, Inc., Redwood Residential Funding, Inc.,
Redwood Commercial Funding, Inc., and Redwood Financial
Services, Inc., and Redwood Trust, Inc.(n)
10.34 Form of Master Forward Commitment Agreements for RWT Holdings,
Inc., Residential Redwood Funding, Inc., Redwood Commercial
Funding, Inc. and Redwood Financial Services, Inc.(n)
11.1 Statement re: Computation of Per Share Earnings
21 List of Subsidiaries(k)
23 Consent of Accountants
27 Financial Data Schedule
- -----------------------------
(a) Incorporated by reference to the correspondingly numbered exhibit to the
Registration Statement on Form S-11 (33-92272) filed by the Registrant with
the Securities and Exchange Commission on May 19, 1995.
(b) Incorporated by reference to the correspondingly numbered exhibit to the
Registration Statement on Form S-11 (33-97946) filed by the Registrant with
the Securities and Exchange Commission on October 10, 1995.
(c) Incorporated by reference to the correspondingly numbered exhibit to the
Registration Statement on Form S-11 (33-94160) filed by the Registrant with
the Securities and Exchange Commission on June 30, 1995.
(d) Incorporated by reference to the correspondingly numbered exhibit to the
Registration Statement on Form S-11 (333-02962) filed by the Registrant
with the Securities and Exchange Commission on March 26, 1996.
(e) [Reserved]
(f) Incorporated by reference to the correspondingly numbered exhibit to the
Registration Statement on Form S-11 (333-08363) filed by the Registrant
with the Securities and Exchange Commission on July 18, 1996.
(g) Incorporated by reference to the Registration Statement on Form S-3
(333-18061) filed by the Registrant with the Securities and Exchange
Commission on January 2, 1997.
(h) Incorporated by reference to the correspondingly numbered exhibit to Form
8-K (000-26436) filed by the Registrant with the Securities and Exchange
Commission on January 7, 1997.
(i) Incorporated by reference to the Form 8-K filed by Sequoia Mortgage Funding
Corporation with the Securities and Exchange Commission on August 12, 1997.
(j) Incorporated by reference to the Form 8-K filed by Sequoia Mortgage Funding
Corporation with the Securities and Exchange Commission on November 18,
1997.
49
(k) Incorporated by reference to the Form 10-K (1-13759) filed by the
Registrant with the Securities and Exchange Commission for the fiscal year
ended December 31, 1997.
(l) Incorporated by reference to the Form 8-K (1-13759) filed by the Registrant
with the Securities and Exchange Commission on July 20, 1998.
(m) Incorporated by reference to the Form 10-Q (0-26436) filed by the
Registrant with the Securities and Exchange Commission for the fiscal
quarter ended June 30, 1999.
(n) Incorporated by reference to the Form 10-K (1-13759) filed by the
Registrant with the Securities and Exchange Commission for the fiscal year
ended December 31, 1998.
(b) Reports on Form 8-K:
None.
50
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) the Securities Exchange Act
of 1934, the Registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
REDWOOD TRUST, INC.
Dated: March 15, 2000 By: /s/ George E. Bull
------------------------------------
George E. Bull
Chairman and 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 Title Date
- --------- ----- ----
/s/ George E. Bull Chairman of the Board and March 15, 2000
- ---------------------------- Chief Executive Officer
George E. Bull (Principal Executive Officer)
/s/ Douglas B. Hansen Director, President March 15, 2000
- ----------------------------
Douglas B. Hansen
/s/ Harold F. Zagunis Chief Financial Officer, Secretary, March 15, 2000
- ---------------------------- Treasurer and Controller
Harold F. Zagunis (Principal Financial and
Accounting Officer)
/s/ Thomas C. Brown Director March 15, 2000
- ----------------------------
Thomas C. Brown
/s/ Mariann Byerwalter Director March 15, 2000
- ----------------------------
Mariann Byerwalter
/s/ Thomas F. Farb Director March 15, 2000
- ----------------------------
Thomas F. Farb
/s/ Nello Gonfiantini Director March 15, 2000
- ----------------------------
Nello Gonfiantini
/s/ Terrance G. Hodel Director March 15, 2000
- ----------------------------
Terrance G. Hodel
/s/ Charles J. Toeniskoetter Director March 15, 2000
- ----------------------------
Charles J. Toeniskoetter
51
REDWOOD TRUST, INC.
CONSOLIDATED FINANCIAL STATEMENTS AND
REPORT OF INDEPENDENT ACCOUNTANTS
For Inclusion in Form 10-K
Annual Report Filed with
Securities and Exchange Commission
December 31, 1999
F-1
REDWOOD TRUST, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Consolidated Financial Statements - Redwood Trust, Inc.:
Consolidated Balance Sheets at December 31, 1999 and 1998.................. F-3
Consolidated Statements of Operations for the years ended
December 31, 1999, 1998 and 1997...................................... F-4
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1999, 1998 and 1997...................................... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1999, 1998 and 1997...................................... F-6
Notes to Consolidated Financial Statements................................. F-7
Report of Independent Accountants............................................... F-23
F-2
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
December 31,
1999 1998
----------- -----------
ASSETS
Mortgage loans
Residential: held-for-sale $ 415,880 $ 265,914
Residential: held-for-investment, net 968,709 1,131,300
Commercial: held-for-sale 8,437 8,287
----------- -----------
1,393,026 1,405,501
Mortgage securities
Residential: trading 946,373 1,257,655
Residential: available-for-sale, net 28,006 7,707
----------- -----------
974,379 1,265,362
U.S. Treasury securities: trading -- 48,009
Cash and cash equivalents 19,881 55,627
Restricted cash 5,384 12,857
Interest rate agreements 2,037 2,517
Accrued interest receivable 13,244 18,482
Investment in RWT Holdings, Inc. 3,391 15,124
Loans to RWT Holdings, Inc. 6,500 6,500
Receivable from RWT Holdings, Inc. 472 445
Other assets 1,614 2,024
----------- -----------
Total Assets $ 2,419,928 $ 2,832,448
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term debt $ 1,253,565 $ 1,257,570
Long-term debt, net 945,270 1,305,560
Accrued interest payable 5,462 10,820
Accrued expenses and other liabilities 2,819 3,022
Dividends payable 2,877 686
----------- -----------
Total Liabilities 2,209,993 2,577,658
----------- -----------
Commitments and contingencies (See Note 13)
STOCKHOLDERS' EQUITY
Preferred stock, par value $0.01 per share;
Class B 9.74% Cumulative Convertible
902,068 and 909,518 shares authorized, issued and outstanding
($28,645 and $28,882 aggregate liquidation preference) 26,517 26,736
Common stock, par value $0.01 per share;
49,097,932 and 49,090,482 shares authorized;
8,783,341 and 11,251,556 issued and outstanding 88 113
Additional paid-in capital 242,094 279,201
Accumulated other comprehensive income (3,348) (370)
Cumulative earnings 8,140 6,412
Cumulative distributions to stockholders (63,556) (57,302)
----------- -----------
Total Stockholders' Equity 209,935 254,790
----------- -----------
Total Liabilities and Stockholders' Equity $ 2,419,928 $ 2,832,448
=========== ===========
The accompanying notes are an integral part of these
consolidated financial statements.
F-3
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share data)
Years Ended December 31,
1999 1998 1997
------------ ------------ ------------
INTEREST INCOME
Mortgage loans
Residential: held-for-sale $ 7,220 $ 9,005 $ --
Residential: held-for-investment 65,930 112,242 65,328
Commercial: held-for-sale 1,081 102 --
------------ ------------ ------------
74,231 121,349 65,328
Mortgage securities
Residential: trading 65,300 46,162 --
Residential: available-for-sale 4,202 52,638 131,950
------------ ------------ ------------
69,502 98,800 131,950
U.S. Treasury securities: trading 919 575 --
Cash and cash equivalents 2,658 2,080 1,326
------------ ------------ ------------
Total interest income 147,310 222,804 198,604
INTEREST EXPENSE
Short-term debt (51,377) (114,763) (140,140)
Long-term debt (65,785) (81,361) (20,137)
------------ ------------ ------------
Total interest expense (117,162) (196,124) (160,277)
Net interest rate agreements expense (2,065) (3,514) (3,741)
------------ ------------ ------------
NET INTEREST INCOME 28,083 23,166 34,586
Net unrealized and realized market value gains (losses)
Loans and securities (1,700) (33,034) 718
Interest rate agreements 1,984 (5,909) (155)
------------ ------------ ------------
284 (38,943) 563
Provision for credit losses (1,346) (1,120) (2,930)
------------ ------------ ------------
NET REVENUES 27,021 (16,897) 32,219
Operating expenses (3,835) (5,876) (4,658)
Other income 175 139 --
Equity in earnings (losses) of RWT Holdings, Inc. (21,633) (4,676) --
------------ ------------ ------------
Net income (loss) before preferred dividend and change in accounting principle 1,728 (27,310) 27,561
Less cash dividends on Class B preferred stock (2,741) (2,747) (2,815)
------------ ------------ ------------
Net income (loss) before change in accounting principle (1,013) (30,057) 24,746
Cumulative transition effect of adopting SFAS No. 133 (See Note 2) -- (10,061) --
------------ ------------ ------------
NET INCOME (LOSS) AVAILABLE TO COMMON STOCKHOLDERS $ (1,013) $ (40,118) $ 24,746
============ ============ ============
Earnings (Loss) per Share:
Basic Earnings (Loss) Per Share:
Net income (loss) before change in accounting principle $ (0.10) $ (2.28) $ 1.86
Cumulative transition effect of adopting SFAS No. 133 $ -- $ (0.76) $ --
Net income (loss) $ (0.10) $ (3.04) $ 1.86
Diluted Earnings (Loss) Per Share:
Net income (loss) before change in accounting principle $ (0.10) $ (2.28) $ 1.81
Cumulative transition effect of adopting SFAS No. 133 $ -- $ (0.76) $ --
Net income (loss) $ (0.10) $ (3.04) $ 1.81
Weighted average shares of common stock and common stock equivalents:
Basic 9,768,345 13,199,819 13,334,163
Diluted 9,768,345 13,199,819 13,680,410
The accompanying notes are an integral part of these
consolidated financial statements.
F-4
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In thousands, except share data)
Class B Accumulated Cumulative
Preferred stock Common stock Additional other distributions
-------------------------------------- paid-in comprehensive Cumulative to
Shares Amount Shares Amount capital income earnings stockholders Total
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 1,006,250 $29,579 10,996,572 $110 $187,507 $ (3,460) $ 16,222 $(18,953) $211,005
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income before
preferred dividend -- -- -- -- -- -- 27,561 -- 27,561
Net unrealized loss on
assets available-
for-sale -- -- -- -- -- (6,611) -- -- (6,611)
--------
Total comprehensive
income -- -- -- -- -- -- -- -- 20,950
Conversion of preferred
stock (96,732) (2,843) 96,732 1 2,842 -- -- -- --
Issuance of common stock -- -- 4,031,353 41 157,321 -- -- -- 157,362
Repurchase of common
stock -- -- (840,000) (9) (23,115) -- -- -- (23,124)
Dividends declared:
Preferred -- -- -- -- -- -- -- (2,815) (2,815)
Common -- -- -- -- -- -- -- (28,841) (28,841)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1997 909,518 26,736 14,284,657 143 324,555 (10,071) 43,783 (50,609) 334,537
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net loss before
preferred dividend and
change in accounting
principle -- -- -- -- -- -- (27,310) -- (27,310)
Reclassification
adjustment due to
adoption of SFAS
No. 133 -- -- -- -- -- 19,457 -- -- 19,457
Net unrealized loss
on assets available-
for-sale -- -- -- -- -- (9,756) -- -- (9,756)
--------
Total comprehensive
income -- -- -- -- -- -- -- -- (17,609)
Cumulative transition
effect of adopting
SFAS No. 133 -- -- -- -- -- -- (10,061) -- (10,061)
Issuance of common stock -- -- 98,399 1 1,563 -- -- -- 1,564
Repurchase of common
stock -- -- (3,131,500) (31) (46,917) -- -- -- (46,948)
Dividends declared:
Preferred -- -- -- -- -- -- -- (2,747) (2,747)
Common -- -- -- -- -- -- -- (3,946) (3,946)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1998 909,518 26,736 11,251,556 113 279,201 (370) 6,412 (57,302) 254,790
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income before
preferred dividend -- -- -- -- -- -- 1,728 -- 1,728
Net unrealized income
on assets available-
for-sale -- -- -- -- -- (2,978) -- -- (2,978)
--------
Total comprehensive loss -- -- -- -- -- -- -- -- (1,250)
Repurchase of preferred
stock (7,450) (219) -- -- -- -- -- -- (219)
Issuance of common stock -- -- 15,285 -- 22 -- -- -- 22
Repurchase of common
stock -- -- (2,483,500) (25) (37,129) -- -- -- (37,154)
Dividends declared:
Preferred -- -- -- -- -- -- -- (2,741) (2,741)
Common -- -- -- -- -- -- -- (3,513) (3,513)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1999 902,068 $26,517 8,783,341 $ 88 $242,094 $ (3,348) $ 8,140 $(63,556) $209,935
====================================================================================================================================
The accompanying notes are an integral part of these
consolidated financial statements.
