UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 2000
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)
Indicate by check mark whether the Registrant (1) has filed all
documents and reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such
shorter period that the Registrant was required to file such reports), and (2)
has been subject to such filing requirements for the past 90 days.
Yes X No
------ ------
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's
classes of stock, as of the last practicable date.
Class B Preferred Stock ($.01 par value) 902,068 as of August 10, 2000
Common Stock ($.01 par value) 8,789,376 as of August 10, 2000
================================================================================
REDWOOD TRUST, INC.
FORM 10-Q
INDEX
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements - Redwood Trust, Inc
Consolidated Balance Sheets at June 30, 2000 and December 31, 1999 ................... 3
Consolidated Statements of Operations for the three and six months ended
June 30, 2000 and June 30, 1999 .................................................... 4
Consolidated Statements of Stockholders' Equity for the three and six months
ended June 30, 2000 ................................................................ 5
Consolidated Statements of Cash Flows for the three and six months ended
June 30, 2000 and June 30, 1999 .................................................... 6
Notes to Consolidated Financial Statements ........................................... 7
Consolidated Financial Statements - RWT Holdings, Inc.
Consolidated Balance Sheets at June 30, 2000 and December 31, 1999 ................... 20
Consolidated Statements of Operations for the three and six months ended
June 30, 2000 and June 30, 1999 .................................................... 21
Consolidated Statements of Stockholders' Equity for the three and six months
ended June 30, 2000 ................................................................ 22
Consolidated Statements of Cash Flows for the three and six months ended
June 30, 2000 and June 30, 1999 .................................................... 23
Notes to Consolidated Financial Statements ........................................... 24
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations ............................................................................ 30
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ....................................................................... 48
Item 2. Changes in Securities ................................................................... 48
Item 3. Defaults Upon Senior Securities ......................................................... 48
Item 4. Submission of Matters to a Vote of Security Holders ..................................... 48
Item 5. Other Information ....................................................................... 48
Item 6. Exhibits and Reports on Form 8-K ........................................................ 49
SIGNATURES ...................................................................................... 50
2
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
June 30, 2000 December 31, 1999
------------- -----------------
ASSETS (Unaudited)
Mortgage loans
Residential: held-for-investment, net $ 1,259,011 $ 968,709
Residential: held-for-sale 7,769 415,880
Commercial: held-for-sale 9,800 8,437
----------- -----------
1,276,580 1,393,026
Mortgage securities
Residential: trading 883,052 941,781
Residential: available-for-sale, net 58,893 27,999
----------- -----------
941,945 969,780
Cash and cash equivalents 8,910 19,881
Restricted cash 3,621 5,384
Interest rate agreements 1,287 2,037
Accrued interest receivable 16,039 13,244
Principal receivable 5,336 4,599
Investment in RWT Holdings, Inc. 2,291 3,391
Loans to RWT Holdings, Inc. -- 6,500
Receivable from RWT Holdings, Inc. -- 472
Other assets 1,324 1,614
----------- -----------
Total Assets $ 2,257,333 $ 2,419,928
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term debt $ 806,643 $ 1,253,565
Long-term debt, net 1,227,546 945,270
Accrued interest payable 5,982 5,462
Accrued expenses and other liabilities 4,581 2,819
Dividends payable 4,197 2,877
----------- -----------
Total Liabilities 2,048,949 2,209,993
----------- -----------
Commitments and contingencies (See Note 13)
STOCKHOLDERS' EQUITY
Preferred stock, par value $0.01 per share; Class B 9.74% Cumulative
Convertible 902,068 shares authorized, issued and outstanding
($28,645 aggregate liquidation preference) 26,517 26,517
Common stock, par value $0.01 per share;
49,097,932 shares authorized;
8,789,376 and 8,783,341 issued and outstanding 88 88
Additional paid-in capital 242,139 242,094
Accumulated other comprehensive income (4,721) (3,348)
Cumulative earnings 15,871 8,140
Cumulative distributions to stockholders (71,510) (63,556)
----------- -----------
Total Stockholders' Equity 208,384 209,935
----------- -----------
Total Liabilities and Stockholders' Equity $ 2,257,333 $ 2,419,928
=========== ===========
The accompanying notes are an integral part of
these consolidated financial statements.
3
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share data)
(Unaudited)
Three Months Ended June 30, Six Months Ended June 30,
---------------------------- ----------------------------
2000 1999 2000 1999
----------- ------------ ----------- ------------
INTEREST INCOME
Mortgage loans
Residential: held-for-investment $ 22,916 $ 16,545 $ 40,134 $ 32,830
Residential: held-for-sale 217 1,427 6,737 5,714
Commercial: held-for-sale 393 293 604 369
----------- ------------ ----------- ------------
23,526 18,265 47,475 38,913
Mortgage securities
Residential: trading 17,097 16,090 34,157 35,064
Residential: available-for-sale 2,237 859 3,852 1,662
----------- ------------ ----------- ------------
19,334 16,949 38,009 36,726
U.S. Treasury securities: trading -- 380 -- 913
Cash and cash equivalents 276 497 590 1,270
----------- ------------ ----------- ------------
Total interest income 43,136 36,091 86,074 77,822
INTEREST EXPENSE
Short-term debt (13,987) (11,880) (33,151) (26,630)
Long-term debt (20,927) (16,657) (36,286) (35,398)
----------- ------------ ----------- ------------
Total interest expense (34,914) (28,537) (69,437) (62,028)
Net interest rate agreements expense (219) (737) (627) (1,070)
----------- ------------ ----------- ------------
NET INTEREST INCOME 8,003 6,817 16,010 14,724
Net unrealized and realized market
value gains (losses)
Loans and securities (856) (1,008) (1,933) 1,982
Interest rate agreements (503) 2,421 (650) 1,600
----------- ------------ ----------- ------------
(1,359) 1,413 (2,583) 3,582
Provision for credit losses (128) (371) (247) (716)
----------- ------------ ----------- ------------
NET REVENUES 6,516 7,859 13,180 17,590
Operating expenses (2,239) (939) (4,386) (1,653)
Other income 21 33 36 41
Equity in earnings (losses) of
RWT Holdings, Inc. (531) (3,757) (1,099) (6,241)
----------- ------------ ----------- ------------
Net income before preferred dividend 3,767 3,196 7,731 9,737
Less cash dividends on Class B
preferred stock (681) (687) (1,362) (1,374)
----------- ------------ ----------- ------------
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS $ 3,086 $ 2,509 $ 6,369 $ 8,363
=========== ============ =========== ============
EARNINGS PER SHARE:
Basic $ 0.35 $ 0.25 $ 0.72 $ 0.80
Diluted $ 0.35 $ 0.25 $ 0.72 $ 0.79
Weighted average shares of common stock and
common stock equivalents:
Basic 8,789,376 10,051,565 8,787,197 10,412,855
Diluted 8,883,651 10,172,960 8,862,505 10,523,329
The accompanying notes are an integral part of
these consolidated financial statements.
4
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In thousands, except share data)
(Unaudited)
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, 1999 902,068 $26,517 8,783,341 $88 $242,094 $(3,348) $ 8,140 $(63,556) $ 209,935
------- ------- --------- --- -------- ------- ------- -------- ---------
Comprehensive income:
Net income before
preferred dividend -- -- -- -- -- -- 3,964 -- 3,964
Net unrealized loss
on assets available-
for-sale -- -- -- -- -- (487) -- -- (487)
---------
Total comprehensive
income -- -- -- -- -- -- -- -- 3,477
Issuance of common stock -- -- 6,035 -- 45 -- -- -- 45
Dividends declared:
Preferred -- -- -- -- -- -- -- (681) (681)
Common -- -- -- -- -- -- -- (3,076) (3,076)
------- ------- --------- --- -------- ------- ------- -------- ---------
Balance, March 31, 2000 902,068 $26,517 8,789,376 $88 $242,139 $(3,835) $12,104 $(67,313) $ 209,700
------- ------- --------- --- -------- ------- ------- -------- ---------
Comprehensive income:
Net income before
preferred dividend -- -- -- -- -- -- 3,767 -- 3,767
Net unrealized loss
on assets available-
for-sale -- -- -- -- -- (886) -- -- (886)
---------
Total comprehensive
income -- -- -- -- -- -- -- -- 2,881
Dividends declared:
Preferred -- -- -- -- -- -- -- (681) (681)
Common -- -- -- -- -- -- -- (3,516) (3,516)
------- ------- --------- --- -------- ------- ------- -------- ---------
Balance, June 30, 2000 902,068 $26,517 8,789,376 $88 $242,139 $(4,721) $15,871 $(71,510) $ 208,384
======= ======= ========= === ======== ======= ======= ======== =========
The accompanying notes are an integral part of
these consolidated financial statements.
5
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Three Months Six Months
Ended June 30, Ended June 30,
------------------------- -------------------------
2000 1999 2000 1999
---------- ---------- ---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income before preferred dividend $ 3,768 $ 3,196 $ 7,732 $ 9,737
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 457 1,868 1,588 4,389
Provision for credit losses 128 371 247 716
Equity in (earnings) losses of RWT Holdings, Inc. 531 3,757 1,099 6,241
Net unrealized and realized market value (gains) losses 1,359 (1,413) 2,583 (3,582)
Purchases of mortgage loans: held-for-sale (9,800) (65,343) (35,534) (71,755)
Proceeds from sales of mortgage loans: held-for-sale 17,298 7,509 422,914 50,138
Principal payments on mortgage loans: held-for-sale 4,906 19,990 19,193 55,239
Purchases of mortgage securities: trading (14,286) (3,725) (179,550) (3,725)
Proceeds from sales of mortgage securities: trading 27,937 7,668 77,309 7,668
Principal payments on mortgage securities: trading 101,730 143,831 158,519 307,377
Purchases of U.S. Treasury securities: trading -- -- -- (45,844)
Proceeds from sales of U.S. Treasury securities: trading -- 32,077 -- 90,519
(Purchases) sales of interest rate agreements (1,002) 897 (885) 488
(Increase) decrease in accrued interest receivable (1,119) 2,460 (2,795) 5,530
(Increase) decrease in principal receivable 101 2,198 (737) 7,600
(Increase) decrease in other assets 2,051 906 155 (81)
Increase (decrease) in accrued interest payable 267 (409) 520 (5,534)
Increase (decrease) in accrued expenses and other liabilities 1,311 1,222 1,762 (189)
---------- ---------- ---------- ----------
Net cash provided by operating activities 135,637 157,060 474,120 414,932
---------- ---------- ---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of mortgage loans: held-for-investment -- -- (384,328) --
Principal payments on mortgage loans: held-for-investment 56,827 84,487 92,703 191,849
Purchases of mortgage securities: available-for-sale (22,475) (934) (31,626) (934)
Principal payments on mortgage securities: available-for-sale 343 62 649 154
Net (increase) decrease in restricted cash (1,176) 2,944 1,763 4,310
Investment in RWT Holdings, Inc., net of dividends received -- (9,900) -- (9,900)
(Loans) to RWT Holdings, Inc., net of repayments 1,400 11,700 6,500 4,500
(Increase) decrease in receivable from RWT Holdings, Inc. 573 (67) 472 236
---------- ---------- ---------- ----------
Net cash provided by (used in) investing activities 35,492 88,292 (313,867) 190,215
---------- ---------- ---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net repayments on short-term debt (115,762) (110,897) (446,922) (334,825)
Proceeds (costs) from issuance of long-term debt -- (337) 375,844 (337)
Repayments on long-term debt (55,239) (103,570) (93,557) (237,706)
Net proceeds from issuance of common stock -- -- 45 1
Repurchases of common stock -- (3,997) -- (20,032)
Dividends paid (3,757) (687) (6,634) (1,373)
---------- ---------- ---------- ----------
Net cash used in financing activities (174,758) (219,488) (171,224) (594,272)
---------- ---------- ---------- ----------
Net increase (decrease) in cash and cash equivalents (3,629) 25,864 (10,971) 10,875
Cash and cash equivalents at beginning of period 12,539 40,638 19,881 55,627
---------- ---------- ---------- ----------
Cash and cash equivalents at end of period $ 8,910 $ 66,502 $ 8,910 $ 66,502
========== ========== ========== ==========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 34,647 $ 28,946 $ 68,917 $ 67,562
========== ========== ========== ==========
The accompanying notes are an integral part of
these consolidated financial statements.
6
REDWOOD TRUST, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2000
(UNAUDITED)
NOTE 1. THE COMPANY
Redwood Trust, Inc. ("Redwood Trust") was incorporated in Maryland on April 11,
1994 and commenced operations on August 19, 1994. During 1997, Redwood Trust
formed Sequoia Mortgage Funding Corporation ("Sequoia"), a special-purpose
finance subsidiary. Redwood Trust acquired an equity interest in RWT Holdings,
Inc. ("Holdings"), a taxable affiliate of Redwood Trust, during the first
quarter of 1998. For financial reporting purposes, references to the "Company"
mean Redwood Trust, Sequoia, and Redwood Trust's equity interest in Holdings.
Redwood Trust, together with its affiliates, is a real estate finance company
specializing in the mortgage portfolio spread lending business. The Company's
primary activity is the acquisition, financing, structuring, and management of
high-quality residential mortgage loans with funds raised through long-term debt
issuance. The Company also acquires, finances, and manages residential mortgage
securities and originates, sells, finances and manages commercial mortgage
loans.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying interim consolidated financial statements are unaudited. In the
opinion of management, all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation have been included. Operating
results for the quarter ended June 30, 2000 are not necessarily indicative of
the results that may be expected for the year ending December 31, 2000. The
accompanying consolidated financial statements should be read in conjunction
with the consolidated financial statements and related notes included in the
Company's Annual Report on Form 10-K for the year ended December 31, 1999.
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 2000 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
7
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 loan portfolio. The reserve is based
upon management's assessment of various factors affecting its mortgage loans,
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.
MORTGAGE ASSETS
The Company's 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 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-Investment
All of the assets of Sequoia that are pledged or subordinated to support the
Long-Term Debt are classified as held-for-investment. Mortgage loans classified
as 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 Loans: Held-for-Sale
The Company classifies certain short-funded mortgage loans as held-for-sale.
These mortgage loans are carried at the lower of original cost or 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 which Holdings will pay to purchase the loans
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 Securities: Trading
The Company classifies all of its mortgage securities with a rating of AA or
higher as 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.
8
Mortgage Securities: Available-for-Sale
The Company classifies all mortgage securities rated A or lower as
available-for-sale. 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.
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.
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
9
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 PER SHARE
Net income per share for the three and six months ended June 30, 2000 and 1999
is shown in accordance with SFAS No. 128, Earnings Per Share. Basic net income
per share is computed by dividing net income available to common stockholders by
the weighted average number of common shares outstanding during the period.
Diluted net income per share is computed by dividing the net income available to
common stockholders by the weighted average number of common shares and common
equivalent shares outstanding during the period. The common equivalent shares
are calculated using the treasury stock method, which assumes that all dilutive
common stock equivalents are exercised and the funds generated by the exercise
are used to buy back outstanding common stock at the average market price during
the reporting period.
The following tables provide reconciliations of the numerators and denominators
of the basic and diluted net income per share computations.
(IN THOUSANDS, EXCEPT SHARE DATA) THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
2000 1999 2000 1999
---------- ------------ ------------ ------------
NUMERATOR:
Numerator for basic and diluted earnings per share--
Net income before preferred dividend $ 3,768 $ 3,196 $ 7,732 $ 9,737
Cash dividends on Class B preferred stock (681) (687) (1,362) (1,374)
---------- ------------ ------------ ------------
Basic and Diluted EPS - Net income
available to common stockholders $ 3,087 $ 2,509 $ 6,370 $ 8,363
========== ============ ============ ============
DENOMINATOR:
Denominator for basic earnings per share--
Weighted average number of common shares
outstanding during the period 8,789,376 10,051,565 8,787,197 10,412,855
Net effect of dilutive stock options 94,275 121,395 75,308 110,474
---------- ------------ ------------ ------------
Denominator for diluted earnings per share-- 8,883,651 10,172,960 8,862,505 10,523,329
========== ============ ============ ============
Net income per share - basic $ 0.35 $ 0.25 $ 0.72 $ 0.80
========== ============ ============ ============
============
Net income per share - diluted $ 0.35 $ 0.25 $ 0.72 $ 0.79
========== ============ ============ ============
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
10
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 June 30, 2000 and December 31,
1999, the only component of Accumulated Other Comprehensive Income was net
unrealized gains and losses on assets available-for-sale.
RECENT ACCOUNTING PRONOUNCEMENT
During March 2000, the Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. 44, Accounting for Certain Transactions involving Stock
Compensation - an interpretation of APB Opinion No. 25 ("FIN 44"). FIN 44
clarifies the application of APB Opinion No. 25 by expanding upon a number of
issues not specifically addressed in the Opinion such as the definition of an
employee for purposes of applying APB Opinion No. 25 and the accounting for
modifications to a previously fixed stock option award. FIN 44 is effective July
1, 2000. The impact on the Company of adopting FIN 44 is not expected to have a
material effect on the operations of the Company.
NOTE 3. MORTGAGE ASSETS
At June 30, 2000 and December 31, 1999, 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 June 30, 2000 and December 31, 1999, the annualized effective yield after
taking into account the amortization expense due to prepayments on the Mortgage
Assets was 7.62% and 7.00%, respectively, based on the reported cost of the
assets. At June 30, 2000, 81% of the Mortgage Assets owned by the Company were
adjustable-rate mortgages, 16% were hybrid mortgages, and 3% were fixed-rate
mortgages. 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 both June 30, 2000 and December 31, 1999, the coupons
on 61% 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). The majority of the coupons on the adjustable-rate and
hybrid Mortgage Assets owned by the Company are limited by lifetime caps. At
June 30, 2000 and December 31, 1999, the weighted average lifetime cap on the
adjustable-rate Mortgage Assets was 11.74% and 11.64%, respectively.
At June 30, 2000 and December 31, 1999, Mortgage Assets consisted of the
following:
MORTGAGE LOANS: RESIDENTIAL
JUNE 30, DECEMBER 31,
2000 1999
HELD-FOR- HELD-FOR- HELD-FOR- HELD-FOR-
(IN THOUSANDS) INVESTMENT SALE TOTAL INVESTMENT SALE TOTAL
----------- ------------- ----------- ----------- ------------ -----------
Current Face $ 1,249,123 $ 7,985 $ 1,257,108 $ 960,928 $ 412,456 $ 1,373,384
Unamortized Discount -- (216) (216) -- (305) (305)
Unamortized Premium 15,230 -- 15,230 12,906 3,729 16,635
----------- ----------- ----------- ----------- ----------- -----------
Amortized Cost 1,264,353 7,769 1,272,122 973,834 415,880 1,389,714
Reserve for Credit Losses (5,342) -- (5,342) (5,125) -- (5,125)
----------- ----------- ----------- ----------- ----------- -----------
Carrying Value $ 1,259,011 $ 7,769 $ 1,266,780 $ 968,709 $ 415,880 $ 1,384,589
=========== =========== =========== =========== =========== ===========
11
The Company recognized gains of $0.1 million and losses of $0.1 million during
the three and six months ended June 30, 2000, respectively, as a result of LOCOM
adjustments on residential mortgage loans held-for-sale. During both the three
and six months ended June 30, 1999, the Company recognized gains of $0.1 million
as a result of LOCOM adjustments on residential mortgage loans held-for-sale.
The LOCOM adjustments are reflected as a component of "Net unrealized and
realized market value gains (losses)" on the Consolidated Statements of
Operations. During the six months ended June 30, 2000, the Company sold to
Holdings a $380.5 million participation agreement on residential mortgage loans
for proceeds of $380.5 million (see Note 12). Additionally, during the three and
six months ended June 30, 2000, the Company sold residential mortgage loans to
Redwood Residential Funding ("RRF"), a subsidiary of Holdings, for proceeds of
$0.4 million and $17.1 million, respectively. Pursuant to the terms of the
Master Forward Commitment Agreement, the mortgage loans were sold to RRF at the
same price for which the Company acquired the mortgage loans (see Note 12).
Accordingly, there were no LOCOM adjustments or gains on sales related to the
RRF sales transactions. During the three and six months ended June 30, 1999, the
Company sold residential mortgage loans held-for-sale for proceeds of $7.5
million and $50.1 million, respectively.
There were no sales of residential mortgage loans held-for-investment during the
three and six months ended June 30, 2000 and 1999.
MORTGAGE LOANS: COMMERCIAL
JUNE 30, 2000 DECEMBER 31, 1999
(IN THOUSANDS) HELD-FOR-SALE HELD-FOR-SALE
------------- -----------------
Current Face $ 9,800 $ 8,450
Unamortized Discount -- (13)
------- -------
Carrying Value $ 9,800 $ 8,437
======= =======
During the three and six months ended June 30, 2000, the Company sold commercial
mortgage loans to Redwood Commercial Funding ("RCF"), a subsidiary of Holdings,
for proceeds of $16.9 million and $25.3 million, respectively. To date, pursuant
to the Master Forward Commitment Agreement, all commercial mortgage loans
purchased or originated by the Company are sold to RCF at the same price for
which the Company acquires or originates the commercial mortgage loans (see Note
12). Accordingly, there are no LOCOM adjustments or gains on sales related to
commercial mortgage loans.
MORTGAGE SECURITIES: RESIDENTIAL
MARCH 31, DECEMBER 31,
2000 1999
AVAILABLE- AVAILABLE-
(IN THOUSANDS) TRADING FOR-SALE TOTAL TRADING FOR-SALE TOTAL
--------- --------- --------- --------- ------------- ---------
Current Face $ 874,653 $ 95,631 $ 970,284 $ 934,360 $ 48,620 $ 982,980
Unamortized Discount (1,750) (31,428) (33,178) (3,548) (16,444) (19,992)
Unamortized Premium 10,149 -- 10,149 10,969 -- 10,969
--------- --------- --------- --------- --------- ---------
Amortized Cost 883,052 64,203 947,255 941,781 32,176 973,957
Reserve for Credit Losses -- (589) (589) -- (829) (829)
Gross Unrealized Gains -- 420 420 -- 166 166
Gross Unrealized Losses -- (5,141) (5,141) -- (3,514) (3,514)
--------- --------- --------- --------- --------- ---------
Carrying Value $ 883,052 $ 58,893 $ 941,945 $ 941,781 $ 27,999 $ 969,780
========= ========= ========= ========= ========= =========
Agency $ 618,964 -- $ 618,964 $ 576,480 -- $ 576,480
Non-Agency 264,088 $ 58,893 322,981 365,301 $ 27,999 393,300
--------- --------- --------- --------- --------- ---------
Carrying Value $ 883,052 $ 58,893 $ 941,945 $ 941,781 $ 27,999 $ 969,780
========= ========= ========= ========= ========= =========
12
For the three and six months ended June 30, 2000, the Company recognized market
value losses of $0.9 million and $1.8 million on mortgage securities classified
as trading, respectively. During the three and six months ended June 30, 1999,
the Company recognized market value gains of $0.3 million and $5.1 million on
mortgage securities classified as trading, respectively. The market value
adjustments are reflected as a component of "Net unrealized and realized market
value gains (losses)" on the Consolidated Statements of Operations. The Company
sold mortgage securities classified as trading for proceeds of $27.9 million and
$77.3 million during the three and six months ended June 30, 2000, respectively.
During both the three and six months ended June 30, 1999, the Company sold
mortgage securities classified as trading for proceeds of $7.7 million.
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:
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
(IN THOUSANDS) 2000 1999 2000 1999
------- ------- ------- -------
Balance at beginning of period $ 5,930 $ 5,197 $ 5,954 $ 4,973
Provision for credit losses 128 371 247 716
Charge-offs (127) (74) (270) (195)
------- ------- ------- -------
Balance at end of period $ 5,931 $ 5,494 $ 5,931 $ 5,494
======= ======= ======= =======
NOTE 5. U.S. TREASURY SECURITIES
The Company did not hold any U.S. Treasury securities at June 30, 2000 or
December 31, 1999. During the three and six months ended June 30, 1999, the
Company recognized market value losses of $1.4 million and $3.3 million on U.S.
Treasury securities and sold U.S. Treasury securities for proceeds of $32.1
million and $90.5 million, respectively. The 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 ("Bond Collateral") in order to secure the
Long-Term Debt issued in the form of collateralized mortgage bonds. 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.
The components of the Bond Collateral are summarized as follows:
(IN THOUSANDS) JUNE 30, 2000 DECEMBER 31, 1999
------------- -----------------
Mortgage loans
Residential: held-for-investment, net $1,259,011 $ 968,709
Restricted cash 3,154 4,791
Accrued interest receivable 7,740 5,633
---------- ----------
$1,269,905 $ 979,133
========== ==========
For presentation purposes, the various components of the Bond Collateral
summarized above are reflected in their corresponding line items on the
Consolidated Balance Sheets.
13
NOTE 7. INTEREST RATE AGREEMENTS
At June 30, 2000 and December 31, 1999, all of the Company's Interest Rate
Agreements were classified as trading, and therefore, reported at fair value.