F-5
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Years Ended December 31,
1999 1998 1997
--------- ----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) before preferred dividend and
change in accounting principle $ 1,728 $ (27,310) $ 27,561
Adjustments to reconcile net income (loss) to net cash
provided by operating activities:
Depreciation and amortization 6,773 32,046 27,066
Provision for credit losses 1,346 1,120 2,930
Equity in (earnings) losses of RWT Holdings, Inc. 21,633 4,676 --
Net unrealized and realized market value (gains) losses (284) 38,943 (563)
Purchases of mortgage loans: held-for-sale (516,408) (8,296) --
Proceeds from sales of mortgage loans: held-for-sale 153,303 688,941 --
Principal payments on mortgage loans: held-for-sale 59,782 202,965 --
Purchases of mortgage securities: trading (170,723) (149,934) --
Proceeds from sales of mortgage securities: trading 7,668 -- --
Principal payments on mortgage securities: trading 468,344 433,314 --
Purchases of U.S. Treasury securities: trading (45,844) (49,704) --
Proceeds from sales of U.S. Treasury securities: trading 90,519 -- --
Purchases of interest rate agreements (1,133) (14,373) (7,892)
Proceeds from sales of interest rate agreements 1,409 2,769 --
(Increase) decrease in accrued interest receivable 5,238 4,637 (8,985)
Decrease in other assets 195 595 11
Increase (decrease) in accrued interest payable (5,358) (3,656) 416
Increase (decrease) in accrued expenses and other liabilities (203) 850 1,411
--------- ----------- -----------
Net cash provided by operating activities 77,985 1,157,583 41,955
--------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of mortgage loans: held-for-investment -- (1,596,673) (1,322,732)
Proceeds from sales of mortgage loans: held-for-investment -- 369,119 --
Principal payments on mortgage loans: held-for-investment 310,892 475,905 288,982
Purchases of mortgage securities: available-for-sale (17,691) (231,167) (978,979)
Proceeds from sales of mortgage securities: available-for-sale -- 9,296 88,284
Principal payments on mortgage securities: available-for-sale 442 443,057 684,150
Net (increase) decrease in restricted cash 7,473 11,800 (24,657)
Investment in RWT Holdings, Inc., net of dividends received (9,900) (19,800) --
Loans to RWT Holdings, Inc., net of repayments -- (6,500) --
Increase in receivable from RWT Holdings, Inc. (27) (445) --
--------- ----------- -----------
Net cash provided by (used in) investing activities 291,189 (545,408) (1,264,952)
--------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net repayments on short-term debt (4,005) (656,955) (38,578)
Proceeds (costs) from issuance of long-term debt (337) 635,193 1,285,197
Repayments on long-term debt (359,180) (502,601) (112,798)
Net proceeds from issuance of common stock 22 1,564 157,362
Repurchases of preferred stock (202) -- --
Repurchases of common stock (37,154) (46,948) (23,124)
Dividends paid (4,064) (11,693) (31,238)
--------- ----------- -----------
Net cash provided by (used in) financing activities (404,920) (581,440) 1,236,821
--------- ----------- -----------
Net increase (decrease) in cash and cash equivalents (35,746) 30,735 13,824
Cash and cash equivalents at beginning of period 55,627 24,892 11,068
--------- ----------- -----------
Cash and cash equivalents at end of period $ 19,881 $ 55,627 $ 24,892
========= =========== ===========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 122,520 $ 199,762 $ 160,690
========= =========== ===========
Conversion of preferred stock $ -- $ -- $ 2,843
========= =========== ===========
The accompanying notes are an integral part of these
consolidated financial statements.
F-6
REDWOOD TRUST, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1999
NOTE 1. THE COMPANY
Redwood Trust, Inc. ("Redwood Trust") was incorporated in Maryland on April 11,
1994 and commenced operations on August 19, 1994. During 1997, Redwood Trust
formed Sequoia Mortgage Funding Corporation ("Sequoia"), a special-purpose
finance subsidiary. Redwood Trust acquired an equity interest in RWT Holdings,
Inc. ("Holdings"), a taxable affiliate of Redwood Trust, during the first
quarter of 1998. For financial reporting purposes, references to the "Company"
mean Redwood Trust, Sequoia, and Redwood Trust's equity interest in Holdings.
Redwood Trust, together with its affiliates, is a finance company specializing
in the mortgage portfolio spread lending business. The Company's primary
activity is the acquisition, financing, and management of high-quality
residential mortgage loans with funds raised through long-term debt issuance.
The Company also acquires, finances, and manages commercial mortgage loans and
residential mortgage securities (collectively "Mortgage Assets").
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Redwood Trust and
Sequoia. Substantially all of the assets of Sequoia are pledged or subordinated
to support long-term debt in the form of collateralized mortgage bonds
("Long-Term Debt") and are not available for the satisfaction of general claims
of the Company. The Company's exposure to loss on the assets pledged as
collateral for Long-Term Debt is limited to its net equity investment in
Sequoia, as the Long-Term Debt is non-recourse to the Company. All significant
inter-company balances and transactions with Sequoia have been eliminated in the
consolidation of the Company. Certain amounts for prior periods have been
reclassified to conform to the 1999 presentation.
During March 1998, the Company acquired an equity interest in Holdings, which
originates and sells commercial mortgage loans. The Company owns all of the
preferred stock and has a non-voting, 99% economic interest in Holdings. As the
Company does not own the voting common stock of Holdings or control Holdings,
its investment in Holdings is accounted for under the equity method. Under this
method, original equity investments in Holdings are recorded at cost and
adjusted by the Company's share of earnings or losses and decreased by dividends
received.
USE OF ESTIMATES
The preparation of financial statements in conformity with Generally Accepted
Accounting Principles requires management to make estimates and assumptions that
affect the reported amounts of certain assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of certain revenues and expenses during the reported
period. Actual results could differ from those estimates. The primary estimates
inherent in the accompanying consolidated financial statements are discussed
below.
Fair Value. Management estimates the fair value of its financial instruments
using available market information and other appropriate valuation
methodologies. The fair value of a financial instrument, as defined by Statement
of Financial Accounting Standards ("SFAS") No. 107, Disclosures about Fair Value
of Financial Instruments, is the amount at which the instrument could be
exchanged in a current transaction between willing parties, other than in a
forced liquidation sale. Management's estimates are inherently subjective in
nature and involve matters of uncertainty and judgement to interpret relevant
market and other data. Accordingly, amounts realized in actual sales may differ
from the fair valueS presented in Notes 3, 7 and 10.
Reserve for Credit Losses. A reserve for credit losses is maintained at a level
deemed appropriate by management to provide for known, losses as well as
potential losses inherent in its Mortgage Asset portfolio. The reserve is
F-7
based upon management's assessment of various factors affecting its Mortgage
Assets, including current and projected economic conditions, delinquency status,
and credit protection. In determining the reserve for credit losses, the
Company's credit exposure is considered based on its credit risk position in the
mortgage pool. These estimates are reviewed periodically and, as adjustments
become necessary, they are reported in earnings in the periods in which they
become known. The reserve is increased by provisions, which are charged to
income from operations. When a loan or portions of a loan are determined to be
uncollectible, the portion deemed uncollectible is charged against the reserve
and subsequent recoveries, if any, are credited to the reserve. The Company's
actual credit losses may differ from those estimates used to establish the
reserve. Summary information regarding the Reserve for Credit Losses is
presented in Note 4.
ADOPTION OF SFAS NO. 133
The Company adopted SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities, effective July 1, 1998. In accordance with the transition
provisions of SFAS No. 133, the Company recorded a net-of-tax cumulative-effect-
type transition adjustment of $10.1 million (loss) in earnings to recognize at
fair value the ineffective portion of all interest rate agreements that were
previously designated as part of a hedging relationship.
The Company, upon its adoption of SFAS No. 133, also reclassified $1.53 billion
of mortgage securities from available-for-sale to trading. This reclassification
resulted in an $11.9 million reclassification loss adjustment, which was
transferred from other comprehensive income to current earnings effective July
1, 1998. Under the provisions of SFAS No. 133, such a reclassification does not
call into question the Company's intent to hold current or future debt
securities to their maturity. Immediately after the adoption of SFAS No. 133 and
the reclassification, the Company elected to not seek hedge accounting for any
of the Company's interest rate agreements.
MORTGAGE ASSETS
The Company's Mortgage Assets consist of mortgage loans and mortgage securities.
Interest is recognized as revenue when earned according to the terms of the
loans and securities and when, in the opinion of management, it is collectible.
Discounts and premiums relating to Mortgage Assets are amortized into interest
income over the lives of the Mortgage Assets using methods that approximate the
effective yield method. Gains or losses on the sale of Mortgage Assets are based
on the specific identification method.
Mortgage Loans: Held-for-Sale
Effective September 30, 1998, the Company elected to reclassify certain
short-funded mortgage loans from held-for-investment to held-for-sale. These
mortgage loans are carried at the lower of original cost or aggregate market
value ("LOCOM"). Realized and unrealized gains and losses on these loans are
recognized in "Net unrealized and realized market value gains (losses)" on the
Consolidated Statements of Operations.
Some of the mortgage loans purchased by the Company for which securitization or
sale is contemplated are committed for sale by the Company to Holdings, or a
subsidiary of Holdings, under a Master Forward Commitment Agreement. As the
forward commitment is entered into on the same date that the Company commits to
purchase the loans, the price under the forward commitment is the same as the
price that the Company paid for the mortgage loans, as established by the
external market. Fair value is therefore equal to the commitment price, which is
the carrying value of the mortgage loans. Accordingly, no gain or loss is
recognized on the subsequent sales of these mortgage loans to Holdings or
subsidiaries of Holdings.
Mortgage Loans: Held-for-Investment
Mortgage loans held-for-investment are carried at their unpaid principal balance
adjusted for net unamortized premiums or discounts, and net of the related
allowance for credit losses.
Mortgage Securities: Trading
Effective July 1, 1998, concurrent with the adoption of SFAS No. 133, the
Company elected to reclassify all of its mortgage securities with a rating of AA
or higher from available-for-sale to trading. Mortgage securities classified as
trading are accounted for in accordance with SFAS No. 115, Accounting for
Certain Investments in Debt and Equity Securities. Accordingly, such securities
are recorded at their estimated fair market value.
F-8
Unrealized and realized gains and losses on these securities are recognized as a
component of "Net unrealized and realized market value gains (losses)" on the
Consolidated Statements of Operations.