For the three and six months ended June 30, 2000, the Company recognized market
value losses of $0.5 million and $0.7 million on Interest Rate Agreements
classified as trading, respectively. During the three and six months ended June
30, 1999, the Company recognized market value gains of $2.4 million and $1.6
million on Interest Rate Agreements classified as trading, respectively. The
market value gains and losses are 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) JUNE 30, 2000 DECEMBER 31, 1999 JUNE 30, 2000 DECEMBER 31, 1999
------------- ----------------- ------------- -----------------
Interest Rate Options
Purchased $1,995,300 $2,960,900 -- --
Sold 25,000 -- -- --
Interest Rate Swaps 15,000 250,000 $ 2,213 $ 2,632
Interest Rate Futures and Forwards
Sold 685,000 630,000 467 593
---------- ---------- ---------- ----------
Total $2,720,300 $3,840,900 $ 2,680 $ 3,225
========== ========== ========== ==========
(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 (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
14
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 June 30, 2000, the Company had $0.8 billion of Short-Term Debt outstanding
with a weighted-average borrowing rate of 6.49% and a weighted-average remaining
maturity of 102 days. This debt was collateralized with $0.8 billion of 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 June 30, 2000 and December 31, 1999, the Short-Term Debt had the following
remaining maturities:
(IN THOUSANDS) JUNE 30, 2000 DECEMBER 31, 1999
------------- -----------------
Within 30 days $ 373,280 $ 163,394
30 to 90 days 243,870 385,729
Over 90 days 189,493 704,442
---------- ----------
Total Short-Term Debt $ 806,643 $1,253,565
========== ==========
For the three and six months ended June 30, 2000, the average balance of
Short-Term Debt was $0.9 billion and $1.0 billion with a weighted-average
interest cost of 6.47% and 6.34%, respectively. For the three and six months
ended June 30, 1999, the average balance of Short-Term Debt was $0.9 billion and
$1.0 billion with a weighted-average interest cost of 5.07% and 5.10%,
respectively. The maximum balance outstanding during both the six months ended
June 30, 2000 and 1999 was $1.3 billion.
15
NOTE 9. LONG-TERM DEBT
Long-Term Debt in the form of collateralized mortgage bonds is secured primarily
by a pledge of residential mortgage loans (see Note 6). As required by the
indentures relating to the Long-Term Debt, the mortgage loans are held in the
custody of trustees. The trustees collect principal and interest payments on the
mortgage loans and make corresponding principal and interest payments on the
Long-Term Debt. The obligations under the Long-Term Debt are payable solely from
the mortgage loans 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 mortgage loans. 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.
The components of the Long-Term Debt at June 30, 2000 and December 31, 1999
along with selected other information are summarized below:
(IN THOUSANDS) JUNE 30, 2000 DECEMBER 31, 1999
------------- -----------------
Long-Term Debt $ 1,227,787 $ 944,225
Unamortized premium on Long-Term Debt 3,448 3,881
Deferred bond issuance costs (3,689) (2,836)
----------- -----------
Total Long-Term Debt $ 1,227,546 $ 945,270
=========== ===========
Range of weighted-average coupon rates, by series 6.40% to 7.06% 6.21% to 6.88%
Stated maturities 2017 - 2029 2017 - 2029
Number of series 4 3
For the three and six months ended June 30, 2000, 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 6.65% and 6.51%,
respectively. The average effective interest cost for the three and six months
ended June 30, 1999 was 5.96% and 6.00%, respectively. At June 30, 2000 and
December 31, 1999, accrued interest payable on Long-Term Debt was $3.4 million
and $3.0 million, respectively, and is reflected as a component of Accrued
Interest Payable on the Consolidated Balance Sheets.
NOTE 10. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying values and estimated fair values of
the Company's financial instruments.
(IN THOUSANDS) JUNE 30, 2000 DECEMBER 31, 1999
-------------------------------- --------------------------------
CARRYING VALUE FAIR VALUE CARRYING VALUE FAIR VALUE
-------------- ---------- -------------- ----------
Assets
Mortgage Loans
Residential: held-for-investment, net $1,259,011 $1,241,469 $ 968,709 $ 955,653
Residential: held-for-sale $ 7,769 $ 7,769 $ 415,880 $ 415,880
Commercial: held-for-sale $ 9,800 $ 9,800 $ 8,437 $ 8,437
Mortgage Securities
Residential: trading $ 883,052 $ 883,052 $ 941,781 $ 941,781
Residential: available-for-sale, net $ 58,893 $ 58,893 $ 27,999 $ 27,999
Interest Rate Agreements $ 1,287 $ 1,287 $ 2,037 $ 2,037
Investment in RWT Holdings, Inc. $ 2,291 $ 2,841 $ 3,391 $ 3,675
Liabilities
Long-Term Debt $1,227,546 $1,211,447 $ 945,270 $ 928,449
16
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. In the event of a liquidation or dissolution of the Company,
the liquidation preference entitles the holders of the Preferred Stock to
receive $31.00 per share plus any accrued dividends before any distribution is
made on the Common Stock. As of June 30, 2000 and December 31, 1999, 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. There were no preferred stock
repurchases during the three and six months ended June 30, 2000 and 1999. At
June 30, 2000 and December 31, 1999, there were 142,550 shares available for
repurchase. At June 30, 2000 and December 31, 1999 there were 902,068 preferred
shares outstanding.
STOCK OPTION PLAN
The Company has adopted a Stock Option Plan for executive officers, employees,
and non-employee directors (the "Plan"). The Plan authorizes the Board of
Directors (or a committee appointed by the Board of Directors) to grant
"incentive stock options" as defined under Section 422 of the Code ("ISOs"),
options not so qualified ("NQSOs"), deferred stock, restricted stock,
performance shares, stock appreciation rights, limited stock appreciation rights
("Awards"), and dividend equivalent rights ("DERs") to such eligible recipients
other than non-employee directors. Non-employee directors are automatically
provided annual grants of NQSOs with DERs pursuant to a formula under the Plan.
The number of shares of Common Stock available under the Plan for options and
Awards, subject to certain anti-dilution provisions, is 15% of the Company's
total outstanding shares of Common Stock. The total outstanding shares are
determined as the highest number of shares outstanding prior to any stock
repurchases. At June 30, 2000 and December 31, 1999, 506,203 and 283,975 shares
of Common Stock, respectively, were available for grant. Of the shares of Common
Stock available for grant, no more than 500,000 shares of Common Stock shall be
cumulatively available for grant as ISOs. At June 30, 2000 and December 31,
1999, 353,110 and 389,942 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 both the three and six months ended June 30, 2000, the stock DERs accrued on
NQSOs that had a stock DER feature resulted in charges to operating expenses of
approximately $0.1 million. For both the three and six months ended June 30,
1999, the stock DERs accrued on NQSOs resulted in a credit to operating expenses
of $0.1 million.
17
A summary of the status of the Company's Plan as of June 30, 2000 and changes
during the periods ending on that date is presented below.
THREE MONTHS ENDED SIX MONTHS ENDED
-------------------------------- ------------------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
EXERCISE EXERCISE
(IN THOUSANDS, EXCEPT SHARE DATA) SHARES PRICE SHARES PRICE
--------- -------------- --------- ----------
Outstanding options at beginning of period 1,578,132 $ 22.66 1,713,836 $ 21.97
Options granted 17,000 $ 14.19 28,000 $ 13.55
Options exercised -- -- (6,035) $ 3.02
Options canceled (113,936) $ 21.94 (258,161) $ 17.22
Stock dividend equivalent rights earned 4,377 -- 7,933 --
---------- ----------
Outstanding options at end of period 1,485,573 $ 22.60 1,485,573 $ 22.60
========== ==========
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. At June 30, 2000
and December 31, 1999, there were 1,000,000 shares authorized and remaining 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 the three and six months ended June 30, 2000, the Company sold $16.9
million and $25.3 million of commercial mortgage loans to RCF, respectively. For
the three and six months ended June 30, 1999, the Company sold $0 million and $8
million of commercial mortgage loans to RCF, respectively. 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. At June 30,
2000, under the terms of the Master Forward Commitment Agreement, the Company
had committed to sell $9.8 million of commercial mortgage loans to RCF for
settlement during the third quarter of 2000.
During the three and six months ended June 30, 2000, the Company sold $0.4
million and $17.1 million of residential mortgage loans, respectively, 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 three and six months ended June 30, 1999. As RRF ceased
operations in 1999, there were no remaining outstanding commitments at June 30,
2000.
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 Participation Purchase
Agreement, the Company purchased a 99% interest in the mortgage loans, and
assumed all related risks of ownership. Holdings did not recognize any gain or
loss on this transaction. During March 2000, the Company sold the participation
agreement back to Holdings for proceeds of $380.5 million. Holdings
simultaneously sold $384 million of residential mortgage loans to Sequoia for
proceeds of $384 million. Sequoia pledged these loans as collateral for a new
issue of Long-Term Debt.
OTHER
Under a revolving credit facility arrangement, the Company may loan funds to
Holdings to finance Holdings' operations. These loans are unsecured,
subordinated, and are repaid within six months. Such loans bear interest at a
rate of 3.50% over the LIBOR interest rate. There were no outstanding loans to
Holdings at June 30, 2000. At December 31, 1999, the Company had loaned $6.5
million to Holdings in accordance with the provisions of this arrangement.
During both the three and six months ended June 30, 2000, the Company earned
$0.1 million
18
in interest on loans to Holdings. The Company earned $0.2 million and $0.4
million in interest on loans to Holdings during the three and six months ended
June 30, 1999, respectively.
The Company shares many of the operating expenses of Holdings, including
personnel and related expenses, subject to full reimbursement by Holdings.
During both the three and six months ended June 30, 2000, $0.1 million of
Holdings' operating expenses were paid by the Company, and were subject to
reimbursement by Holdings. During the three and six months ended June 30, 1999,
the Company paid $0.8 million and $1.5 million of Holdings' operating expenses,
respectively.
The Company may provide credit support to Holdings to facilitate Holdings'
financings from third-party lenders. As part of this arrangement, Holdings is
authorized as a co-borrower under some of the Company's Short-Term Debt
agreements subject to the Company continuing to remain jointly and severally
liable for repayment. Accordingly, Holdings pays the Company credit support fees
on borrowings subject to this arrangement. At June 30, 2000 and December 31,
1999, the Company was providing credit support on $41.6 million and $22.4
million of Holdings' Short-Term Debt. During both the three and six months ended
June 30, 2000 and 1999, the Company recognized approximately $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 June 30, 2000, the Company had entered into commitments to sell $9.8 million
of commercial mortgage loans to RCF for settlement during the third quarter of
2000.
At June 30, 2000, 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 $439,405 and is expected to be recognized
as follows: 2000 - $170,402; 2001 - $171,856; 2002 - $53,546; 2003 - $43,601.
NOTE 14. SUBSEQUENT EVENT
On August 10, 2000, the Company declared a $0.755 per share preferred stock
dividend and a $0.42 per share common stock dividend for the third quarter ended
September 30, 2000. The dividends are payable on October 23, 2000 to
shareholders of record on September 29, 2000.
19
RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
June 30, 2000 December 31, 1999
------------- -----------------
(Unaudited)
ASSETS
Mortgage loans: held-for sale
Commercial $ 42,482 $ 29,605
Residential -- 4,399
-------- --------
42,482 34,004
Cash and cash equivalents 2,655 1,999
Restricted cash 1,813 50
Accrued interest receivable 273 1,520
Property, equipment and leasehold improvements, net 93 299
Other assets 112 1,081
-------- --------
Total Assets $ 47,428 $ 38,953
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term debt $ 41,634 $ 22,427
Loans from Redwood Trust, Inc. -- 6,500
Payable to Redwood Trust, Inc. -- 472
Accrued interest payable 286 831
Accrued restructuring charges 1,126 4,039
Accrued expenses and other liabilities 2,067 1,259
-------- --------
Total Liabilities 45,113 35,528
-------- --------
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 29,700
Common stock, par value $0.01 per share;
10,000 shares authorized; 3,000 issued and outstanding -- --
Additional paid-in capital 300 300
Accumulated deficit (27,685) (26,575)
-------- --------
Total Stockholders' Equity 2,315 3,425
-------- --------
Total Liabilities and Stockholders' Equity $ 47,428 $ 38,953
======== ========
The accompanying notes are an integral part of
these consolidated finanical statements.
20
RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands)
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
--------------------- -----------------------
2000 1999 2000 1999
------ -------- -------- --------
REVENUES
Interest income
Mortgage loans: held-for-sale
Commercial $ 637 $ 197 $ 1,137 $ 323
Residential -- 253 67 307
------ -------- -------- --------
637 450 1,204 630
Mortgage securities: trading -- 447 -- 654
Cash and cash equivalents 49 107 81 216
------ -------- -------- --------
Total interest income 686 1,004 1,285 1,500
Interest expense
Short-term debt (496) (497) (796) (604)
Credit support fees (21) (33) (36) (41)
Loans from Redwood Trust, Inc. (16) (196) (105) (355)
------ -------- -------- --------
Total interest expense (533) (726) (937) (1,000)
Net interest income 153 278 348 500
Net unrealized and realized market
value gains (losses) (99) 137 (7) 614
Other income (expense) -- (8) -- 48
------ -------- -------- --------
Net revenues 54 407 341 1,162
EXPENSES
Compensation and benefits (395) (2,553) (980) (4,812)
General and administrative (195) (1,649) (471) (2,655)
------ -------- -------- --------
Total expenses (590) (4,202) (1,451) (7,467)
------ -------- -------- --------
NET LOSS $ (536) $ (3,795) $ (1,110) $ (6,305)
====== ======== ======== ========
The accompanying notes are an integral part of
these consolidated finanical statements.