Mortgage Securities: Available-for-Sale
Effective July 1, 1998, the Company reclassified all of its mortgage securities
rated AA or higher as trading investments, while all mortgage securities rated A
or lower remained in the available-for-sale classification. All mortgage
securities classified as available-for-sale are carried at their estimated fair
value. Current period unrealized gains and losses are excluded from net income
and reported as a component of Other Comprehensive Income in Stockholders'
Equity with cumulative unrealized gains and losses classified as Accumulated
Other Comprehensive Income in Stockholders' Equity.
Unrealized losses on mortgage securities classified as available-for-sale that
are considered other-than-temporary, are recognized in income and the carrying
value of the mortgage security is adjusted. Other-than-temporary unrealized
losses are based on management's assessment of various factors affecting the
expected cash flow from the mortgage securities, including an
other-than-temporary deterioration of the credit quality of the underlying
mortgages and/or the credit protection available to the related mortgage pool
and a significant change in the prepayment characteristics of the underlying
collateral.
U.S. TREASURY SECURITIES
U.S. Treasury securities include notes issued by the U.S. Government. Interest
is recognized as revenue when earned according to the terms of the Treasury
securities. Discounts and premiums are amortized into interest income over the
life of the security using the effective yield method. U.S. Treasury securities
are classified as trading and, accordingly, are recorded at their estimated fair
market value with unrealized gains and losses recognized as a component of "Net
unrealized and realized market value gains (losses)" on the Consolidated
Statements of Operations.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand and highly liquid investments
with original maturities of three months or less. At December 31, 1998, cash
equivalents included $25 million in reverse repurchase agreements.
RESTRICTED CASH
Restricted cash of the Company includes principal and interest payments on
mortgage loans held as collateral for the Company's Long-Term Debt, and cash
pledged as collateral on certain interest rate agreements.
INTEREST RATE AGREEMENTS
The Company maintains an overall interest-rate risk-management strategy that
incorporates the use of derivative interest rate agreements to minimize
significant unplanned fluctuations in earnings that are caused by interest-rate
volatility. Interest rate agreements that are used as part of the Company's
interest-rate risk management strategy include interest rate options, swaps,
options on swaps, futures contracts, options on futures contracts, forward sales
of fixed-rate Agency mortgage securities ("MBS"), and options on forward
purchases or sales of MBS' (collectively "Interest Rate Agreements"). On the
date an Interest Rate Agreement is entered into, the Company designates the
interest rate agreement as (1) a hedge of the fair value of a recognized asset
or liability or of an unrecognized firm commitment ("fair value" hedge), (2) a
hedge of a forecasted transaction or of the variability of cash flows to be
received or paid related to a recognized asset or liability ("cash flow" hedge),
or (3) held for trading ("trading" instruments). Since the adoption of SFAS No.
133, the Company has elected to designate all of its Interest Rate Agreements as
trading instruments. Accordingly, such instruments are recorded at their
estimated fair market value with changes in their fair value reported in
current-period earnings in "Net unrealized and realized market value gains
(losses)" on the Consolidated Statements of Operations.
Net premiums on interest rate options are amortized as a component of net
interest income over the effective period of the interest rate option using the
effective interest method. The income and/or expense related to interest rate
options and swaps are recognized on an accrual basis.
F-9
Prior to the adoption of SFAS No. 133, Interest Rate Agreements that were
hedging mortgage securities available-for-sale were carried at fair value with
unrealized gains and losses reported as a component of Accumulated Other
Comprehensive Income in Stockholders' Equity, consistent with the reporting of
unrealized gains and losses on the related securities. Similarly, Interest Rate
Agreements that were used to hedge mortgage loans, Short-Term Debt or Long-Term
Debt was carried at amortized cost. Realized gains and losses from the
settlement or early termination of Interest Rate Agreements were deferred and
amortized into net interest income over the remaining term of the original
Interest Rate Agreement, or, if shorter, over the remaining term of the
associated hedged asset or liability, as adjusted for estimated future principal
repayments.
DEBT
Short-Term and Long-Term Debt are carried at their unpaid principal balances,
net of any unamortized discount or premium and any unamortized deferred bond
issuance costs. The amortization of any discount or premium is recognized as an
adjustment to interest expense using the effective interest method based on the
maturity schedule of the related borrowings. Bond issuance costs incurred in
connection with the issuance of Long-Term Debt are deferred and amortized over
the estimated lives of the Long-Term Debt using the interest method adjusted for
the effects of prepayments.
INCOME TAXES
The Company has elected to be taxed as a Real Estate Investment Trust ("REIT")
under the Internal Revenue Code (the "Code") and the corresponding provisions of
State law. In order to qualify as a REIT, the Company must annually distribute
at least 95% of its taxable income to stockholders and meet certain other
requirements. If these requirements are met, the Company generally will not be
subject to Federal or state income taxation at the corporate level with respect
to the taxable income it distributes to its stockholders. Because the Company
believes it meets the REIT requirements and also intends to distribute all of
its taxable income, no provision has been made for income taxes in the
accompanying consolidated financial statements.
Under the Code, a dividend declared by a REIT in October, November or December
of a calendar year and payable to shareholders of record as of a specified date
in such month, will be deemed to have been paid by the Company and received by
the shareholders on the last day of that calendar year, provided the dividend is
actually paid before February 1st of the following calendar year, and provided
that the REIT has any remaining undistributed taxable income on the record date.
Therefore, the dividends declared in December 1999 which were paid in January
2000 are considered taxable income to shareholders in 1999, the year declared.
NET INCOME (LOSS) PER SHARE
Net income (loss) per share for the years ended December 31, 1999, 1998, and
1997 is shown in accordance with SFAS No. 128, Earnings Per Share. Basic net
income (loss) per share is computed by dividing net income (loss) available to
common stockholders by the weighted average number of common shares outstanding
during the period. Diluted net income (loss) per share is computed by dividing
the net income (loss) available to common stockholders by the weighted average
number of common shares and common equivalent shares outstanding during the
period. The common equivalent shares are calculated using the treasury stock
method, which assumes that all dilutive common stock equivalents are exercised
and the funds generated by the exercise are used to buy back outstanding common
stock at the average market price during the reporting period. Due to the net
loss available to common stockholders for both the years ended December 31, 1999
and 1998, the addition of potential dilutive shares is anti-dilutive and
therefore, the basic and diluted loss per share are the same.
F-10
The following tables provide reconciliations of the numerators and denominators
of the basic and diluted net income (loss) per share computations.
(IN THOUSANDS, EXCEPT SHARE DATA) YEARS ENDED DECEMBER 31,
1999 1998 1997
----------- ------------ ------------
NUMERATOR:
Numerator for basic and diluted earnings per share--
Net income (loss) before preferred dividend and
change in accounting principle $ 1,728 $ (27,310) $ 27,561
Cash dividends on Class B preferred stock (2,741) (2,747) (2,815)
----------- ------------ ------------
Net income (loss) before change in accounting principle (1,013) (30,057) 24,746
Cumulative transition effect of adopting SFAS No. 133 -- (10,061) --
----------- ------------ ------------
Basic and Diluted EPS - Net income (loss)
available to common stockholders $ (1,013) $ (40,118) $ 24,746
=========== ============ ============
DENOMINATOR:
Denominator for basic earnings (loss) per share--
Weighted average number of common shares
outstanding during the period 9,768,345 13,199,819 13,334,163
Net effect of dilutive stock options -- -- 346,247
----------- ------------ ------------
Denominator for diluted earnings (loss) per share-- 9,768,345 13,199,819 13,680,410
=========== ============ ============
BASIC EARNINGS (LOSS) PER SHARE:
Net income (loss) before change in accounting principle $ (0.10) $ (2.28) $ 1.86
Cumulative transition effect of adopting SFAS No. 133 -- (0.76) --
----------- ------------ ------------
Net income (loss) per share $ (0.10) $ (3.04) $ 1.86
=========== ============ ============
DILUTED EARNINGS (LOSS) PER SHARE:
Net income (loss) before change in accounting principle $ (0.10) $ (2.28) $ 1.81
Cumulative transition effect of adopting SFAS No. 133 -- (0.76) --
----------- ------------ ------------
Net income (loss) per share $ (0.10) $ (3.04) $ 1.81
=========== ============ ============
COMPREHENSIVE INCOME
SFAS No. 130, Reporting Comprehensive Income, requires the Company to classify
items of "other comprehensive income" by their nature in a financial statement
and display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in capital in the equity section of
the balance sheet. In accordance with SFAS No. 130, current period unrealized
gains and losses on assets available-for-sale are reported as a component of
Comprehensive Income on the Consolidated Statements of Stockholders' Equity with
cumulative unrealized gains and losses classified as Accumulated Other
Comprehensive Income in Stockholders' Equity. At December 31, 1999 and 1998, the
only component of Accumulated Other Comprehensive Income was net unrealized
gains and losses on assets available-for-sale.
F-11
NOTE 3. MORTGAGE ASSETS
At December 31, 1999 and 1998, investments in Mortgage Assets consisted of
interests in adjustable-rate, hybrid or fixed-rate mortgage loans on residential
and commercial properties. The hybrid mortgages have an initial fixed coupon
rate for three to ten years followed by annual adjustments. Agency mortgage
securities ("Agency Securities") represent securitized interests in pools of
adjustable-rate mortgages from the Federal Home Loan Mortgage Corporation and
the Federal National Mortgage Association. The Agency Securities are guaranteed
as to principal and interest by these United States government-sponsored
entities. The original maturity of the majority of the Mortgage Assets is thirty
years; the actual maturity is subject to change based on the prepayments of the
underlying mortgage loans.
At December 31, 1999 and 1998, the annualized effective yield after taking into
account the amortization expense due to prepayments on the Mortgage Assets was
7.00% and 6.95%, respectively, based on the reported cost of the assets. At
December 31, 1999, 81% of the Mortgage Assets owned by the Company were
adjustable-rate mortgages, 17% were hybrid mortgages, and 2% were fixed-rate
mortgages. At December 31, 1998, 76% of the Mortgage Assets owned by the Company
were adjustable-rate mortgages, 23% were hybrid mortgages, and 1% were
fixed-rate mortgages. At December 31, 1999 and 1998, the coupons on 61% and 64%
of the adjustable-rate Mortgage Assets were limited by periodic caps (generally
interest rate adjustments are limited to no more than 1% every six months or 2%
every year), respectively. The majority of the coupons on the adjustable-rate
and hybrid Mortgage Assets owned by the Company are limited by lifetime caps. At
December 31, 1999 and 1998, the weighted average lifetime cap on the
adjustable-rate Mortgage Assets was 11.64% and 11.48%, respectively.
At December 31, 1999 and 1998, Mortgage Assets consisted of the following:
MORTGAGE LOANS: RESIDENTIAL
DECEMBER 31, DECEMBER 31,
1999 1998
HELD-FOR- HELD-FOR- HELD-FOR- HELD-FOR-
(IN THOUSANDS) SALE INVESTMENT TOTAL SALE INVESTMENT TOTAL
--------- ------------ ----------- --------- ------------ -----------
Current Face $ 412,456 $ 960,928 $ 1,373,384 $ 266,306 $ 1,118,375 $ 1,384,681
Unamortized Discount (305) -- (305) (1,062) -- (1,062)
Unamortized Premium 3,729 12,906 16,635 670 16,709 17,379
--------- --------- ----------- --------- ----------- -----------
Amortized Cost 415,880 973,834 1,389,714 265,914 1,135,084 1,400,998
Reserve for Credit Losses -- (5,125) (5,125) -- (3,784) (3,784)
--------- --------- ----------- --------- ----------- -----------
Carrying Value $ 415,880 $ 968,709 $ 1,384,589 $ 265,914 $ 1,131,300 $ 1,397,214
========= ========= =========== ========= =========== ===========
The Company recognized gains of $0.3 million during the year ended December 31,
1999 and losses of $6.5 million during the year ended December 31, 1998 as a
result of LOCOM adjustments on residential mortgage loans held-for-sale. Also
during the years ended December 31, 1999 and 1998, the Company sold residential
mortgage loans held-for-sale for proceeds of $103.0 million and $688.9 million,
resulting in net gains of $0.1 million and $4.6 million, respectively. There
were no mortgage loans classified as held-for-sale during the year ended
December 31, 1997. The LOCOM adjustments and net gains on sales are reflected as
a component of "Net unrealized and realized market value gains (losses)" on the
Consolidated Statements of Operations.
There were no sales of residential mortgage loans held-for-investment for the
years ended December 31, 1999 and 1997. During the year ended December 31, 1998,
the Company sold held-for-investment residential mortgage loans with an
amortized cost of $370.1 million for proceeds of $369.1 million. The net
realized loss of $1 million is reflected as a component of "Net unrealized and
realized market value gains (losses)" on the Consolidated Statements of
Operations.
During the second quarter of 1999, as a result of the call and subsequent
restructuring of a portion of the Long-Term Debt, the Company reclassified $154
million of residential mortgage loans held-for-sale to residential mortgage
loans held-for-investment (see Note 9).
F-12
MORTGAGE LOANS: COMMERCIAL
DECEMBER 31, 1999 DECEMBER 31, 1998
(IN THOUSANDS) HELD-FOR-SALE HELD-FOR-SALE
----------------- -----------------
Current Face $8,450 $8,324
Unamortized Discount (13) (37)
------ ------
Carrying Value $8,437 $8,287
====== ======
During the year ended December 31, 1999, the Company sold commercial mortgage
loans to Redwood Commercial Funding ("RCF"), a subsidiary of Holdings, for
proceeds of $50.3 million. To date, pursuant to the Master Forward Commitment
Agreement, all commercial mortgage loans purchased by the Company are sold to
RCF at the same price for which the Company acquires the commercial mortgage
loans (see Note 12). Accordingly, there were no LOCOM adjustments or gains on
sales related to commercial mortgage loans during the years ended December 31,
1999 and 1998.
MORTGAGE SECURITIES: RESIDENTIAL
DECEMBER 31, DECEMBER 31,
1999 1998
AVAILABLE- AVAILABLE-
(IN THOUSANDS) TRADING FOR-SALE TOTAL TRADING FOR-SALE TOTAL
--------- --------- --------- ----------- ------------ -----------
Current Face $ 938,943 $ 48,627 $ 987,570 $ 1,250,749 $ 17,281 $ 1,268,030
Unamortized Discount (3,548) (16,444) (19,992) (3,089) (8,015) (11,104)
Unamortized Premium 10,978 -- 10,978 9,995 -- 9,995
--------- -------- --------- ----------- -------- -----------
Amortized Cost 946,373 32,183 978,556 1,257,655 9,266 1,266,921
Reserve for Credit Losses -- (829) (829) -- (1,189) (1,189)
Gross Unrealized Gains -- 166 166 -- 313 313
Gross Unrealized Losses -- (3,514) (3,514) -- (683) (683)
--------- -------- --------- ----------- -------- -----------
Carrying Value $ 946,373 $ 28,006 $ 974,379 $ 1,257,655 $ 7,707 $ 1,265,362
========= ======== ========= =========== ======== ===========
Agency $ 580,958 -- $ 580,958 $ 617,423 -- $ 617,423
Non-Agency 365,415 $ 28,006 393,421 640,232 $ 7,707 647,939
--------- -------- --------- ----------- -------- -----------
Carrying Value $ 946,373 $ 28,006 $ 974,379 $ 1,257,655 $ 7,707 $ 1,265,362
========= ======== ========= =========== ======== ===========
For the year ended December 31, 1999, the Company recognized a market value gain
of $1.2 million on mortgage securities classified as trading and sold mortgage
securities classified as trading for proceeds of $7.7 million. During the year
ended December 31, 1998, the Company elected to reclassify all of its
short-funded mortgage securities from available-for-sale to trading (see Note
2). As a result of this reclassification, the Company recognized a
reclassification loss of $11.9 million, which was transferred from other
comprehensive income to current earnings, and a market value loss of $17.5
million on mortgage securities classified as trading. The market value
adjustments are reflected as a component of "Net unrealized and realized market
value gains (losses)" on the Consolidated Statements of Operations.
No sales or write-downs of available-for-sale mortgage securities occurred
during the year ended December 31, 1999. During the years ended December 31,
1998 and 1997, the Company sold mortgage securities available-for-sale for
proceeds of $9.3 million and $88.3 million, resulting in net gains of $0 and
$0.5 million, respectively. The Company also recognized a $0.7 million loss on
the write-down of certain mortgage securities available-for-sale during the year
ended December 31, 1998. The gains and losses on the sales and write-downs of
mortgage securities available-for-sale are reflected as a component of "Net
unrealized and realized market value gains (losses)" on the Consolidated
Statements of Operations.
F-13
NOTE 4. RESERVE FOR CREDIT LOSSES
The Reserve for Credit Losses is reflected as a component of Mortgage Assets on
the Consolidated Balance Sheets. The following table summarizes the Reserve for
Credit Losses activity:
YEARS ENDED DECEMBER 31,
(IN THOUSANDS) 1999 1998 1997
------ ------- ------
Balance at beginning of year $4,973 $ 4,931 $2,180
Provision for credit losses 1,346 1,120 2,930
Charge-offs (365) (1,078) (179)
------ ------- ------
Balance at end of year $5,954 $4,973 $4,931
====== ======= ======
NOTE 5. U.S. TREASURY SECURITIES
The Company did not hold any U.S. Treasury securities at December 31, 1999. At
December 31, 1998, the Company owned $45 million face value of U.S. Treasury
securities at a carrying value of $48 million. For the years ended December 31,
1999 and 1998, the Company recognized market value losses of $3.3 million and
market value gains of $0.1 million on U.S. Treasury securities, respectively.
During the year ended December 31, 1999, the Company sold U.S. Treasury
securities for proceeds of $90.5 million. The market value adjustments are
reflected as a component of "Net unrealized and realized market value gains
(losses)" on the Consolidated Statements of Operations.
NOTE 6. COLLATERAL FOR LONG-TERM DEBT
The Company has pledged collateral in order to secure the Long-Term Debt issued
in the form of collateralized mortgage bonds ("Bond Collateral"). This Bond
Collateral consists primarily of adjustable-rate and hybrid, conventional,
30-year mortgage loans secured by first liens on one- to four-family residential
properties. All Bond Collateral is pledged to secure repayment of the related
Long-Term Debt obligation. All principal and interest (less servicing and
related fees) on the Bond Collateral is remitted to a trustee and is available
for payment on the Long-Term Debt obligation. The Company's exposure to loss on
the Bond Collateral is limited to its net investment, as the Long-Term Debt is
non-recourse to the Company.
During 1999, as a result of the call and subsequent restructuring of a portion
of the Long-Term Debt, the Company reclassified $154 million of mortgage loans
held-for-sale to mortgage loans held-for-investment (see Note 9).
The components of the Bond Collateral are summarized as follows:
DECEMBER 31, DECEMBER 31,
(IN THOUSANDS) 1999 1998
------------ ------------
Mortgage loans
Residential: held-for-sale $ -- $ 197,646
Residential: held-for-investment, net 968,709 1,131,300
Restricted cash 4,791 12,857
Accrued interest receivable 5,633 7,707
-------- ----------
$979,133 $1,349,510
======== ==========
For presentation purposes, the various components of the Bond Collateral
summarized above are reflected in their corresponding line items on the
Consolidated Balance Sheets.
F-14
NOTE 7. INTEREST RATE AGREEMENTS
At December 31, 1999 and 1998, all of the Company's Interest Rate Agreements
were classified as trading, and therefore, reported at fair value.
For the year ended December 31, 1999, the Company recognized a market value gain
of $2.0 million on Interest Rate Agreements classified as trading and sold
Interest Rate Agreements classified as trading for proceeds of $1.4 million. The
market value gains are reflected as a component of "Net unrealized and realized
market value gains (losses)" on the Consolidated Statements of Operations.
During the year ended December 31, 1998, as a result of adopting SFAS No. 133,
the Company recorded a net-of-tax cumulative-effect-type transition adjustment
of $10.1 million loss in earnings to recognize at fair value the ineffective
portion of Interest Rate Agreements that were previously designated as part of a
hedging relationship (see Note 2). This loss is reflected on the Consolidated
Statements of Operations as "Cumulative Transition Effect of Adopting SFAS No.
133." Approximately $7.6 million of this transition adjustment was transferred
from other comprehensive income to current earnings. Additionally, during the
year ended December 31, 1998, the Company recognized a net market value loss of
$5.9 million on Interest Rate Agreements classified as trading. This loss is
reflected as a component of "Net unrealized and realized market value gains
(losses)" on the Consolidated Statements of Operations.
The following table summarizes the aggregate notional amounts of all of the
Company's Interest Rate Agreements as well as the credit exposure related to
these instruments.
NOTIONAL AMOUNTS CREDIT EXPOSURE(a)
(IN THOUSANDS) DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1999 1998 1999 1998
------------ ------------ ----------- ------------
Interest Rate Options Purchased $2,960,900 $3,569,200 -- --
Interest Rate Swaps 250,000 440,000 $2,632 $8,673
Interest Rate Futures and Forwards 630,000 -- 593 --
---------- ---------- ------ ------
Total $3,840,900 $4,009,200 $3,225 $8,673
========== ========== ====== ======
(a) Reflects the fair market value of all cash and collateral of the Company
held by counterparties.
Interest Rate Options purchased (sold), which may include caps, floors, call and
put corridors, options on futures, options on MBS forwards, and swaption collars
(collectively, "Options"), are agreements which transfer, modify or reduce
interest rate risk in exchange for the payment (receipt) of a premium when the
contract is initiated. Purchased interest rate cap agreements provide cash flows
to the Company to the extent that a specific interest rate index exceeds a fixed
rate. Conversely, purchased interest rate floor agreements produce cash flows to
the Company to the extent that the referenced interest rate index falls below
the agreed upon fixed rate. Purchased call (put) corridors will cause the
Company to incur a gain to the extent that the yield of the specified index is
below (above) the strike rate at the time of the option expiration. The maximum
gain or loss on a purchased call (put) corridor is equal to the up-front
premium. Call (put) corridors that are sold will cause the Company to incur a
loss to the extent that the yield of the specified index is below (above) the
strike rate at the time of the option expiration. Such loss, if any, will, in
part, be offset by upfront premium received. The maximum gain or loss on a call
(put) corridor sold is determined at the time of the transaction by establishing
a minimum (maximum) index rate. The Company will receive cash on the purchased
options on futures/forwards if the futures/forward price exceeds (is below) the
call (put) option strike price at the expiration of the option. For the written
options on futures/forwards, the Company receives an up-front premium for
selling the option, however, the Company will incur a loss on the written option
if the futures/forward price exceeds (is below) the call (put) option strike
price at the expiration of the option. Purchased receiver (payor) swaption
collars will cause the Company to incur a gain (loss) should the index rate be
below (above) the strike rate as of the expiration date. The maximum gain or
loss on a receiver (payor) swaption is established at the time of the
transaction by establishing a minimum
F-15
(maximum) index rate. The Company's credit risk on the purchased Options is
limited to the carrying value of the Options agreements. The credit risk on
options on futures is limited due to the fact that the exchange and its members
are required to satisfy the obligations of any member that fails to perform.
Interest Rate Swaps ("Swaps") are agreements in which a series of interest rate
flows are exchanged over a prescribed period. The notional amount on which the
interest payments are based is not exchanged. Most of the Company's Swaps
involve the exchange of one floating interest payment for another floating
interest payment based on a different index. Most of the Swaps require that the
Company provide collateral, such as mortgage securities, to the counterparty.
Should the counterparty fail to return the collateral, the Company would be at
risk for the fair market value of that asset.