21
RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In thousands, except share data)
(Unaudited)
Series A
Preferred stock Common stock Additional
--------------------- ------------------- paid-in Accumulated
Shares Amount Shares Amount capital deficit Total
------ ------- ------ ------ ---------- ----------- -------
Balance, December 31, 1999 5,940 $29,700 3,000 $ -- $300 $(26,575) $ 3,425
----- ------- ----- ---- ---- -------- -------
Comprehensive income:
Net loss -- -- -- -- -- (574) (574)
----- ------- ----- ---- ---- -------- -------
Balance, March 31, 2000 5,940 $29,700 3,000 $ -- $300 $(27,149) $ 2,851
----- ------- ----- ---- ---- -------- -------
Comprehensive income:
Net loss -- -- -- -- -- (536) (536)
----- ------- ----- ---- ---- -------- -------
Balance, June 30, 2000 5,940 $29,700 3,000 $ -- $300 $(27,685) $ 2,315
===== ======= ===== ==== ==== ======== =======
The accompanying notes are an integral part of
these consolidated finanical statements.
22
RWT HOLDINGS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- -------------------------
2000 1999 2000 1999
-------- -------- --------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (536) $ (3,795) $ (1,110) $ (6,305)
Adjustments to reconcile net loss to net cash used
in operating activities:
Depreciation and amortization 9 93 17 196
Net unrealized and realized market value (gains) losses 99 (137) 7 (615)
Purchases of mortgage loans: held for sale (31,255) (49,839) (437,838) (152,181)
Proceeds from sales of mortgage loans: held for sale 6,276 26,176 429,145 44,017
Principal payments on mortgage loans: held for sale 34 778 213 808
Proceeds from sales of mortgage securities: trading -- 44,018 -- 54,520
Principal payments on mortgage securities: trading -- 1,825 -- 2,343
(Increase) decrease in accrued interest receivable (118) 50 1,247 (65)
(Increase) decrease in other assets (94) 817 964 (418)
Increase (decrease) in amounts due to Redwood Trust (573) 67 (472) (236)
Increase (decrease) in accrued interest payable 276 (100) (545) 12
Decrease in accrued restructuring charges (1,159) -- (2,913) --
Increase in accrued expenses and other liabilities 1,495 615 808 718
-------- -------- --------- ---------
Net cash provided by (used in) operating activities (25,546) 20,568 (10,477) (57,206)
-------- -------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
(Purchases) sales of property and equipment, net -- (1,452) 189 (2,282)
Net increase in restricted cash (1,721) -- (1,763) --
-------- -------- --------- ---------
Net cash used in investing activities (1,721) (1,452) (1,574) (2,282)
-------- -------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from issuance of short-term debt
(net of repayments) 27,698 (19,210) 19,207 53,103
Loans from Redwood Trust, Inc. (net of repayments) (1,400) (11,700) (6,500) (4,500)
Net proceeds from issuance of preferred stock -- 9,900 -- 9,900
Net proceeds from issuance of common stock -- 100 -- 100
-------- -------- --------- ---------
Net cash provided by (used in) financing activities 26,298 (20,910) 12,707 58,603
-------- -------- --------- ---------
Net increase (decrease) in cash and cash equivalents (969) (1,794) 656 (885)
Cash and cash equivalents at beginning of period 3,624 10,620 1,999 9,711
-------- -------- --------- ---------
Cash and cash equivalents at end of period $ 2,655 $ 8,826 $ 2,655 $ 8,826
======== ======== ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest expense $ 257 $ 794 $ 1,482 $ 947
======== ======== ========= =========
The accompanying notes are an integral part of
these consolidated finanical statements.
23
RWT HOLDINGS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2000
(UNAUDITED)
NOTE 1. THE COMPANY
RWT Holdings, Inc. ("Holdings") was incorporated in Delaware on February 13,
1998 and commenced operations on April 1, 1998. Holdings 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 wholly-owned 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 accompanying interim consolidated financial statements are unaudited. In the
opinion of management, all adjustments (consisting of normal recurring accruals)
considered necessary for a fair presentation have been included. Operating
results for the quarter ended June 30, 2000 are not necessarily indicative of
the results that may be expected for the year ending December 31, 2000. The
accompanying consolidated financial statements should be read in conjunction
with the consolidated financial statements and related notes included in the
Annual Report on Form 10-K filed by Redwood Trust for the year ended December
31, 1999.
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 7.
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 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
24
is accrued based on the outstanding principal amount of the mortgage loans and
their contractual terms. Realized and unrealized gains or losses on the loans
are based on the specific identification method and are recognized in "Net
unrealized and realized 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 which Holdings will pay to purchase the loans
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
Prior to 2000, Holdings invested in residential mortgage securities. These
mortgage securities were classified as trading and were accounted for in
accordance with SFAS No. 115, Accounting for Certain Investments in Debt and
Equity Securities. Accordingly, such securities were recorded at their estimated
fair market value. Unrealized and realized gains and losses on these securities
were recognized as a component of "Net unrealized and realized market value
gains (losses)" on the Consolidated Statements of Operations. Holdings did not
own any mortgage securities at June 30, 2000 or December 31, 1999.
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.
RESTRICTED CASH
Restricted cash includes cash held back from borrowers until certain loan
agreement requirements have been met. The corresponding liability for this cash
is reflected as a component of "Accrued expenses and other liabilities" on the
Consolidated Balance Sheets.
INCOME TAXES
Taxable earnings of Holdings are subject to state and federal income taxes at
the applicable statutory rates. Holdings provides for deferred income taxes if
any, to reflect the estimated future tax effects under the provisions of SFAS
No. 109, Accounting for Income Taxes. Under this pronouncement, deferred income
taxes, if any, reflect the estimated future tax effects of temporary differences
between the amount of assets and liabilities for financial reporting purposes
and such amounts as measured by tax laws and regulations.
COMPREHENSIVE INCOME
SFAS No. 130, Reporting Comprehensive Income, requires Holdings to classify
items of "other comprehensive income" by their nature in a financial statement
and display the accumulated balance of other comprehensive income separately
from retained earnings and additional paid-in capital in the equity section of
the balance sheet. As of June 30, 2000, there was no other comprehensive income.
RECENT ACCOUNTING PRONOUNCEMENT
During March 2000, the Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. 44, Accounting for Certain Transactions involving Stock
Compensation - an interpretation of APB Opinion No. 25 ("FIN 44"). FIN 44
clarifies the application of APB Opinion No. 25 by expanding upon a number of
issues not specifically addressed in the Opinion such as the definition of an
employee for purposes of applying APB Opinion No. 25 and the accounting for
modifications to a previously fixed stock option award. FIN 44 is effective July
1, 2000. The impact on Holdings of adopting FIN 44 is not expected to have a
material impact on the operating results of Holdings.
25
NOTE 3. MORTGAGE ASSETS
At June 30, 2000 and December 31, 1999 Mortgage Assets consisted of the
following:
MORTGAGE LOANS: HELD-FOR-SALE
(IN THOUSANDS) JUNE 30, 2000 DECEMBER 31, 1999
------------- ----------------------------------------------------------
COMMERCIAL RESIDENTIAL COMMERCIAL TOTAL
------------- ----------- ---------- --------
Current Face $ 43,794 $ 4,995 $ 30,324 $ 35,319
Unamortized Discount (1,312) (596) (719) (1,315)
-------- -------- -------- --------
Carrying Value $ 42,482 $ 4,399 $ 29,605 $ 34,004
======== ======== ======== ========
Holdings recognized losses of $0.2 million for both the three and six months
ended June 30, 2000, as a result of LOCOM adjustments on mortgage loans
held-for-sale. Additionally, during the three and six months ended June 30,
2000, Holdings sold residential and commercial mortgage loans for proceeds of
$6.3 million and $429.1 million, resulting in net gains of $0.1 million and $0.2
million, respectively. During the three and six months ended June 30, 1999,
Holdings recognized $0.1 million and $0.2 million in LOCOM loss adjustments on
mortgage loans held-for-sale and sold mortgage loans held-for-sale for proceeds
of $26.2 million and $44.0 million, respectively. The LOCOM adjustments and
gains on sale are reflected as a component of "Net unrealized and realized
market value gains (losses)" on the Consolidated Statements of Operations.
MORTGAGE SECURITIES: TRADING
Holdings did not own any mortgage securities at June 30, 2000 or December 31,
1999. For the three and six months ended June 30, 1999, Holdings recognized
market value gains of $0.2 million and $0.8 million on mortgage securities
classified as trading. These gains are reflected as a component of "Net
unrealized and realized market value gains (losses)" on the Consolidated
Statements of Operations. Also during the three and six months ended June 30,
1999, Holdings sold mortgage securities classified as trading for proceeds of
$44.0 million and $54.5 million, respectively.
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. This Short-Term Debt
is collateralized by a portion of Holdings' mortgage loans.
At June 30, 2000, and December 31, 1999, Holdings had $41.6 million and $22.4
million of Short-Term Debt outstanding with a weighted-average borrowing rate of
8.54% and 7.02%, respectively. The average balance of Short-Term Debt
outstanding during the three and six months ended June 30, 2000 was $23 million
and $20 million with a weighted-average interest cost of 8.49% and 7.97%,
respectively. The maximum balance outstanding during both the three and six
months ended June 30, 2000 was $41.6 million. During the three and six months
ended June 30, 1999, the average balance of Short-Term Debt outstanding was $38
million and $23 million with a weighted-average interest cost of 5.29% and
5.17%, respectively. The maximum balance outstanding during both the three and
six months ended June 30, 1999 was $88 million.
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
26
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 liability.
TOTAL REMAINING LIABILITY
-------------------------------------
(IN THOUSANDS) JUNE 30, 2000 DECEMBER 31, 1999
------------- -----------------
Payroll, severance, and termination benefits $ 488 $2,431
Lease and other commitments 593 1,068
Other 45 540
------ ------
Total $1,126 $4,039
Holdings expects to pay the majority of the remaining restructuring costs during
the year 2000. The liability for restructuring costs is reflected as "Accrued
restructuring charges" on the Consolidated Balance Sheets.
NOTE 6. INCOME TAXES
The provision for income taxes for the three and six months ended June 30, 2000
and 1999 is $3,200 and represents minimum California franchise taxes. No
additional tax provision has been recorded for these periods, as Holdings
reported a loss in each of the periods. Due to the uncertainty of realization of
net operating losses, a valuation allowance has been provided to eliminate the
deferred tax assets related to net operating loss carryforwards at June 30, 2000
and December 31, 1999. At June 30, 2000 and December 31, 1999, the deferred tax
assets and associated valuation allowances were approximately $9.2 million and
$8.0 million, respectively. At December 31, 1999 Holdings had net operating loss
carryforwards of approximately $19.5 million for federal tax purposes, and $9
million for state tax purposes. The federal loss carryforwards and a portion of
the state loss carryforwards expire between 2018 and 2019, while the largest
portion of the state loss carryforwards expire between 2003 and 2004.
NOTE 7. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying values and estimated fair values of
Holdings' financial instruments at June 30, 2000 and December 31, 1999.
(IN THOUSANDS) JUNE 30, 2000 DECEMBER 31, 1999
---------------------------------- -----------------------------------
CARRYING VALUE FAIR VALUE CARRYING VALUE FAIR VALUE
-------------- ---------- -------------- ----------
Assets
Mortgage loans: held-for-sale
Commercial $42,482 $43,038 $29,605 $29,876
Residential -- -- $ 4,399 $ 4,415
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
27
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 the three and six months ended June 30, 2000, RCF purchased $16.9 million
and $25.3 million of commercial mortgage loans from Redwood Trust, respectively.
For the three and six months ended June 30, 1999, RCF purchased $0 million and
$8 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. At June 30, 2000, under the terms of the Master Forward Commitment
Agreement, Redwood Trust had committed to sell $9.8 million of commercial
mortgage loans to RCF for settlement during the third quarter of 2000.
During the three and six months ended June 30, 2000, RRF purchased $0.4 million
and $17.1 million of residential mortgage loans from Redwood Trust,
respectively. 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 such purchases during the three and
six months ended June 30, 1999. As RRF ceased operations in 1999, there were no
remaining outstanding commitments at June 30, 2000.
During December 1999, Holdings purchased $390 million of residential mortgage
loans and subsequently sold a participation agreement on the mortgage loans to
Redwood Trust. Pursuant to the terms of the Mortgage Loan Participation Purchase
Agreement, Redwood Trust purchased a 99% interest in the mortgage loans, and
assumed all related risks of ownership. Holdings did not recognize any gain or
loss on this transaction. During March 2000, Redwood Trust sold the
participation agreement back to Holdings for proceeds of $380.5 million.
Holdings simultaneously sold $384 million of residential mortgage loans to
Sequoia for proceeds of $384 million.