Interest Rate Futures and Forwards ("Futures and Forwards") are contracts for
the purchase or sale of securities or cash in which the seller (buyer) agrees to
deliver (purchase) on a specified future date, a specified instrument (or the
cash equivalent), at a specified price or yield. Under these agreements, if the
Company has sold (bought) the futures/forwards, the Company will generally
receive additional cash flows if interest rates rise (fall). Conversely, the
Company will generally pay additional cash flows if interest rates fall (rise).
The credit risk inherent in futures and forwards arises from the potential
inability of counterparties to meet the terms of their contracts, however, the
credit risk on futures is limited by the requirement that the exchange and its
members make good on obligations of any member that fails to perform.
In general, the Company has incurred credit risk to the extent that the
counterparties to the Interest Rate Agreements do not perform their obligations
under the Interest Rate Agreements. If one of the counterparties does not
perform, the Company would not receive the cash to which it would otherwise be
entitled under the Interest Rate Agreement. In order to mitigate this risk, the
Company has only entered into Interest Rate Agreements that are either a)
transacted on a national exchange or b) transacted with counterparties that are
either i) designated by the U.S. Department of the Treasury as a "primary
government dealer", ii) affiliates of "primary government dealers", or iii)
rated BBB or higher. Furthermore, the Company has entered into Interest Rate
Agreements with several different counterparties in order to diversify the
credit risk exposure.
NOTE 8. SHORT-TERM DEBT
The Company has entered into repurchase agreements, bank borrowings, and other
forms of collateralized short-term borrowings (collectively, "Short-Term Debt")
to finance acquisitions of a portion of its Mortgage Assets. This Short-Term
Debt is collateralized by a portion of the Company's Mortgage Assets.
At December 31, 1999, the Company had $1.3 billion of Short-Term Debt
outstanding with a weighted-average borrowing rate of 6.22% and a
weighted-average remaining maturity of 96 days. This debt was collateralized
with $1.3 billion of Mortgage Assets. At December 31, 1998, the Company had $1.3
billion of Short-Term Debt outstanding with a weighted-average borrowing rate of
5.62% and a weighted-average remaining maturity of 48 days. This debt was
collateralized with $1.3 billion of Mortgage Assets and U.S. Treasury
securities.
At December 31, 1999 and 1998, the Short-Term Debt had the following remaining
maturities:
(IN THOUSANDS) DECEMBER 31, DECEMBER 31,
1999 1998
------------ ------------
Within 30 days $ 163,394 $ 428,292
30 to 90 days 385,729 714,114
Over 90 days 704,442 115,164
---------- ----------
Total Short-Term Debt $1,253,565 $1,257,570
========== ==========
For the years ended December 31, 1999, 1998 and 1997, the average balance of
Short-Term Debt was $1.0 billion, $2.0 billion and $2.4 billion with a
weighted-average interest cost of 5.35%, 5.81%, and 5.86%,
F-16
respectively. The maximum balance outstanding during the years ended December
31, 1999, 1998, and 1997 was $1.3 billion, $2.5 billion, and $3.1 billion,
respectively.
In July 1999, the Company entered into a one-year, $90 million revolving
mortgage warehousing credit facility with two banks. At the Company's request,
this line was reduced to $20 million in December 1999. The facility is primarily
intended to finance newly originated residential mortgage loans. At December 31,
1999, the Company had outstanding borrowings of $6.4 million under this
facility, which are reflected as a component of Short-Term Debt. Holdings may
borrow under this facility as a co-borrower. At December 31, 1999, Holdings had
no outstanding borrowings under this facility. Borrowings under this facility
bear interest based on a specified margin over the London Interbank Offered Rate
("LIBOR"). At December 31, 1999, the weighted-average borrowing rate under this
facility was 6.87%. The Company and Holdings were in compliance with all
material representations, warranties, and covenants under this credit facility
at December 31, 1999, or had obtained the appropriate waivers.
In July 1999, the Company entered into a one-year, $350 million master loan and
security agreement with a Wall Street firm. The facility is primarily intended
to finance newly originated commercial and residential mortgage loans. At
December 31, 1999, the Company had outstanding borrowings of $119.9 million
under this facility, which are reflected as a component of Short-Term Debt.
Holdings may borrow under this facility as a co-borrower. At December 31, 1999,
Holdings had outstanding borrowings of $19.8 million under this facility.
Borrowings under this facility bear interest based on a specified margin over
LIBOR. At December 31, 1999, the weighted-average borrowing rate under this
facility was 5.72%. The Company and Holdings were in compliance with all
material representations, warranties, and covenants under this credit facility
at December 31, 1999.
NOTE 9. LONG-TERM DEBT
Long-Term Debt in the form of collateralized mortgage bonds is secured by a
pledge of Bond Collateral. As required by the indentures relating to the
Long-Term Debt, the Bond Collateral is held in the custody of trustees. The
trustees collect principal and interest payments on the Bond Collateral and make
corresponding principal and interest payments on the Long-Term Debt. The
obligations under the Long-Term Debt are payable solely from the Bond Collateral
and are otherwise non-recourse to the Company.
Each series of Long-Term Debt consists of various classes of bonds at variable
rates of interest. The maturity of each class is directly affected by the rate
of principal prepayments on the related Bond Collateral. Each series is also
subject to redemption according to the specific terms of the respective
indentures. As a result, the actual maturity of any class of a Long-Term Debt
series is likely to occur earlier than its stated maturity.
During the second quarter of 1999, the Company exercised its right to call the
Long-Term Debt of Sequoia Mortgage Trust 1 ("Sequoia 1"), a series of debt
issued by Sequoia. This Long-Term Debt was called on May 4, 1999. In conjunction
with this call, the Company restructured and contributed the Sequoia 1 debt to
Sequoia Mortgage Trust 1A ("Sequoia 1A"), a newly formed trust, and Sequoia 1A
issued Long-Term Debt collateralized by Sequoia 1 debt. As a result, the $154
million of Bond Collateral in the form of mortgage loans held-for-sale was
reclassified to mortgage loans held-for-investment.
For the years ended December 31, 1999, 1998, and 1997, the average effective
interest cost for Long-Term Debt, as adjusted for the amortization of bond
premium, deferred bond issuance costs, and other related expenses, was 6.03%,
6.38%, and 6.31%, respectively. At December 31, 1999 and December 31, 1998,
accrued interest payable on Long-Term Debt was $3.0 million and $4.2 million,
respectively, and is reflected as a component of Accrued Interest Payable on the
Consolidated Balance Sheets.
F-17
The components of the Long-Term Debt at December 31, 1999 and 1998 along with
selected other information are summarized below:
(IN THOUSANDS) DECEMBER 31, DECEMBER 31,
1999 1998
------------ ------------
Long-Term Debt $944,225 $1,303,405
Unamortized premium on Long-Term Debt 3,881 5,783
Deferred bond issuance costs (2,836) (3,628)
-------- ----------
Total Long-Term Debt $945,270 $1,305,560
======== ==========
Range of weighted-average interest rates, by series 6.21% to 6.88% 5.75% to 6.55%
Stated maturities 2017 - 2029 2017 - 2029
Number of series 3 3
NOTE 10. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying values and estimated fair values of
the Company's financial instruments at December 31, 1999 and 1998.
(IN THOUSANDS) DECEMBER 31, 1999 DECEMBER 31, 1998
CARRYING VALUE FAIR VALUE CARRYING VALUE FAIR VALUE
-------------- ---------- -------------- ----------
Assets
Mortgage Loans
Residential: held-for-sale $ 415,880 $ 415,880 $ 265,914 $ 266,015
Residential: held-for-investment $ 968,709 $ 955,653 $1,131,300 $1,120,376
Commercial: held-for-sale $ 8,437 $ 8,437 $ 8,287 $ 8,287
Mortgage Securities
Residential: trading $ 946,373 $ 946,373 $1,257,655 $1,257,655
Residential: available-for-sale $ 28,006 $ 28,006 $ 7,707 $ 7,707
U.S. Treasury Securities -- -- $ 48,009 $ 48,009
Interest Rate Agreements $ 2,037 $ 2,037 $ 2,517 $ 2,517
Investment in RWT Holdings, Inc. $ 3,391 $ 3,675 $ 15,124 $ 15,132
Liabilities
Short-Term Debt $1,253,565 $1,253,565 $1,257,570 $1,257,570
Long-Term Debt $ 945,270 $ 928,449 $1,305,560 $1,302,330
The carrying values of all other balance sheet accounts as reflected in the
financial statements approximate fair value because of the short-term nature of
these accounts.
NOTE 11. STOCKHOLDERS' EQUITY
CLASS B 9.74% CUMULATIVE CONVERTIBLE PREFERRED STOCK
On August 8, 1996, the Company issued 1,006,250 shares of Class B Preferred
Stock ("Preferred Stock"). Each share of the Preferred Stock is convertible at
the option of the holder at any time into one share of Common Stock. Effective
October 1, 1999, the Company can either redeem or, under certain circumstances,
cause a conversion of the Preferred Stock. The Preferred Stock pays a dividend
equal to the greater of (i) $0.755 per share, per quarter or (ii) an amount
equal to the quarterly dividend declared on the number of shares of the Common
Stock into which the Preferred Stock is convertible. The Preferred Stock ranks
senior to the Company's Common Stock as to the payment of dividends and
liquidation rights. The liquidation preference entitles the holders of the
Preferred Stock to receive $31.00 per share plus any accrued dividends before
any distribution is
F-18
made on the Common Stock. As of December 31, 1999 and 1998, 96,732 shares of the
Preferred Stock have been converted into 96,732 shares of the Company's Common
Stock.
In March 1999, the Company's Board of Directors approved the repurchase of up to
150,000 shares of the Company's Preferred Stock. Pursuant to this repurchase
program, the Company repurchased 7,450 shares of its Preferred Stock for $0.2
million during the year ended December 31, 1999. At December 31, 1999, there
were 142,550 shares available for repurchase.
STOCK OPTION PLAN
The Company has adopted a Stock Option Plan for executive officers, employees,
and non-employee directors (the "Plan"). The Plan authorizes the Board of
Directors (or a committee appointed by the Board of Directors) to grant
"incentive stock options" as defined under Section 422 of the Code ("ISOs"),
options not so qualified ("NQSOs"), deferred stock, restricted stock,
performance shares, stock appreciation rights, limited stock appreciation rights
("Awards"), and dividend equivalent rights ("DERs") to such eligible recipients
other than non-employee directors. Non-employee directors are automatically
provided annual grants of NQSOs with DERs pursuant to a formula under the Plan.
The number of shares of Common Stock available under the Plan for options and
Awards, subject to certain anti-dilution provisions, is 15% of the Company's
total outstanding shares of Common Stock. The total outstanding shares are
determined as the highest number of shares outstanding prior to any stock
repurchases. At December 31, 1999 and 1998, 283,975 and 273,312 shares of Common
Stock, respectively, were available for grant. Of the shares of Common Stock
available for grant, no more than 500,000 shares of Common Stock shall be
cumulatively available for grant as ISOs. At December 31, 1999 and 1998, 389,942
and 381,298 ISOs had been granted, respectively. The exercise price for ISOs
granted under the Plan may not be less than the fair market value of shares of
Common Stock at the time the ISO is granted. All stock options granted under the
Plan vest no earlier than ratably over a four-year period from the date of grant
and expire within ten years after the date of grant.
The Company's Plan permits certain stock options granted under the plan to
accrue stock DERs. Stock DERs represent shares of stock which are issuable to
holders of stock options when the holders exercise the underlying stock options.
The number of stock DER shares accrued is based on the level of the Company's
dividends and on the price of the stock on the related dividend payment date.
For the years ended December 31, 1999, 1998, and 1997, the stock DERs accrued on
NQSOs that had a stock DER feature resulted in charges to operating expenses of
$68,319, $55,222, and $437,393, respectively.