OTHER
Under a revolving credit facility arrangement, Redwood Trust may loan funds to
Holdings to finance Holdings' operations. These loans are unsecured,
subordinated, and are repaid within six months. Such loans bear interest at a
rate of 3.50% over the LIBOR interest rate. Holdings had no outstanding loans
from Redwood Trust at June 30, 2000. At December 31, 1999, Holdings had borrowed
$6.5 million from Redwood Trust in accordance with the provisions of this
arrangement. During both the three and six months ended June 30, 2000, Holdings
incurred $0.1 million in interest expense on loans from Redwood Trust. Holdings
incurred $0.2 million and $0.4 million in interest expense on loans from Redwood
Trust during the three and six months ended June 30, 1999, respectively.
Redwood Trust shares many of the operating expenses of Holdings, including
personnel and related expenses, subject to full reimbursement by Holdings.
During both the three and six months ended June 30, 2000, $0.1 million of
Holdings' operating expenses were paid by Redwood Trust, and were subject to
reimbursement by Holdings. During the three and six months ended June 30, 1999,
$0.8 million and $1.5 million, respectively of Holdings' operating expenses were
paid by Redwood Trust.
Redwood Trust may provide credit support to Holdings to facilitate Holdings'
financings from third-party lenders. As part of this arrangement, Holdings is
authorized as a co-borrower under some of Redwood Trust's Short-Term
28
Debt agreements subject to Redwood Trust continuing to remain jointly and
severally liable for repayment. Accordingly, Holdings pays Redwood Trust credit
support fees on borrowings subject to this arrangement. At June 30, 2000 and
December 31, 1999, Redwood Trust was providing credit support on $41.6 million
and $22.4 million of Holdings' Short-Term Debt. During both the three and six
months ended June 30, 2000 and 1999, Holdings recognized approximately $0.1
million in credit support fee expense.
NOTE 10. COMMITMENTS AND CONTINGENCIES
At June 30, 2000, RCF is obligated under non-cancelable operating leases with
expiration dates through 2004. The total future minimum lease payments under
these non-cancelable leases is $339,116 and is expected to be recognized as
follows: 2000- $48,844; 2001 - $80,940; 2002 - $76,672; 2003 - $78,972; 2004 -
$53,688.
At June 30, 2000, RCF had entered into commitments to purchase $9.8 million of
commercial mortgage loans from Redwood Trust for settlement during the third
quarter of 2000.
29
ITEM 2. 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 our 1999 Form 10-K included in
our 1999 Annual Report.
OVERVIEW
Redwood Trust is a real estate finance company. We acquire, originate,
finance, structure, and manage residential and commercial mortgage loans
and mortgage securities representing interests in real estate property
nationwide.
Our core business of real estate finance is conducted through Redwood
Trust, Inc. ("Redwood"), 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 conduct a portion of our financing transactions through our
special-purpose finance subsidiary, Sequoia Mortgage Funding Corporation
("Sequoia"). We utilize Sequoia to finance our residential mortgage loans
through the issuance of long-term debt.
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 subsidiary, Redwood
Commercial Funding, Inc. ("RCF"). RCF originates shorter-term
floating-rate commercial mortgage loans to borrowers who require more
flexible borrowing arrangements than are usually offered by life
insurance companies or commercial mortgage conduit lending programs.
For more information, please visit Redwood's Web site at:
www.redwoodtrust.com and RCF's Web site at www.rcfloans.com.
SIGNIFICANT ASPECTS OF THE QUARTER
In accordance with the acquisition strategy discussed in previous
reports, we continued to acquire, and increase our equity capital
allocation to, subordinated residential mortgage securities that bear
some credit risk of the underlying mortgage pool. This acquisition
program has increased our overall credit risk profile somewhat. The loans
in the pools underlying these securities are prime quality residential
loans. We use our capital to provide credit-enhancement to the issuer of
these securities, allowing them to sell the more senior securities in the
transaction structure with investment grade ratings.
The purchase of a subordinated residential mortgage security is similar
economically to our Sequoia mortgage finance program. In the first
instance, a third party securitizes the mortgages and we acquire the
credit enhancement interests. In the case of Sequoia, we acquire
residential whole loans, issue high-grade debt
30
securities, and retain the credit enhancement interest. There are
advantages and disadvantages to Redwood to both methods of asset
acquisition.
On our reported balance sheet, there is differing treatment of these
similar assets. Loans in the mortgage pool in which we acquire a
subordinated interest do not appear on our reported balance sheet, only
the value of our subordinated interest does. Each loan acquired and owned
by Sequoia appears on our balance sheet, however, even though we have
reduced our credit exposure to a fraction of that amount through issuing
non-recourse Sequoia debt. Thus, to the extent we acquire subordinated
mortgage securities, our balance sheet asset size will appear
significantly smaller than if we employed the same amount of equity
capital in our Sequoia program. Economically, however, the two strategies
are similar.
Although the amount of assets shown on our reported balance sheet fell
during the quarter, we actually increased our net equity investment in
mortgage assets during the quarter by 2%, according to our internal
risk-adjusted capital allocation system. Assets which were substantially
leveraged and required little equity (such as AAA-rated mortgage
securities) paid down during the quarter. In general, we re-deployed that
equity capital into purchases of subordinated mortgage securities, which
require a higher equity capital commitment. As a result, our reported
asset balances went down, but the measure that we believe best determines
our profitability - the amount of equity committed to the real estate
finance business - went up.
For the first time since early 1996, as of June 30, 2000, we have a net
discount position in our mortgage assets. In addition, in the second
quarter of 2000, our discount amortization income exceeded our premium
amortization expense. Our increased acquisitions of subordinated
residential mortgage securities at a discount have brought our net
discount or premium near zero. In general, we are well balanced with
respect to potential income variations caused by increases or decreases
in mortgage principal prepayment rates. Income variations can still occur
as prepayment rates change, however, because different assets in our
portfolio can respond to general changes in prepayment rates in different
ways, both in terms of premium and discount amortization rates and
mark-to-market effects.
Short-term interest rates rose by .50% during the quarter. Rapid
increases in short-term interest rates can reduce our profits in the
short-term, but this did not happen in the second quarter of 2000.
Instead, we were able to increase our interest rate spreads and margins,
as described below.
Management believes that perhaps the most important measure of our income
is earnings from on-going operations before mark-to-market adjustments.
This is also the measure of our income that is most comparable to the
earnings reported by most other financial institutions. By this measure,
we earned $0.51 in the second quarter of 2000 and $1.02 in the first half
of 2000. Our earnings per share increased by 42% over the second quarter
of 1999 and by 17% over the first half of 1999 on this basis.
FINANCIAL CONDITION
Redwood's balance sheet presents our real estate 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 46.
At June 30, 2000, we owned $1.3 billion mortgage loans and $0.9 billion
mortgage securities. At December 31, 1999, we owned $1.4 billion mortgage
loans and $1.0 billion mortgage loans.
Our mix of debt changed over this period. At June 30, 2000, we financed
these mortgage assets with $0.8 billion of short-term debt, $1.2 billion
of long-term debt, and $208 million of equity. At December 31, 1999, we
financed our mortgage assets with $1.3 billion of short-term debt, $0.9
billion of long-term debt, and $210 million of equity. This increase in
long-term debt and reduction in short-term debt was the result of our
issuance of long-term debt in the first quarter of 2000.
31
Our exposure to credit loss from the bulk of our residential mortgage
loans is limited, to some degree, by the methods we use to finance these
loans. The long-term debt we issue is non-recourse to us; as a result,
our credit exposure to our long-term debt financed loans is limited to
our net investment remaining after the issuance of such debt. A total of
$1.2 billion of non-recourse assets and liabilities are owned by trusts
created by Sequoia. The trusts are "bankruptcy-remote" with respect to
Redwood. Although the net earnings of the trusts accrue to Redwood,
Redwood is not responsible for the repayment of Sequoia debt and Sequoia
has no call on the liquidity of Redwood. Likewise, the assets of these
trusts are pledged to secure the related debt of each trust and
accordingly, are not available for general creditors of Redwood. Our
recourse exposure to Sequoia's mortgage assets is limited to our equity
investments in these trusts. At June 30, 2000, these equity investments
had a reported net value of $40 million.
At June 30, 2000, the portion of our balance sheet that was subject to
recourse was $1.0 billion of assets, $0.8 billion of borrowings, and $0.2
billion of equity. The ratio of equity-to-recourse-assets was 20.3%. The
ratio of recourse-debt-to-equity was 3.9 to 1.0.
At December 31, 1999, we reported $2.4 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 $0.2 billion. The ratio of
equity-to-recourse-assets was 14.3% and the ratio of
recourse-debt-to-equity was 6.0 to 1.0. The improvement in our debt-based
ratios during the first quarter of 2000 was due to our issuance of
additional long-term debt.
EARNING ASSETS
At June 30, 2000, according to our internal risk-adjusted capital
allocation process we employed $181 million of equity capital in our core
real estate finance business (excluding capital allocated to our
commercial mortgage origination business, of which RCF is a part). This
was a slight increase over the capital employed at March 31, 2000 and a
slight decrease from equity capital employed at December 31, 1999.
At June 30, 2000, we owned $2.2 billion of earning assets, a decrease
from the December 31, 1999 level of $2.4 billion of earning assets.
During the first six months of 2000, we acquired $251 million in assets
and sold $110 million in assets. We received $271 million in mortgage
principal paydowns during the first half of 2000.
MORTGAGE LOANS
At June 30, 2000, $910 million carrying value, or 41% of our total
mortgage asset portfolio, were high-quality residential mortgage loans
with adjustable-rate coupons with a principal value of $899 million. Our
carrying value of these loans, after $3.0 million of credit reserves, was
101.18% of the face or principal value of the loans. At December 31,
1999, we owned $993 million carrying value of these loans, or 42% of our
portfolio, at a carrying value of 101.21% of the $981 million principal
value (net of a $2.8 million credit reserve). Seriously delinquent loans
(over 90 days delinquent, in foreclosure, or REO) in this portion of our
portfolio were $4.0 million at June 30, 2000 and $3.4 million at December
31, 1999.
At June 30, 2000, $357 million carrying value and principal value, or 16%
of our total mortgage asset portfolio, were high-quality residential
mortgage loans with hybrid coupons. Our hybrid mortgage loans have an
initial fixed coupon rate for three to ten years followed by annual
coupon adjustments. On average, these loans become floating-rate in
December 2002. This portion of our portfolio is matched to the $349
million of long-term debt we have issued that is fixed-rate debt until
December 2002. Our carrying value of these loans, after $2.3 million of
credit reserves, was 99.74% of the $358 million face value. At December
31, 1999 we owned $391 million carrying value of these loans, or 17% of
our portfolio, at a carrying value of 99.84% of the $392 million
principal value (net of a $2.3 million credit reserve). Seriously
delinquent loans in this portion of our portfolio were $0.7 million at
June 30, 2000 and $1.3 million at December 31, 1999.
At June 30, 2000, $9.8 million carrying value, or 0.4% of our total
mortgage asset portfolio, were commercial mortgage loans originated by
our affiliate, RCF. Our carrying value of these loans was 100.00% of
principal value. At December 31, 1999, we owned $8.4 million carrying
value of these loans, or 0.4% of our portfolio, at a carrying value of
99.85% of principal value. All of these loans were current at June 30,
2000 and December 31, 1999. The amount of commercial loans on our balance
sheet varies over time as RCF originates and sells
32
commercial mortgage loans, and depends on the amount of RCF's warehouse
that we finance at Redwood as opposed to at Holdings. Furthermore, we may
acquire commercial mortgage loans with the intention of retaining such
loans until maturity.
We own residential mortgage loans on real estate properties located
throughout the United States. At June 30, 2000, the geographic
distribution of our residential loan portfolio was as follows: California
25%; Florida 9%; New York 8%; New Jersey 5%; Texas 5%; Georgia 5%. The
remaining 43% of our investments were in states located throughout the
country, with no one state greater than 5%. At June 30, 2000, our
residential loan portfolio consisted of 4,021 loans, with an average loan
size of $312,600. The geographic distribution of our residential loan
portfolio at December 31, 1999 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, 1999, we owned 4,366 loans
with an average loan size of $315,700.
At June 30, 2000, commercial loans held on Redwood's balance sheet
consisted of one loan of $9.8 million. This loan was located in New
Jersey. At December 31, 1999, we owned three loans with an average loan
size of $2.8 million, all of which were located in California. These
loans were originated by our affiliate RCF, will be sold by RCF, and may
be temporarily owned by us during this interim period. RCF also holds
loans on its balance sheet after origination and prior to sale. Such
loans are discussed below under the Holdings' "Management's Discussion
and Analysis."
For presentation purposes, the $1.3 billion at June 30, 2000 and the $1.0
billion at December 31, 1999 of residential 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 residential and commercial
mortgage loans that are funded with short-term debt and equity ($17
million at June 30, 2000 and $424 million at December 31, 1999) 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 our income statement.