A summary of the status of the Company's Plan as of December 31 and changes
during the periods ending on that date is presented below.
1999 1998 1997
-------------------- -------------------- ------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
(IN THOUSANDS, EXCEPT SHARE DATA) SHARES PRICE SHARES PRICE SHARES PRICE
--------- -------- ------- -------- ------- --------
Outstanding options at January 1 1,739,787 $23.68 840,644 $29.79 421,583 $19.05
Options granted 371,950 $13.37 929,125 $16.73 460,328 $37.08
Options exercised (15,285) $ 0.68 (29,723) $ 0.11 (54,485) $ 0.89
Options canceled (387,990) $21.50 (2,699) $29.81 -- --
Dividend equivalent rights earned 5,374 -- 2,440 -- 13,218 --
--------- --------- -------
Outstanding options at December 31 1,713,836 $21.97 1,739,787 $23.68 840,644 $29.79
========= ========= =======
Options exercisable at year-end 401,697 $26.89 336,121 $25.95 81,774 $22.10
Weighted average fair value of options
granted during the year $ 1.33 $ 1.63 $ 3.17
F-19
The following table summarizes information about stock options outstanding at
December 31, 1999.
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------------ -----------------------------
WEIGHTED-AVERAGE
RANGE OF NUMBER REMAINING WEIGHTED-AVERAGE NUMBER WEIGHTED-AVERAGE
EXERCISE PRICES OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
- --------------- ----------- ---------------- ---------------- ----------- ----------------
$0 to 10 41,360 6.9 $ 1.10 35,312 $ 1.29
10 to 20 851,668 8.8 $13.94 97,626 $18.16
20 to 30 398,756 8.0 $22.46 93,348 $22.61
30 to 40 302,200 7.0 $37.45 141,218 $37.49
40 to 50 111,102 7.5 $45.09 29,193 $45.09
50 to 53 8,750 7.5 $52.25 5,000 $52.25
--------- ------
$0 to 53 1,713,836 8.2 $21.97 401,697 $26.89
========= ======
At December 31, 1999, the Company had one Stock Option Plan, which is described
above. The Company applies Accounting Principles Board ("APB") Opinion 25 and
related interpretations in accounting for this plan. Accordingly, no
compensation cost has been recognized for its Plan. Had compensation cost for
the Company's Plan been determined consistent with SFAS No. 123, the Company's
net income and earnings per share would have been reduced to the pro forma
amounts indicated below:
YEAR ENDED DECEMBER 31,
1999 1998 1997
------- -------- -------
Net income (loss) As reported $(1,013) $(40,118) $24,746
(IN THOUSANDS) Pro Forma $(1,687) $(40,674) $24,504
Basic net income (loss) As reported $ (0.10) $ (3.04) $ 1.86
per share Pro Forma $ (0.17) $ (3.08) $ 1.84
Diluted net income (loss) As reported $ (0.10) $ (3.04) $ 1.81
per share Pro Forma $ (0.17) $ (3.08) $ 1.79
For purposes of determining option values for use in the above tables, the
values are based on American valuation using the Black/Scholes option pricing
model as of the various grant dates, using the following principal assumptions:
expected stock price volatility 33%, risk free rates of return based on the 5
year treasury rate at the date of grant, and a dividend growth rate of 10%. The
actual value, if any, that the option recipient will realize from these options
will depend solely on the increase in the stock price over the option price when
the options are exercised.
COMMON STOCK REPURCHASES
Since September 1997, the Company's Board of Directors has approved the
repurchase of 7,455,000 shares of the Company's Common Stock. Pursuant to this
repurchase program, the Company repurchased 2,483,500 shares for $37 million at
an average price of $14.96 per share during the year ended December 31, 1999.
During the year ended December 31, 1998, the Company repurchased 3,131,500
shares of its Common Stock for $47 million at an average price of $14.99 per
share. During the year ended December 31, 1997, the Company repurchased 840,000
shares of its Common Stock for $23 million at an average price of $27.53 per
share. At December 31, 1999, there were 1,000,000 shares available for
repurchase. The repurchased shares have been returned to the Company's
authorized but unissued shares of Common Stock.
NOTE 12. RELATED PARTY TRANSACTIONS
PURCHASES AND SALES OF MORTGAGE LOANS
During December 1999, Holdings purchased $390 million of residential mortgage
loans and subsequently sold a participation agreement on the mortgage loans to
the Company. Pursuant to the terms of the Mortgage Loan
F-20
Participation Purchase Agreement, the Company purchased a 99% interest in the
mortgage loans, and assumes all related risks of ownership. Holdings did not
recognize any gain or loss on this transaction.
During the year ended December 31, 1999, the Company sold $50 million of
commercial mortgage loans to RCF. Pursuant to the Master Forward Commitment
Agreement, the Company sold the mortgage loans to RCF at the same price for
which the Company acquired the mortgage loans. There were no such sales during
the year ended December 31, 1998. At both December 31, 1999 and 1998, under the
terms of the Master Forward Commitment Agreement, the Company had committed to
sell $8 million of commercial mortgage loans to RCF for settlement during the
first quarter of 2000 and 1999, respectively.
During the year ended December 31, 1999, the Company sold $61 million of
residential mortgage loans to Redwood Residential Funding ("RRF"), a subsidiary
of Holdings. Pursuant to the Master Forward Commitment Agreement, the Company
sold the mortgage loans to RRF at the same price for which the Company acquired
the mortgage loans. There were no such sales during the year ended December 31,
1998. At December 31, 1999, under the terms of the Master Forward Commitment
Agreement, the Company had committed to sell $16 million of residential mortgage
loans to RRF during the first and second quarters of 2000. There were no such
commitments at December 31, 1998.
OTHER
Under a revolving credit facility arrangement, the Company may loan funds to
Holdings to finance certain mortgage loans owned by Holdings. These loans are
typically unsecured and are repaid within six months. Such loans bear interest
at a rate of 3.50% over the LIBOR interest rate. At both December 31, 1999 and
1998, the Company had loaned $6.5 million to Holdings in accordance with the
provisions of this arrangement. During the years ended December 31, 1999 and
1998, the Company earned $1.1 million and $18,539, respectively, in interest on
loans to Holdings.
The Company shares many of the operating expenses of Holdings, including
personnel and related expenses, subject to full reimbursement by Holdings.
During the years ended December 31, 1999 and 1998, $3.0 million and $2.3
million, respectively, of Holdings' operating expenses were paid by the Company,
and were subject to reimbursement by Holdings.
The Company may provide credit support to Holdings to facilitate Holdings'
financings from third-party lenders and/or hedging arrangements with
counterparties. As part of this arrangement, Holdings is authorized as a
co-borrower under some of the Company's Short-Term Debt agreements subject to
the Company continuing to remain jointly and severally liable for repayment.
Accordingly, Holdings pays the Company credit support fees on borrowings subject
to this arrangement. At December 31, 1999, the Company was providing credit
support on $22.4 million of Holdings' Short-Term Debt. No such borrowings were
outstanding at December 31, 1998. During the years ended December 31, 1999 and
1998, the Company recognized $0.1 million and $0.1 million in credit support fee
income. Credit support fees are reflected as a component of "Other Income" on
the Consolidated Statements of Operations.
NOTE 13. COMMITMENTS AND CONTINGENCIES
At December 31, 1999, the Company had entered into commitments to purchase $18.0
million of residential mortgage securities and $7.7 million of residential
mortgage loans for settlement during January and February 2000. At December 31,
1999, the Company had also entered into commitments to sell $8.4 million of
commercial mortgage loans to RCF and $16.0 million of residential mortgage loans
to RRF for settlement during the first and second quarters of 2000.
At December 31, 1999, the Company is obligated under non-cancelable operating
leases with expiration dates through 2003. The total future minimum lease
payments under these non-cancelable leases is $632,574 and is expected to be
recognized as follows: 2000 - $363,571; 2001 - $171,856; 2002 - $53,546; 2003 -
$43,601.
F-21
NOTE 14. SUBSEQUENT EVENTS
On March 9, 2000, the Company declared a $0.35 per share common stock dividend
for the first quarter of 2000. The common stock dividend is payable on April 21,
2000 to shareholders of record on March 31, 2000.
On March 8, 2000, the Company committed to the issuance of $377 million in face
value of Long-Term Debt, for settlement on March 21, 2000. This Long-Term Debt
will be issued by Sequoia Mortgage Trust 4, a business trust that will be
established by Sequoia. The debt will be collateralized by a pool of
adjustable-rate, 30-year mortgage loans. The proceeds received from this
issuance are expected to be used to pay down a portion of the Company's
Short-Term Debt.
NOTE 15. QUARTERLY FINANCIAL DATA - UNAUDITED
Selected quarterly financial data follows:
(IN THOUSANDS, EXCEPT SHARE DATA) THREE MONTHS ENDED
----------------------------------------------------
MARCH 31 JUNE 30 SEPTEMBER 30 DECEMBER 31
-------- -------- ------------ -----------
1999
Operating results:
Interest income $ 41,731 $ 36,091 $ 34,555 $ 34,933
Interest expense (33,491) (28,537) (27,390) (27,744)
Interest rate agreement expense (333) (737) (457) (538)
Net interest income 7,907 6,817 6,708 6,651
Net income (loss) available to common stockholders 5,854 2,509 (3,738) (5,638)
Per share data:
Net income (loss) - diluted $ 0.54 $ 0.25 $ (0.39) $ (0.64)
Dividends declared per common share(a) -- -- $ 0.150 $ 0.250
Dividends declared per preferred share $ 0.755 $ 0.755 $ 0.755 $ 0.755
1998
Operating results:
Interest income $ 53,861 $ 53,783 $ 61,558 $ 53,602
Interest expense 46,097 50,169 56,170 43,688
Interest rate agreement expense 1,378 1,624 247 265
Net interest income 6,386 1,990 5,141 9,649
Income (loss) before change in accounting principle 2,450 (491) (37,805) 5,789
Cumulative transition effect of adopting SFAS No. 133 -- -- (10,061) --
Net income (loss) available to common stockholders 2,450 (491) (47,866) 5,789
Per share data:
Income (loss) before change in accounting principle - diluted 0.17 (0.03) (2.85) 0.51
Cumulative transition effect of adopting SFAS No. 133 -- -- (0.76) --
Net income (loss) - diluted 0.17 (0.03) (3.61) 0.51
Dividends declared per common share(a) 0.270 0.010 -- --
Dividends declared per preferred share 0.755 0.755 0.755 0.755
(a) Reflects period for which the common dividend was declared. Reported
dividends may have been declared during the following quarter.
F-22
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Redwood Trust, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of stockholders' equity (deficit) and of
cash flows present fairly, in all material respects, the financial position of
Redwood Trust, Inc. and subsidiary (the Company), at December 31, 1999 and 1998,
and the results of its operations and its cash flows for each of the three years
in the period ended December 31, 1999, in conformity with accounting principles
generally accepted in the United States. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with auditing standards generally
accepted in the United States which require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
In July 1998, the Company adopted Financial Accounting Standards Board Statement
No. 133, Accounting for Derivative Instruments and Hedging Activities. This
change is discussed in Note 2 to the consolidated financial statements.
/s/ PricewaterhouseCoopers L.L.P.
San Francisco, California
February 21, 2000
F-23
RWT HOLDINGS, INC.
CONSOLIDATED FINANCIAL STATEMENTS AND
REPORT OF INDEPENDENT ACCOUNTANTS
For Inclusion in Form 10-K
Annual Report Filed with
Securities and Exchange Commission
December 31, 1999
F-24
RWT HOLDINGS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Consolidated Financial Statements - RWT Holdings, Inc.
Consolidated Balance Sheets at December 31, 1999 and 1998 .................................. F-26
Consolidated Statements of Operations for the year ended December 31, 1999 and for the
period from April 1, 1998 (commencement of operations) to December 31, 1998 ............ F-27
Consolidated Statements of Stockholders' Equity for the year ended December 31, 1999 and
for the period from April 1, 1998 (commencement of operations) to December 31, 1998 .... F-28
Consolidated Statements of Cash Flows for the year ended December 31, 1999 and for the
period from April 1, 1998 (commencement of operations) to December 31, 1998 ............ F-29
Notes to Consolidated Financial Statements ................................................. F-30
Report of Independent Accountants ................................................................ F-36
F-25
RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
December 31,
1999 1998
-------- --------
ASSETS
Mortgage loans: held-for sale
Residential $ 4,399 $ 12,247
Commercial 29,605 --
-------- --------
34,004 12,247
Cash and cash equivalents 1,999 9,711
Restricted cash 50 --
Accrued interest receivable 1,520 78
Property, equipment and leasehold improvements, net 299 622
Other assets 1,081 120
-------- --------
Total Assets $ 38,953 $ 22,778
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term debt $ 22,427 $ --
Loans from Redwood Trust, Inc. 6,500 6,500
Payable to Redwood Trust, Inc. 472 445
Accrued interest payable 831 3
Accrued restructuring charges 4,039 --
Accrued expenses and other liabilities 1,259 554
-------- --------
Total Liabilities 35,528 7,502
-------- --------
Commitments and contingencies (See Note 10)
STOCKHOLDERS' EQUITY
Series A preferred stock, par value $0.01 per share; 10,000 shares
authorized; 5,940 issued and outstanding
($5,940 aggregate liquidation preference) 29,700 19,800
Common stock, par value $0.01 per share;
10,000 shares authorized; 3,000 issued and outstanding -- --
Additional paid-in capital 300 200
Accumulated deficit (26,575) (4,724)
-------- --------
Total Stockholders' Equity 3,425 15,276
-------- --------
Total Liabilities and Stockholders' Equity $ 38,953 $ 22,778
======== ========
The accompanying notes are an integral part of these
consolidated financial statements.
F-26
RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands)
For the period
from April 1, 1998
(commencement of
Year Ended operations) to
December 31, 1999 December 31, 1998
----------------- -----------------
REVENUES
Interest income
Mortgage loans: held-for-sale
Residential $ 1,955 $ 2,803
Commercial 1,555 --
-------- -------
3,510 2,803
Mortgage securities: trading 1,021 --
Cash and cash equivalents 330 350
-------- -------
Total interest income 4,861 3,153
Interest expense
Short-term debt (2,457) (2,503)
Credit support fees (149) (139)
Loans from Redwood Trust, Inc. (1,118) (18)
-------- -------
Total interest expense (3,724) (2,660)
Net interest income 1,137 493
Net unrealized and realized market value gains (losses) (747) 18
Other income 26 --
-------- -------
Net revenues 416 511
EXPENSES
Compensation and benefits (8,414) (3,395)
General and administrative (5,430) (1,840)
Restructuring charge (8,423) --
-------- -------
Total expenses (22,267) (5,235)
NET LOSS $(21,851) $(4,724)
======== =======
The accompanying notes are an integral part of these
consolidated financial statements.
F-27
RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In thousands, except share data)
Series A
Preferred stock Common stock Additional
------------------------------------- paid-in Accumulated
Shares Amount Shares Amount capital deficit Total
- -----------------------------------------------------------------------------------------------------------
Balance, April 1, 1998 -- $ -- -- $-- $ -- $ -- $ --
- -----------------------------------------------------------------------------------------------------------
Comprehensive income:
Net loss -- -- -- -- -- (4,724) (4,724)
Issuance of preferred stock 3,960 19,800 -- -- -- -- 19,800
Issuance of common stock -- -- 2,000 -- 200 -- 200
- -----------------------------------------------------------------------------------------------------------
Balance, December 31, 1998 3,960 19,800 2,000 -- 200 (4,724) 15,276
- -----------------------------------------------------------------------------------------------------------
Comprehensive income:
Net loss -- -- -- -- -- (21,851) (21,851)
Issuance of preferred stock 1,980 9,900 -- -- -- -- 9,900
Issuance of common stock -- -- 1,000 -- 100 -- 100
- -----------------------------------------------------------------------------------------------------------
Balance, December 31, 1999 5,940 $29,700 3,000 $-- $300 $(26,575) $ 3,425
===========================================================================================================
The accompanying notes are an integral part of these
consolidated financial statements.
F-28
RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
For the period
from April 1, 1998
(commencement of
Year Ended operations) to
December 31, 1999 December 31, 1998
----------------- -----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (21,851) $ (4,724)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization 829 27
Net unrealized and realized market value (gains) losses 747 (18)
Write-off of property, equipment and leasehold improvements, net 3,131 --
Purchases of mortgage loans: held for sale (657,295) (543,296)
Proceeds from sales of mortgage loans: held for sale 533,743 525,418
Principal payments on mortgage loans: held for sale 1,614 5,622
Purchases of mortgage securities: trading (4,619) --
Proceeds from sales of mortgage securities: trading 99,488 --
Principal payments on mortgage securities: trading 3,549 --
Increase in accrued interest receivable (1,442) (78)
(Increase) decrease in other assets 54 (55)
Increase in amounts due to Redwood Trust 27 445
Increase in accrued interest payable 828 3
Increase in accrued restructuring charges 4,039 --
Increase in accrued expenses and other liabilities 705 554
--------- ---------
Net cash used in operating activities (36,453) (16,102)
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property, equipment and leasehold improvements, net (3,636) (687)
Net increase in restricted cash (50) --
--------- ---------
Net cash used in investing activities (3,686) (687)
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of short-term debt 22,427 --
Loans from Redwood Trust, Inc. (net of repayments) -- 6,500
Net proceeds from issuance of preferred stock 9,900 19,800
Net proceeds from issuance of common stock 100 200
--------- ---------
Net cash provided by financing activities 32,427 26,500
--------- ---------
Net increase (decrease) in cash and cash equivalents (7,712) 9,711
Cash and cash equivalents at beginning of period 9,711 --
--------- ---------
Cash and cash equivalents at end of period $ 1,999 $ 9,711
========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest expense $ 2,810 $ 2,518
Non-cash transaction:
Securitization of mortgage loans into mortgage securities $ 98,315 $ --
========= =========
The accompanying notes are an integral part of these
consolidated financial statements.
F-29
RWT HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1999
NOTE 1. THE COMPANY
RWT Holdings, Inc. ("Holdings") was incorporated in Delaware on February 13,
1998 and commenced operations on April 1, 1998. Holdings originates and sells
commercial mortgage loans. Redwood Trust, Inc. ("Redwood Trust") owns all of the
preferred stock and has a non-voting, 99% economic interest in Holdings. The
consolidated financial statements include the three subsidiaries of Holdings.
Redwood Commercial Funding, Inc. ("RCF") originates commercial mortgage loans
for sale to institutional investors. Redwood Residential Funding, Inc. ("RRF")
and Redwood Financial Services, Inc. ("RFS") were start-up ventures that ceased
operations in 1999. Holdings and its subsidiaries currently utilize both debt
and equity to finance acquisitions. References to Holdings in the following
footnotes refer to Holdings and its subsidiaries.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of Holdings and its
subsidiaries. All significant intercompany balances and transactions with
Holdings' consolidated subsidiaries have been eliminated.
USE OF ESTIMATES
The preparation of financial statements in conformity with Generally Accepted
Accounting Principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and the disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenue and expenses during the reported period. Actual
results could differ from those estimates. The primary estimates inherent in the
accompanying consolidated financial statements are discussed below.
Fair Value. Management estimates the fair value of its financial instruments
using available market information and other appropriate valuation
methodologies. The fair value of a financial instrument, as defined by Statement
of Financial Accounting Standards ("SFAS") No. 107, Disclosures about Fair Value
of Financial Instruments, is the amount at which the instrument could be
exchanged in a current transaction between willing parties, other than in a
forced liquidation sale. Management's estimates are inherently subjective in
nature and involve matters of uncertainty and judgement to interpret relevant
market and other data. Accordingly, amounts realized in actual sales may differ
from the fair values presented in Note 6.
ADOPTION OF SFAS NO. 133
Holdings adopted SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, effective July 1, 1998. Upon the adoption of SFAS No. 133, Holdings
did not record a transition adjustment, as there were no outstanding derivative
instruments. Immediately after the adoption of SFAS No. 133, Holdings elected to
not seek hedge accounting for any of its derivative financial instruments
employed for hedging activities.
MORTGAGE ASSETS
Holdings' mortgage assets consist of mortgage loans and mortgage securities
("Mortgage Assets"). Interest is recognized as revenue when earned according to
the terms of the loans and when, in the opinion of management, it is
collectible.
Mortgage Loans: Held-for-Sale
Mortgage loans are recorded at the lower of cost or aggregate market value
("LOCOM"). Cost generally consists of the loan principal balance net of any
unamortized premium or discount and net loan origination fees. Interest income
is accrued based on the outstanding principal amount of the mortgage loans and
their contractual terms. Realized and unrealized gains or losses on the loans
are based on the specific identification method and are
F-30
recognized in "Net unrealized and realized market value gains (losses)" on the
Consolidated Statements of Operations.
Some of the mortgage loans purchased by Redwood Trust for which securitization
or sale is contemplated are committed for sale by Redwood Trust to Holdings, or
a subsidiary of Holdings, under a Master Forward Commitment Agreement. As the
forward commitment is entered into on the same date that Redwood Trust commits
to purchase the loans, the price under the forward commitment is the same as the
price Redwood Trust paid for the mortgage loans, as established by the external
market.
Mortgage Securities: Trading
Mortgage securities classified as trading are accounted for in accordance with
SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities.
Accordingly, such securities are recorded at their estimated fair market value.
Unrealized and realized gains and losses on these securities are recognized as a
component of "Net unrealized and realized market value gains (losses)" on the
Consolidated Statements of Operations.
LOAN ORIGINATION FEES
Loan fees, discount points and certain direct origination costs are recorded as
an adjustment to the cost of the loan and are recorded in earnings when the loan
is sold.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand and highly liquid investments
with original maturities of three months or less.
DERIVATIVE FINANCIAL INSTRUMENTS
Holdings utilizes derivative financial instruments to mitigate the risks that a
change in interest rates will result in a change in the value of the Mortgage
Assets. At December 31, 1999, Holdings had entered into forward contracts for
the sale of mortgage loans. Holdings currently designates all derivative
financial instruments as trading instruments. Accordingly, such instruments are
recorded at their estimated fair market value with unrealized and realized gains
and losses on these instruments recognized as a component of "Net unrealized and
realized market value gains (losses)" on the Consolidated Statements of
Operations. During the year ended December 31, 1999, Holdings recognized market
value gains on derivative financial instruments of $1.0 million. There were no
derivative financial instruments outstanding during the period ended December
31, 1998. At December 31, 1999, Holdings had $1 million notional value of
outstanding derivative financial instruments.
INCOME TAXES
Taxable earnings of Holdings are subject to state and federal income taxes at
the applicable statutory rates. Holdings provides for deferred income taxes if
any, to reflect the estimated future tax effects under the provisions of SFAS
No. 109, Accounting for Income Taxes. Under this pronouncement, deferred income
taxes, if any, reflect the estimated future tax effects of temporary differences
between the amount of assets and liabilities for financial reporting purposes
and such amounts as measured by tax laws and regulations.
COMPREHENSIVE INCOME
SFAS No. 130, Reporting Comprehensive Income, requires Holdings to classify
items of "other comprehensive income" by their nature in a financial statement
and display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in capital in the equity section of
the balance sheet. As of December 31, 1999 there was no other comprehensive
income.