MORTGAGE SECURITIES
At June 30, 2000, 28% of our total mortgage asset portfolio, or $619
million carrying value with a principal value of $610 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, $613 million or 99%, were adjustable-rate securities with the
remaining 1% fixed-rate securities. The carrying value of these
securities was 101.51% of principal value. At December 31, 1999, we owned
$575 million carrying value of these securities, or 24% of our portfolio,
at a carrying value of 101.73% of the $565 million principal value.
At June 30, 2000, 10% of our total mortgage asset portfolio, or $214
million carrying and principal 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 100.19% of face value. At December 31, 1999, we owned $291
million carrying value and principal value of these securities, or 12% of
our portfolio, at a carrying value of 99.86%.
At June 30, 2000, 3% of our mortgage asset portfolio, or $59 million
carrying value with a principal value of $96 million, consisted of
lower-rated, residential mortgage securities issued by private-label
security issuers. Due to their subordinated status, these securities bore
some degree of credit risk and were rated "A" or below. The loans
underlying these securities were, with minor exceptions, high-quality
loans. The carrying value of these securities, after $0.6 million of
credit reserves, was 61.58% of face value. At December 31, 1999, we owned
$28 million carrying value of these securities, or 1% of our portfolio,
at a carrying value, after credit reserves, of 57.85% of the $49 million
face value. We intend to continue to increase our investment in
lower-rated, subordinated residential mortgage securities backed by
high-quality loans in the future.
At June 30, 2000, 1% of our total mortgage asset portfolio, or $23
million carrying value and principal value, consisted of residential
floating-rate mortgage securities rated "AAA" or "AA" which were backed
by home
33
equity loans, or "HEL". The carrying value of these securities was 99.94%
of face value. At December 31, 1999, we owned $47 million carrying value
of these securities, or 2% of our portfolio, at a carrying value of
98.79% of the $48 million principal value.
At June 30, 2000, 1% of our mortgage asset portfolio, or $14 million
carrying value and $15 million principal 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 96.46% of principal value. At
December 31, 1999, we owned $16 million carrying value and principal
value of these securities, or 1% of our portfolio, at a carrying value of
97.28% of principal value.
At June 30, 2000, 0.5% of our mortgage asset portfolio, or $12 million
carrying value with a principal 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 93.09% of face
value. At December 31, 1999, we owned $12 million carrying value of these
securities, or 0.5% of our portfolio, at a carrying value of 91.00% of
the $13 million principal value. The average life of these assets was 7.5
years at June 30, 2000 and 8.2 years at December 31, 1999
In the second quarter of 2000, we sold our floating-rate CMO mortgage
securities. 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 principal value.
At June 30, 2000, 0.01% of our mortgage asset portfolio, or $0.2 million
carrying value with no principal value, consisted of interest-only
mortgage securities rated "AAA" or "AA". At December 31, 1998, we owned
$0.1 million carrying value of these securities, or 0.005% 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 our
income statement. The $59 million at June 30, 2000 and $28 million at
December 31, 1999, 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 our
income statement but are included in "accumulated other comprehensive
income" in the equity portion of our balance sheet.
CASH
The amount of liquidity we maintain on a daily basis may differ from the
amount of cash we show on our balance sheet at the end of each reporting
period. Please refer to the discussion regarding our liquidity beginning
on page 43.
We had $9 million of unrestricted cash at June 30, 2000 and $20 million
at year-end 1999.
Sequoia held cash totaling $3 million at June 30, 2000 and $5 million at
December 31, 1999. 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 $1.3 million at June 30, 2000 and $2.0
million at December 31, 1999. 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
34
to Holdings' "Consolidated Financial Statements and Notes" and Holdings'
"Management's Discussion and Analysis" below for more information on
Holdings.
The carrying value of our equity investment in Holdings was $2.3 million
at June 30, 2000 and $3.4 million at December 31, 1999.
From time to time, we may provide additional liquidity to Holdings. At
June 30, 2000, no such additional liquidity was needed. At December 31,
1999, loans to Holdings totaled $6.5 million and receivables from
Holdings were $0.5 million.
OTHER ASSETS
Our other assets include principal receivable, accrued interest
receivables, other receivables, fixed assets, leasehold improvements and
prepaid expenses. These totaled $22.7 million at June 30, 2000 and $19.4
million at December 31, 1999.
SHORT-TERM DEBT
Short-term borrowings totaled $0.8 billion at June 30, 2000, or 40% of
our total debt. At December 31, 1999, short-term borrowings were $1.3
billion, or 57% of our total debt. The level of short-term borrowings was
reduced in the first half of 2000 as we issued long-term debt and used
the proceeds to reduce short-term debt. We pledge a portion of our
mortgage securities portfolio, mortgage loan portfolio, and other assets
to secure our short-term 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 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 June 30, 2000, we owned $1.3 billion of residential mortgage loans
that were financed with long-term debt through trusts owned by our
financing subsidiary, 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 June 30, 2000, 60% of our total debt, or $1.2 billion, was long-term
mortgage-backed debt. Of this long-term debt, $555 million had a
floating-rate based on one-month LIBOR and $324 million had a
floating-rate based on the twelve-month average of the one-year Treasury
rate. An additional $349 million was fixed-rate until December 2002 with
a floating-rate coupon thereafter; this debt is matched to our portfolio
of hybrid fixed/floating residential mortgage loans.
At December 31, 1999, 43% of our total debt, or $945 million, was
long-term mortgage-backed debt. Of this long-term debt, $212 million had
a floating-rate based on one-month LIBOR, $351 had a floating-rate based
on the twelve-month average of the one-year Treasury rate, and $382
million had a fixed-rate until December 2002 with a floating-rate coupon
thereafter.
OTHER LIABILITIES
Our other liabilities include accrued interest payable, accrued expenses,
and dividends payable. The net balance of these accounts totaled $11.1
million at June 30, 2000 and $11.2 million at December 31, 1999.
STOCKHOLDERS' EQUITY
At June 30, 2000, total equity capital was $208 million, preferred stock
equity was $27 million, and reported common equity totaled $181 million,
or $20.69 per common share outstanding.
35
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 $212 million at June 30, 2000.
After subtracting out the preference value of the preferred stock, common
equity on a full mark-to-market basis was $178 million and the net asset
value, or "NAV," per common share was $20.30.
At December 31, 1999, reported equity capital was $210 million, preferred
stock equity was $27 million, and reported common equity was $183
million, or $20.88 per common share outstanding. Mark-to-market common
equity was $185 million, or a NAV of $21.07 per common share.
During the first half of 2000, our total equity, book value per share,
and NAV per share declined slightly after accruing for our $0.75 per
share common dividends. These dividends exceeded slightly our first half
GAAP earnings of $0.72 per share. The additional reduction in our book
value was due the negative net market value adjustments on the assets and
liabilities whose adjustments do not flow through our income statement.
However, given the rising interest rate environment, which saw short-term
rates rise by .75% during the past six months, we had a relatively small
net market valuation adjustment on all our assets and liabilities, with
the average net decline in our assets being 0.28% of average principal
value of all our assets.
RESULTS OF OPERATIONS
In the second quarter of 2000, despite rising short-term interest rates,
earnings before mark-to-market from ongoing operations remained strong
relative to the previous quarter and much improved over last year's
second quarter. As a result of rising rates over the past year, both the
coupon rates on our assets and the cost of our liabilities increased. Due
to the nature of our assets we were able to maintain our interest rate
spread during the quarter. The discussion below provides more detail as
to the components of net income achieved during the second quarter of
2000.
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's Discussion and Analysis of Financial
Condition and Results of Operations" commencing on page 46 of this Form
10-Q for further discussion of Holdings' financial position and
performance.
INTEREST INCOME
For the quarter ended June 30, 2000, interest income generated by our
real estate finance operations was $43 million. Our portfolio had average
earning assets of $2.3 billion and earned an average yield of 7.54%.
During this quarter, the average coupon rate, or the cash-earning rate on
mortgage principal, was 7.53%. The average value of assets included a net
unamortized discount of 0.06% of mortgage principal totaling $1 million.
We write off premium balances as an expense over the life of our assets
and take into income discount balances over the life of the asset. The
rate at which we take the premium amortization expense as compared to the
discount amortization into income will be dependent on the prepayments of
specific assets. The discount amortization exceeded the premium
amortization expense for the quarter by $0.1 million, which increased our
earning asset yield by 0.02%. The annualized prepayment rate on our
mortgage assets, which drives the rate at which we write off net premium
and discount balances, was 17% Conditional Prepayment Rate ("CPR") during
the quarter. Other factors reduced the earning asset yield by 0.01%.
36
For the preceding quarter (ended March 31, 2000), interest income was $43
million. Our portfolio had average earning assets of $2.4 billion and
earned an average yield of 7.24%. The average coupon rate was 7.35%. The
average reported value of assets included a 0.25% net premium, or $6
million. Net premium amortization expense was $0.5 million, which reduced
earning asset yield by 0.08%. Prepayments during the quarter averaged 17%
CPR. Other factors reduced the earning asset yield by 0.03%.
From the first quarter of 2000 to the second quarter of 2000, our yield
on assets rose by 0.30%, from 7.24% to 7.54%, due to rising short-term
interest rates and acquisitions of higher yielding assets. Short-term
interest rates have risen by 1.00% to 1.50% since the beginning of 1999,
and as the coupon rates on our adjustable-rate assets reset, our earning
rates are increasing. Additionally, we purchased more subordinated
mortgage securities during the second quarter which, in general, earn a
higher yield than the majority of our other portfolio assets. Total
interest income remained at $43 million from quarter to quarter as the
increase in yield was offset by a lower asset balance.
For the quarter ended June 30, 1999, interest income was $36 million. Our
portfolio had average earning assets of $2.2 billion and earned an
average yield of 6.54%. The average coupon rate was 6.82%. The reported
value of assets included a 0.80% net premium, or $17 million. Net premium
amortization expense was $1.6 million, which reduced earning asset yield
by 0.23%. Prepayments during the quarter were 30% CPR. Other factors
reduced the earning asset yield by 0.05%.
Total interest income increased from the second quarter of 1999 to the
second quarter of 2000 as a result of higher short-term interest rates.
Year over year earning asset yields increased 1.00% due to rising
interest rates and a larger investment in higher yielding assets.
Furthermore, prepayment speeds have slowed down, decreasing the rate by
which we take the premium amortization expense thereby further improving
the yield on our assets.
For the first six months of 2000, total interest income was $86 million.
This was generated from our $2.3 billion average earning assets portfolio
yielding 7.39%. Coupon rates averaged 7.44% during the six months. The
average reported value of assets included a 0.10% net premium, or $2
million. Net premium amortization expense was $0.5 million, which reduce
earnings asset yield by 0.03%. Prepayments during the first six months of
2000 averaged 17% CPR. Other factors reduced the earning asset yield by
0.02%.
For the first six months of 1999, total interest income was $78 million.
A yield of 6.55% was earned on average assets of $2.4 billion. The
average coupon rate was 6.91% with the net premium amortization expense
of $3.9 million reducing the yield by 0.30%. The average reported value
of the assets included a 0.75% premium, of $17 million. Prepayments
during the first half of 1999 were 32% CPR. Other factors reduced earning
asset yield by 0.06%.
Total interest income increased from the first half of 1999 to the first
half of 2000 due to rising interest rates, slower prepayments, and a
larger investment in higher yielding assets. The results of these two
factors increased the yield on the earning assets that offset the
reduction in the size of the portfolio. This reduction in the size of the
portfolio was the result of a change in the mix of assets we own in the
portfolio.
INTEREST EXPENSE
Interest expense for the quarter ended June 30, 2000 was $35 million. We
funded our mortgage portfolio and other assets with an average of $213
million of equity and $2.1 billion of borrowings. We paid an average cost
of funds of 6.58% for these borrowings. Short-term debt averaged 41% of
total debt and cost us 6.47%. Long-term debt averaged 59% of total debt
and cost us 6.65%.
In the previous quarter (the first quarter of 2000), interest expense was
also $35 million. We funded our mortgage portfolio with an average of
$210 million of equity and $2.2 billion of borrowings. We paid an average
cost of funds of 6.29% for these borrowings. Short-term debt averaged 56%
of total debt and cost us 6.25%. Long-term debt averaged 44% of total
debt and cost us 6.32%.
37
Total interest expense was about the same in the second quarter of 2000
as in the previous quarter as the increase in the cost of borrowings was
offset by lower borrowing needs. Our cost of funds rose from quarter to
quarter by 0.30%, from 6.28% to 6.58%, primarily a result of increases in
one-month LIBOR, our main borrowing rate.
For the quarter ended June 30, 1999, interest expense was $29 million. We
funded our mortgage portfolio with an average of $245 million of equity
and $2.1 billion of borrowings. We paid an average cost of funds of 5.55%
for these borrowings. Short-term debt averaged 46% of total debt and cost
us 5.07%. Long-term debt averaged 54% of total debt and cost us 5.96%.
The increase in interest expense from year to year is the result of
increases in one-month LIBOR and other short-term interest rates during
this time and a slight increase in average borrowings.
For the first six months of 2000, interest expense totaled $69 million.
Our borrowings averaged $2.2 billion and our cost of funds was 6.43%.