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NOTE 3. MORTGAGE ASSETS
At December 31, 1999 and 1998 Mortgage Assets consisted of the following:
MORTGAGE LOANS: HELD-FOR-SALE
(IN THOUSANDS) DECEMBER 31, 1999 DECEMBER 31, 1998
RESIDENTIAL COMMERCIAL TOTAL RESIDENTIAL COMMERCIAL TOTAL
-------------------------------- --------------------------------
Current Face $4,995 $30,324 $35,319 $12,072 -- $12,072
Unamortized Premium (Discount) (596) (719) (1,315) 175 -- 175
-------------------------------- --------------------------------
Carrying Value $4,399 $29,605 $34,004 $12,247 -- $12,247
================================ ================================
For the years ended December 31, 1999 and 1998, Holdings recognized losses of
$1.8 million and $11,118, respectively, as a result of LOCOM adjustments on
mortgage loans held-for-sale. These losses are reflected as a component of "Net
unrealized and realized market value gains (losses)" on the Consolidated
Statements of Operations.
MORTGAGE SECURITIES: TRADING
For the year ended December 31, 1999, Holdings recognized a market value gain of
$0.1 million on mortgage securities classified as trading. This gain is
reflected as a component of "Net unrealized and realized market value gains
(losses)" on the Consolidated Statements of Operations. During the year ended
December 31, 1999, Holdings sold mortgage securities classified as trading for
proceeds of $99.5 million. Holdings did not own any mortgage securities prior to
1999.
NOTE 4. SHORT-TERM DEBT
Holdings has entered into reverse repurchase agreements and other forms of
collateralized short-term borrowings (collectively, "Short-Term Debt") to
finance acquisitions of a portion of its Mortgage Assets. The average balance of
Short-Term Debt outstanding during the years ended December 31, 1999 and 1998
was $42 million and $55 million with a weighted-average borrowing rate of 6.22%
and 6.30%, respectively. The maximum balance outstanding during the years ended
December 31, 1999 and 1998 was $397 million and $367 million, respectively.
In July 1999, Redwood Trust entered into a one-year, $90 million revolving
mortgage warehousing credit facility with two banks. At Redwood Trust's request,
this line was reduced to $20 million in December 1999. The facility is primarily
intended to finance newly originated residential mortgage loans. Holdings may
borrow under this facility as a co-borrower. At December 31, 1999, Holdings had
no outstanding borrowings under this facility. Redwood Trust and Holdings were
in compliance with all material representations, warranties, and covenants under
this credit facility at December 31, 1999, or had obtained the appropriate
waivers.
In July 1999, Redwood Trust entered into a one-year, $350 million master loan
and security agreement with a Wall Street firm. The facility is primarily
intended to finance newly originated commercial and residential mortgage loans.
Holdings may borrow under this facility as a co-borrower. At December 31, 1999,
Holdings had outstanding borrowings of $19.8 million under this facility.
Borrowings under this facility bear interest based on a specified margin over
the London Interbank Offered Rate ("LIBOR"). At December 31, 1999, the
weighted-average borrowing rate under this facility was 7.23%. Redwood Trust and
Holdings were in compliance with all material representations, warranties, and
covenants under this credit facility at December 31, 1999.
Redwood Trust may provide credit support to Holdings to facilitate Holdings'
financings from third-party lenders and/or hedging arrangements with
counterparties. As part of this arrangement, Holdings is authorized as a
co-borrower under some of Redwood Trust's Short-Term Debt agreements subject to
Redwood Trust continuing to
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remain jointly and severally liable for repayment. Accordingly, Holdings pays
Redwood Trust credit support fees on borrowings subject to this arrangement. At
December 31, 1999, Redwood Trust was providing credit support on $22.4 million
of Holdings' Short-Term Debt. No such borrowings were outstanding at December
31, 1998. These expenses are reflected as "Credit support fees" on the
Consolidated Statements of Operations.
NOTE 5. RESTRUCTURING CHARGE
During the year ended December 31, 1999, Holdings recognized $8.4 million in
restructuring charges as a result of the closure of two of its subsidiaries, RRF
and RFS. Restructuring charges were determined in accordance with the provisions
of Staff Accounting Bulletin No. 100 "Restructuring and Impairment Charges",
Emerging Issues Task Force No. 94-3 "Liability Recognition for Certain Employee
Termination Benefits and Other Costs to Exit an Activity", and other relevant
accounting guidance. The restructuring accrual includes costs associated with
existing contractual and lease arrangements at both subsidiaries which have no
future value. In addition, as a result of the closure of the two subsidiaries,
certain assets utilized in these businesses were determined to have little or no
realizable value, resulting in impairment losses. These assets included software
developed for use at RRF and certain fixed assets at both subsidiaries. The
following table provides a summary of the primary components of the
restructuring charge and the associated liability.
TOTAL ESTIMATED TOTAL ACTUAL
(IN THOUSANDS) LIABILITY/IMPAIRMENTS PAYMENTS/CHARGE-OFFS
--------------------- --------------------
Payroll, severance, and termination $3,511 $1,080
benefits
Asset impairments 2,858 2,858
Lease and other commitments 1,314 246
Other 740 200
------ ------
Total $8,423 $4,384
====== ======
The Company expects to pay the majority of the remaining restructuring costs
during the year 2000. The remaining liability for restructuring costs of $4.0
million is reflected as "Accrued restructuring charges" on the Consolidated
Statements of Operations.
NOTE 6. INCOME TAXES
The provision for income taxes for the period from January 1, 1999 through
December 31, 1999 amounted to $3,200 and represents minimum California franchise
taxes. The effective tax rate differs from the statutory federal income tax rate
primarily due to state limitations on recognizing the benefit of net operating
losses (NOL).
At December 31, 1999, Holdings had NOL carryforwards of approximately $21
million for federal tax purposes and $11 million for state income tax purposes.
The federal and state carryforwards expire through 2018 and 2004 respectively.
Due to the uncertainty of realization of the $8 million tax benefit of the NOL,
a valuation allowance of $8 million has been provided to eliminate the deferred
tax assets at December 31, 1999. The increase in the valuation allowance
amounted to $6.1 million for the period ended December 31, 1999.
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NOTE 7. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying values and estimated fair values of
Holdings' financial instruments at December 31, 1999 and 1998.
(IN THOUSANDS) DECEMBER 31, 1999 DECEMBER 31, 1998
CARRYING VALUE FAIR VALUE CARRYING VALUE FAIR VALUE
-------------- ---------- -------------- ----------
Assets
Mortgage loans: held-for-sale
Residential $ 4,399 $ 4,415 $12,247 $12,255
Commercial $29,605 $29,876 -- --
Liabilities
Short-term debt $22,427 $22,427 -- --
Loans from Redwood Trust, Inc. $ 6,500 $ 6,500 $ 6,500 $ 6,500
The carrying amounts of all other balance sheet accounts as reflected in the
financial statements approximate fair value because of the short-term nature of
these accounts.
NOTE 8. STOCKHOLDERS' EQUITY
The authorized capital stock of Holdings consists of Series A Preferred Stock
("Preferred Stock") and Common Stock. Holdings is authorized to issue 10,000
shares of Common Stock, each having a par value of $0.01, and 10,000 shares of
Preferred Stock, each having a par value of $0.01. All voting power is vested in
the common stock.
Holdings has issued a total of 5,940 shares of Preferred Stock to Redwood Trust.
The Preferred Stock entitles Redwood Trust to receive 99% of the aggregate
amount of any such dividends or distributions made by Holdings. The holders of
the Common Stock are entitled to receive the remaining 1% of the aggregate
amount of such dividends or distributions. The Preferred Stock ranks senior to
the Common Stock as to the payment of dividends and liquidation rights. The
liquidation preference entitles the holders of the Preferred Stock to receive
$1,000 per share liquidation preference before any distribution is made on the
Common Stock. After the liquidation preference, the holders of Preferred Stock
are entitled to 99% of any remaining assets.
NOTE 9. RELATED PARTY TRANSACTIONS
PURCHASES AND SALES OF MORTGAGE LOANS
During December 1999, Holdings purchased $390 million of residential mortgage
loans and subsequently sold a participation agreement to Redwood Trust on the
mortgage loans. Pursuant to the terms of the Mortgage Loan Participation
Purchase Agreement, Redwood purchased a 99% interest in the mortgage loans, and
assumes all related risks of ownership. Holdings did not recognize any gain or
loss on this transaction.
During the year ended December 31, 1999, RCF purchased $50 million of commercial
mortgage loans from Redwood Trust. Pursuant to the Master Forward Commitment
Agreement, RCF purchased the mortgage loans from Redwood Trust at the same price
for which Redwood Trust acquired the mortgage loans. There were no such
purchases during the year ended December 31, 1998. At both December 31, 1999 and
1998, under the terms of the Master Forward Commitment Agreement, Redwood Trust
had committed to sell $8 million of commercial mortgage loans to RCF during the
first quarter of 2000 and 1999, respectively.
During the year ended December 31, 1999, RRF purchased $61 million of
residential mortgage loans from Redwood Trust. Pursuant to the Master Forward
Commitment Agreement, RRF purchased the mortgage loans from Redwood Trust at the
same price for which Redwood Trust acquired the mortgage loans. There were no
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such sales during the year ended December 31, 1998. At December 31, 1999, under
the terms of the Master Forward Commitment Agreement, Redwood Trust had
committed to sell $16 million of residential mortgage loans to RRF during the
first and second quarters of 2000. There were no such commitments at December
31, 1998.
OTHER
Under a revolving credit facility arrangement, Redwood Trust may loan funds to
Holdings to finance certain Mortgage Assets owned by Holdings. These loans are
typically unsecured and are repaid within six months. Such loans bear interest
at a rate of 3.5% over LIBOR. At both December 31, 1999 and 1998, Holdings had
borrowed $6.5 million from Redwood Trust in accordance with the provisions of
this arrangement. During the years ended December 31, 1999 and 1998, Holdings
incurred $1.1 million and $18,539, respectively, in interest on loans from
Redwood Trust.
Redwood Trust shares many of the operating expenses of Holdings, including
personnel and related expenses, subject to full reimbursement by Holdings.
During the years ended December 31, 1999 and 1998, $3.0 million and $2.3
million, respectively, of Holdings' operating expenses were paid by Redwood
Trust and were subject to reimbursement by Holdings.
Holdings may borrow under several of Redwood Trust's Short-Term Debt agreements
as a co-borrower (see Note 4). At December 31, 1999, Holdings had borrowings of
$22.4 million subject to this arrangement. No such borrowings were outstanding
at December 31, 1998.
NOTE 10. COMMITMENTS AND CONTINGENCIES
At December 31, 1999, RCF is obligated under non-cancelable operating leases
with expiration dates through 2006. The total future minimum lease payments
under these non-cancelable leases is $419,821 and is expected to be recognized
as follows: 2000- $73,949; 2001 - $85,240; 2002 - $87,472; 2003 - $89,772; 2004
through 2006 - $83,388.
At December 31, 1999, RCF had entered into commitments to purchase $8.4 million
of commercial mortgage loans from Redwood Trust for settlement during the first
quarter of 2000.
At December 31, 1999, RRF had entered into commitments to purchase $16.0 million
of residential mortgage loans from Redwood Trust for settlement during the first
and second quarters of 2000.
F-35
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of RWT Holdings, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of stockholders' equity (deficit) and of
cash flows present fairly, in all material respects, the financial position of
RWT Holdings, Inc. and subsidiaries (the Company), at December 31, 1999 and
1998, and the results of its operations and its cash flows for the year ended
December 31, 1999, and the period from April 1, 1998 (commencement of
operations) to December 31, 1998 in conformity with accounting principles
generally accepted in the United States. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with auditing standards generally
accepted in the United States which require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers L.L.P.
San Francisco, California
February 21, 2000
F-36
REDWOOD TRUST, INC.
INDEX TO EXHIBIT
Sequentially
Exhibit Numbered
Number Page
- ------- ------------
10.14.3 Amended and Restated Executive and Non-Employee
Director Stock Option Plan, amended March 4, 1999
11.1 Computation of Earnings per Share
23 Consent of Accountants
27 Financial Data Schedule