Short-term debt averaged 48% of total debt and cost us 6.34%. Long-term
debt averaged 52% of total debt and cost us 6.51%.
For the first six months of 1999, interest expense totaled $62 million.
Our borrowing cost us 5.58% on an average balance of $2.2 billion.
Short-term debt averaged 47% of total debt and cost us 5.10%. Long-term
debt averaged 53% of total debt and cost us 6.00%.
Interest expense increased from the first six months of 1999 to the first
six months of 2000 due to rising short-term interest rates.
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.
For reporting purposes, instruments classified as trading are recorded at
their estimated fair value with changes in their fair value reported in
current period earnings. Total interest rate agreement expense (hedging
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 in the line item
"Realized and Unrealized Market Value Gains (Losses)", was $0.2 million
for the quarter ended June 30, 2000, $0.4 million for the quarter ended
March 31, 2000, and $0.7 million for the quarter ended June 30, 1999. As
a percent of average borrowings, net interest rate agreements expense was
0.04% during the second quarter of 2000, 0.07% during the first quarter
of 2000, and 0.14% during the second quarter of 1999. Net hedging
expenses vary as a result of various asset/liability strategies we employ
and the characteristics of the specific hedges we use to employ such
strategy. In the second quarter of 2000, net hedge expense decreased due
to an increase in hedge income caused by rising interest rates.
For the first six month of 2000, net interest rate agreements expense
totaled $0.6 million, or 0.06% of average borrowings. For the first six
months of 1999, net interest rate agreements expense totaled $1.1million,
or 0.10% of average borrowings.
NET INTEREST INCOME
Net interest income, which equals interest income less interest expense
less interest rate agreements expense, was $8.0 million for the quarter
ended June 30, 2000. Our interest rate spread, which equals the yield on
earning assets less the cost of funds and hedging, was 0.92%. Our net
interest margin, which equals net interest income divided by average
assets, was 1.36%. Our net interest income as a percent of average equity
was 15.4% during this quarter.
For the first quarter of 2000, net interest income was $8.0 million, our
interest rate spread was 0.88%, and our net interest margin was 1.32%.
Net interest income as a percent of average equity was 15.2%.
38
Net interest income was equal in the first and second quarters of 2000.
Our interest rate spread was relatively stable as rising short-term
interest rates increased both the yields on our assets and our cost of
borrowings. Our net interest margin increased slightly as we funded a
greater portion of our assets with equity, given the mix of assets we
acquired during the period.
For the quarter ended June 30, 1999, net interest income was $6.8
million, our interest rate spread was 0.85%, and our net interest margin
was 1.18%. Net interest income as a percent of average equity was 11.2%.
We earned more net interest income in the second quarter of 2000 ($8.0
million) than we did in the second quarter of 1999 ($6.8 million)
primarily as a result of higher short-term interest rates. Although the
average earning asset balance, the average borrowings, and the average
interest rate spread were relatively similar during these three-month
periods, short-term rates were 1.00% to 1.50% higher. Income increased
because our asset balances exceed our debt balances.
In the first half of 2000, our net interest income totaled $16.0 million,
or net interest rate spread was 0.90%, and our net interest margin was
1.34%. Net interest income as a percent of average equity was 15.3%. In
the first half of 1999, our net interest income totaled $14.7 million, or
net interest rate spread was 0.87%, and our net interest margin was
1.19%. Net interest income as a percent of average equity was 11.9%.
Higher short-term interest rates and a change in the mix of our assets
were the primary reasons net interest income was higher in the first six
months of 2000 than in the similar period in 1999.
NET UNREALIZED AND REALIZED MARKET VALUE GAINS AND LOSSES
As a result of changes in accounting methodologies we instituted in 1998,
we record both realized and unrealized market value gains and losses on
many of our mortgage securities, short-term funded mortgage loans, and
interest rate agreements as an item in our income statement. 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.
Our freedom to manage and hedge our portfolio is enhanced by the use of
these accounting techniques. However, very few other financial
institutions use these accounting methods; as a result, direct
comparisons of our reported earnings with those of other companies on an
"apples-to-apples" basis may be more difficult.
Relatively small changes in portfolio market values can have a
significant impact on our reported earnings per share. In our opinion,
quarter-to-quarter fluctuations in mark-to-market earnings adjustments
are probably of less import than would be a cumulative positive or
negative adjustment established over a longer period of time that was
large relative to our asset base. For example, our cumulative
mark-to-market earnings adjustment since the beginning of 1999 is
negative $2.3 million ($0.26 per share). This is a minor amount, in our
opinion, compared to the size of our portfolio and given how much
short-term interest rates have risen during this time.
In comparing our results with other financial institutions, the earnings
from our ongoing operations before mark-to-market adjustments may be an
appropriate measure. Our earnings before mark-to-market adjustments were
$4.5 million ($0.51 per share) in the second quarter of 2000, $4.5
million ($0.51 per share) in the first quarter of 2000, and $3.7 million
($0.36 per share) in the second quarter of 1999. In the first half of
2000, our earnings before mark-to-market adjustments were $9.0 million,
or $1.02 per share, as compared to $9.2 million, or $0.87 per share in
the first six months of 1999.
During the second quarter of 2000, our portfolio of assets that were
marked-to-market for income statement purposes decreased in estimated
market value by $1.4 million. This net loss consisted of $0.9 million
market value loss on mortgage assets and $0.5 million market value loss
on interest rate agreements. Market values for our mortgage assets fell
as interest rates rose. Since most of these assets are adjustable rate,
the coupon rates will reset to higher levels. The market values may, in
the future, adjust accordingly. Losses in our interest rate agreements
portfolio were due to falling volatility and other factors. The net
combined market valuation adjustment loss of $1.4 million represents
0.15% of our portfolio of assets that is marked to market.
39
Total net losses on assets that were marked-to-market in the first
quarter of 2000 were $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.
The net gain on our portfolio of assets that were marked-to-market in the
second quarter of 1999 was $1.4 million. This net gain consisted of a
$2.4 million market value gain on interest rate agreements partially
offset by a $1.0 million market value loss on mortgage assets and other
securities.
In the first half of 2000, our mark-to-market adjustment recognized
through our income statement totaled negative $2.6 million. In the first
half of 1999, our mark-to-market adjustment totaled a positive $3.6
million.
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 quarter ended June
30, 2000, credit provisions were $0.1 million. In the quarter ended March
31, 2000, credit provisions were $0.1 million. In the second quarter of
1999, credit provisions were $0.4 million. Credit provisions have
decreased over time as the credit performance outlook of our loans
continues to improve. We have reduced our provision rates on our more
seasoned loans. During the second quarter of 2000, we realized $0.03
million in actual credit losses on mortgage loans. We did not incur any
credit losses on our mortgage loans during the quarters ended March 31,
2000 or June 30, 1999. However, credit provision expense will increase in
the future should we acquire additional mortgage loans that are held for
investment and may increase if credit conditions deteriorate.
Prior to 1998, we also expensed credit provisions on our portfolio of
subordinated mortgage securities. We stopped taking credit provisions on
this pool of securities in December 1997 when we restructured and reduced
our credit risk on these securities through a resecuritization
transaction ("SMFC re-REMIC securities"). The existing reserve for the
SMFC re-REMIC securities is $0.6 million at June 30, 2000. Actual
realized taxable credit losses against these securities were $0.1 million
in the second quarter of 2000, $0.1 million in the first quarter of 2000,
and $0.1 million in the second quarter of 1999.
We have purchased, and intend to continue to purchase, mortgage-backed
securities that have risk of credit loss. We no longer take explicit
credit provisions for these assets, but rather use a different means of
reducing current reported income in anticipation of credit losses. 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.) We calculate and book as income an
effective yield on such assets after factoring in anticipated losses.
Once acquired, we continue to review the projected losses on each asset.
Should projected credit losses change, the effective yield earned over
the remaining life of these assets will change accordingly.
OPERATING EXPENSES
Total operating expenses recognized at Redwood were $2.2 million in the
second quarter of 2000, $2.1 million in the first quarter of 2000, and
$0.9 million in the second quarter of 1999. Due to changes in amounts of
expense allocated and recognized between Redwood and Holdings, we believe
a more useful number for understanding trends in operating expenses is
the total operating expenses of Redwood and Holdings combined. Combined
operating expenses were $2.8 million in the second quarter of 2000, $3.0
million in the first quarter of 2000, and $5.1 million in the second
quarter of 1999.
Some of these expenses were associated with business units that have been
closed. Combined operating expenses for on-going operations -- Redwood
portfolio lending and RCF -- were $2.8 million in each of the second and
first quarter of 2000, and $2.2 million in the second quarter of 1999.
Expenses are higher in 2000 than in 1999 as we have expanded our
residential whole loan operations, increased dividend equivalent rights
payments to employees as a result of our increasing dividend, and built
origination and sales staff at RCF. For the same reasons, our combined
operating expenses from on-going operations increased to $5.6 million in
the first half of 2000 from the $3.8 million of expenses in the first
half of 1999.
40
EQUITY IN EARNINGS (LOSSES) OF RWT HOLDINGS, INC.
In the second quarter of 2000, our share of the losses generated by
Holdings was $0.5 million. This accounting loss at Holdings' subsidiary
RCF is not representative of the profitability of our overall commercial
operations because it does not include related income recorded at
Redwood.
In the second quarter of 2000, our share of the losses generated by
Holdings was $0.5 million. In the second quarter of 1999, we recognized
losses from Holdings of $3.8 million, which included losses from the
operations of two subsidiaries that have since been shut down.
In the first half of 2000, our share of the losses generated by Holdings
was $1.1 million. In the first half of 1999, our share of losses from
Holdings was $6.2 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 quarter ended June 30, 2000, net income from all of our
operations was $3.8 million. After preferred dividends of $0.7 million,
net income available to common shareholders was $3.1 million. For the
quarter ended March 31, 2000, net income from all of our operations was
$4.0 million. After preferred dividends of $0.7 million, net income
available to common stockholders was $3.3 million. For the quarter ended
June 30, 1999, net income from all of our operations was $3.2 million.
After preferred dividends of $0.7 million, net income available to common
stockholders was $2.5 million.
For the first six months of 2000, net income from all of our operations
was $7.7 million. After preferred dividends of $1.3 million, net income
available to common stockholders was $6.4 million. For the first six
months of 1999, net income from all our operations was $9.7 million.
After preferred dividends of $1.3 million, net income available to
commons shareholders was $8.4 million.
EARNINGS PER SHARE
Average diluted common shares outstanding were 8.9 million for the
quarter ended June 30, 2000, 8.8 million for the quarter ended March 31,
2000, and 10.2 million for the second quarter of 1999. Shares outstanding
declined over the past year as a result of our common stock repurchase
program. We repurchased 2.5 million shares during 1999. We did not
acquire any of our own shares in the first half of 2000.
Earnings per share from continuing operations before mark-to-market were
$0.51 in the second quarter of 2000, $0.51 in the first quarter of 2000,
and $1.02 for the first half of 2000.
Earnings per share from continuing operations before mark-to-market were
$0.36 in the second quarter of 1999, $0.51 in the first quarter of 1999,
and $0.87 for the first half of 1999.
Reported earnings per share were $0.35 for the second quarter of 2000,
$0.37 for first quarter of 2000, and $0.25 for second quarter of 1999.
Reported earnings per share for the first six months of 2000 were $0.72,
as compared to reported earnings per share of $0.79 per share for the
first six months of 1999. Average diluted common shares outstanding were
8.8 million in the first six months of 2000 as compared to 10.5 million
in the first half of 1999.
DIVIDENDS
We declared common stock dividends of $0.40 per share for the quarter
ended June 30, 2000 and $0.35 per share for the quarter ended March 31,
2000. For the first six months of 2000, common dividends declared totaled
$0.75 per share. No common dividends were declared in the first half of
1999.
41
On August 10, 2000, we declared a common stock dividend of $0.42 for the
third quarter of 2000. This dividend is payable on October 23, 2000 to
shareholders of record as of September 29, 2000. We continue to pay
$0.755 per share in quarterly preferred stock dividends.
RISK MANAGEMENT
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 stock ownership in our company. We seek, to the
best of our ability, to only 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.
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 reported earnings.
At June 30, 2000, we owned mortgage securities and loans totaling $1.0
billion that we account for on a mark-to-market basis or, in the case of
mortgage loans, on a lower-of-cost-or-market basis, for purposes of
determining reported earnings. Of these assets, 97% had adjustable-rate
coupons and 3% had fixed-rate coupons.
Our interest rate agreements hedging program may offset some asset market
value fluctuations due to interest rate changes, or, in some cases, may
exacerbate such fluctuations. All of our $2.7 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 June 30, 2000, we owned $2.3 billion of assets and had $2.1 billion of
liabilities. The majority of the assets were adjustable-rate, as were a
majority of the liabilities.
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 addition, 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 may be mitigated to some
extent by our interest rate agreements hedging program and by any
concurrent slowing of mortgage prepayment rates that may occur.
Hybrid mortgage assets (with fixed-rate coupons for 3 to 7 years and
adjustable-rate coupons thereafter) totaled $0.4 billion. We had debt
with interest rate reset characteristics matched to the hybrid mortgages
totaling $0.4 billion.
Our net income may vary somewhat as the yield curve between one-month
interest rates and six- and twelve-month interest rates vary. At June 30,
2000, we effectively owned $0.6 billion of adjustable-rate mortgage
assets with interest rates that adjust every six months as a function of
six-month LIBOR interest rates funded with equity and with debt that had
an interest rate that adjusts monthly as a function of one-month LIBOR
interest rates.
At June 30, 2000, we owned $0.5 billion of adjustable-rate mortgage
assets that adjust monthly as a function of one-month LIBOR interest
rates, funded with equity and with debt that also adjusts monthly as a
function of one-month LIBOR interest rates.
Adjustable-rate assets with earnings rates dependent on one-year U.S.
Treasury rates with annual adjustments totaled $0.7 billion at June 30,
2000. These Treasury-based assets were effectively funded with equity and
with
42
$0.3 billion of liabilities with a cost of funds dependent on one-year
U.S. Treasury rates with annual adjustments. The remainder of associated
liabilities had a cost of funds dependent on one-month LIBOR rates or the
daily Fed Funds rate. To the extent our Treasury-based assets are not
funded with Treasury-based liabilities, 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-collaterization requirements, and in the capital markets can impact
our access to liquidity.
At June 30, 2000, we had $68 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 8% of our
short-term debt balances.
At June 30, 2000, we had two committed lines of short-term financing, one
for residential and commercial mortgage loans and one solely for
commercial. 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 such lines upon expiration. We believe we
have many alternative uncommitted financing sources available to us for
our residential loan acquisitions. We continue to pursue additional
sources of financing in order to enhance the liquidity of our portfolio.
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 June 30, 2000, mortgage
premium balances were $25.4 million and mortgage discount balances were
$33.4 million. Net mortgage discount was $8.0 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 $3.6
million at June 30, 2000. 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 $3.4 million at June 30,
2000. The combined effect of these two items was to increase our
effective mortgage-related premium by $0.2 million.
Our net discount at June 30, 2000 for assets and liabilities affected by
the rate of mortgage principal receipts was $8.0 million. This net
discount equaled 4.3% of common equity. Amortization expense and income
will vary as prepayment rates on mortgage assets vary. In addition,
changes in prepayment rates will affect the market value of our assets
and our earnings.
43
CREDIT RISK
Our principal credit risk comes from mortgage loans owned by Sequoia,
mortgage loans held in portfolio, commercial mortgage loans held prior to
sale, 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 $7.8 million in
residential mortgage loans at June 30, 2000. Of these, $0.3 million were
seriously delinquent (delinquent over 90 days, in foreclosure, in
bankruptcy, or real estate owned). We also owned $9.8 million in
commercial mortgage loans. These commercial mortgage loans were all
current at June 30, 2000.
The four Sequoia trusts owned $1.3 billion in residential mortgage loans
at June 30, 2000. Our total credit risk from these trusts is limited to
our equity investment in these trusts. These equity investments had a
reported value of $40 million, net of related credit reserves, at June
30, 2000. At that time, $4.6 million of the underlying loans, or 0.36%,
were seriously delinquent.
At June 30, 2000, we had $5.3 million of credit reserves to provide for
potential future credit losses from our mortgage loans held for
investment by the Sequoia trusts. 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. To date, our realized credit losses from defaulted
residential mortgage loans have averaged 9% of the loan balance of the
defaulted loans. Delinquencies, defaults, and loss severities may
increase in the future, however, particularly if real estate values
decline or the general U.S. economy weakens. We believe our current level
of reserve and credit provision policy is reasonable.
At June 30, 2000, we also had $0.6 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 $6.2
million.
It should be noted that the establishment of a credit reserve for GAAP
purposes does not reduce our taxable income or our dividend payment
obligations as a REIT. For taxable income, credit expenses are recognized
as incurred, and will have the effect of reducing taxable income and our
minimum dividend payment obligation at that point.
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 residential mortgage securities rated below AA
and commercial mortgage whole loans are generally higher than for
higher-rated residential securities and residential whole loans. Capital
requirements for these less-liquid assets depend chiefly on our access to
secure funding for these assets, the number of sources of such funding,
the funding terms, and on the amount of extra capital we decide to hold
on hand to protect against possible liquidity events with these assets.
Capital requirements for equity interests in Sequoia 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.
Generally, our 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 guideline ratio has increased as we have
acquired new types of assets requiring more capital, 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
44
mortgages would increase, at least on a temporary basis, due to periodic
and life caps and slowing prepayment rates. We measure all of our
mortgage assets funded with short-term debt at estimated market value for
the purpose of making risk-adjusted capital calculations. Our actual
capital levels, as determined for the risk-adjusted capital policy, would
likely fall as rates increase as the market values of our mortgages, net
of mark-to-market gains on hedges, decreased. (Such market value declines
may be temporary as well, as future coupon adjustments on adjustable-rate
mortgage loans may help to restore some of the lost market value.)
In this circumstance, or any other circumstance in which our actual
capital levels decreased below our capital adequacy guideline amount, we
would generally cease the acquisition of new mortgage assets until
capital balance was restored through prepayments, interest rate changes,
or other means. In certain cases prior to a planned equity offering or
other circumstances, the Board of Directors has authorized management to
acquire mortgage assets in a limited amount beyond the usual constraints
of our risk-adjusted capital policy.
Growth in assets and earnings may be limited when our access to new
equity capital is limited. Holdings can benefit over time from the
re-investment of retained earnings at Holdings. Our mortgage finance
operation, however, is generally required to distribute at least 95% of
taxable income as dividends due to its REIT status.
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 GAAP 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.
45
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 (including Redwood Trust) through its Redwood Commercial Funding, Inc.
("RCF") subsidiary. 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.
For reporting purposes, some of RCF's commercial operations take place at
Redwood Trust. Therefore, the reported earnings of Holdings' subsidiary RCF are
not representative of the profitability of our overall commercial operations
because it does not include related income recorded at Redwood.
FINANCIAL CONDITION
At June 30, 2000, Holdings owned $42.5 million of commercial mortgage loans.
Holdings also had $2.7 million in unrestricted cash, $1.8 million in restricted
cash, $0.3 million of accrued interest receivable, and $0.2 million in other
assets, for total assets of $47.4 million. Holdings had commitments to acquire
$9.8 million of commercial mortgage loans from Redwood Trust for settlement
during the third quarter of 2000. Holdings intends to sell all $52.3 million of
commercial loans in 2000.
The loans owned by Holdings were funded with short-term borrowings and equity.
Short-term debt was $41.6 million, accrued restructuring charges were $1.1
million, holdback accounts totaled $1.7 million, and other liabilities totaled
$0.7 million, for total liabilities of $45.1 million. Redwood Trust expects to
continue to provide liquidity to Holdings, when necessary, during the year 2000.
Holdings' total equity at June 30, 2000 was $2.3 million.
At December 31, 1999, Holdings owned $4.4 million of residential mortgage loans,
$29.6 million of commercial mortgage loans, $2.0 million in cash, and $1.3
million in other assets, for total assets of $39.0 million. Short-term debt
totaled $22.4 million, loans from Redwood Trust totaled $6.5 million,
receivables due Redwood Trust were $0.5 million, accrued restructuring charges
totaled $4.0 million, other liabilities were $2.1 million, and total equity
totaled $3.4 million.
RESULTS OF OPERATIONS
For the quarter ended June 30, 2000, Holdings' operations consisted almost
entirely of RCF as the shutdown of RRF was substantially completed early in the
period. Net interest income for Holdings was $0.2 million, including interest
income of $0.7 million and interest expense of $0.5 million. Holdings had net
losses in its commercial loan portfolio, net of gains on sales, of $0.1 million
during the second quarter of 2000, resulting in net revenues of $0.1 million.
Operating expenses at Holdings totaled $0.6 million for the three months ended
June 30, 2000. Holdings' net loss for the quarter ended June 30, 2000 was $0.5
million.
46
In the second quarter of 2000, RCF originated $24.0 million of commercial
mortgage loans and sold $5.8 million. At June 30, 2000, commercial mortgage
loans originated or acquired by RCF that had not yet been sold totaled $52.3
million, of which $9.8 million were held by Redwood Trust and $42.5 million were
held at Holdings. These loans are all held for future sale. RCF expects to
recognize sale revenues upon the sale of the commercial loan portfolio.
For the quarter ended March 31, 2000, Holdings' operations consisted of RCF and
some expenses related to the shutdown of RRF. Net interest income for Holdings
was $0.2 million, including interest income of $0.6 million and interest
expenses of $0.4 million. Holdings also had net gains as a result of mortgage
asset sales and market value adjustments of $0.1 million during the first
quarter of 2000, resulting in net revenues of $0.3 million. Operating expenses
at Holdings totaled $0.9 million for this quarter. Holdings' net loss for the
quarter ended March 31, 2000 was $0.6 million.
From the first quarter to the second quarter of 2000, the loss recorded at
Holdings was similar. RCF realized more gains on sales in the first quarter than
in the second, offset by fewer operating expenses in the second quarter as the
shutdown of RRF was completed.
For the quarter ended June 30, 1999, net interest income for Holdings was $0.3
million, including interest income of $1.0 million and interest expense of $0.7
million. Holdings also had net gains as a result of commercial and residential
mortgage loan sales and market value adjustments of $0.1 million during the
second quarter of 1999, resulting in net revenues of $0.4 million. Operating
expenses at Holdings totaled $4.2 million for the second quarter of 1999.
Holdings' net loss for the quarter ended June 30, 1999 was $3.8 million.
Holdings' losses in the second quarter of 2000 were much lower than in the
second quarter of 1999 due to the shut-down of operations at RRF and RFS in the
second half of 1999. In the second quarter of 1999, these operations were
incurring significant start-up operating expenses.
In the first half of 2000, Holdings generated net income of $0.4 million on $1.3
million of interest income and $0.9 million of interest expenses. Holdings also
had net losses as a result of mortgage asset sales and market value adjustments
of $0.1 million during the first half of 2000, resulting in net revenues of $0.3
million. Operating expenses totaled $1.4 million, resulting in net losses of
$1.1 million being recorded at Holdings during the first six months of 2000.
In the first half of 1999, Holdings generated net income of $0.5 million on $1.5
million of interest income and $1.0 million of interest expenses. Holdings also
had net gains as a result of mortgage asset sales and market value adjustments
of $0.6 million during the first half of 1999, and $0.1 million of other income,
resulting in net revenues of $1.2 million. Operating expenses totaled $7.5,
resulting in net losses of $6.3 million being recorded at Holdings during the
first six months of 1999.
At December 31, 2000, Holdings had net operating loss carryforwards of
approximately $19.5 million for federal tax purposes and $9 million for state
income tax purposes. The federal carryforwards expire through 2019 and the state
carryforwards expire through 2004.
47
PART II OTHER INFORMATION
Item 1. Legal Proceedings
At June 30, 2000, there were no pending legal proceedings to which the
Company was a party or of which any of its property was subject.
Item 2. Changes in Securities
Not applicable
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
(a) The Annual Meeting of Shareholders of the Company was held on
May 11, 2000.
(b) The following matters were voted on at the Annual Meeting:
Votes
-----------------------------------------------------
For Against Abstain
--------- ------- -------
1. Election of Directors
Thomas C. Brown 8,534,241 42,894 --
George E. Bull 8,457,440 119,695 --
Terrance G. Hodel 8,535,248 41,887 --
The following Directors' terms of office continue after the
meeting:
Mariann Byerwalter
Thomas F. Farb
Nello Gonfiantini
Douglas B. Hansen
Charles J. Toeniskoetter
Votes
--------------------------------------
For Against Abstain
--------- ------- -------
2. Ratification of PricewaterhouseCoopers LLP as the Company's
independent public accountants for the fiscal year ending
December 31, 2000 8,487,980 82,349 6,806
Item 5. Other Information
None
48
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 11.1 to Part I - Computation of Earnings Per Share for
the three and six months ended June 30, 2000 and June 30, 1999.
Exhibit 27 - Financial Data Schedule
(b) Reports
None
49
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
REDWOOD TRUST, INC.
Dated: August 10, 2000 By: /s/ Douglas B. Hansen
--------------------------------------------
Douglas B. Hansen
President
(authorized officer of registrant)
Dated: August 10, 2000 By: /s/ Harold F. Zagunis
--------------------------------------------
Harold F. Zagunis
Vice President, Chief Financial Officer
Secretary, Treasurer and Controller
(principal financial and accounting officer)
50
REDWOOD TRUST, INC.
INDEX TO EXHIBIT
Sequentially
Exhibit Numbered
Number Page
- ------- -------------
11.1 Computations of Earnings per Share for the three and six
months ended June 30, 2000 and June 30, 1999 .............................. 52
27 Financial Data Schedule ................................................... 54
51