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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
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COMMISSION FILE NUMBER: 1-13759
REDWOOD TRUST, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 68-0329422
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
591 REDWOOD HIGHWAY, SUITE 3100
MILL VALLEY, CALIFORNIA 94941
(Address of principal executive offices) (Zip Code)
(415) 389-7373
(Registrant's telephone number, including area code)
Securities registered pursuant Name of Exchange on
to Section 12(b) of the Act: Which Registered:
CLASS B 9.74% CUMULATIVE NEW YORK STOCK EXCHANGE
CONVERTIBLE PREFERRED STOCK,
PAR VALUE $0.01 PER SHARE
(Title of Class)
COMMON STOCK, PAR VALUE $0.01 PER SHARE NEW YORK STOCK EXCHANGE
(Title of Class)
Securities registered pursuant to Section 12(g) of the Act:
NONE
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
At March 21, 2002 the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $393,359,292.
The number of shares of the Registrant's Common Stock outstanding on March 21,
2002 was 14,623,022. The number of shares of the Registrant's Preferred Stock
outstanding on March 21, 2002 was 902,068.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement issued in connection
with the 2002 Annual Meeting of Stockholders are incorporated by reference into
Part III.
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REDWOOD TRUST, INC.
2001 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
Page
PART I
Item 1. BUSINESS...................................................... 3
Item 2. PROPERTIES.................................................... 29
Item 3. LEGAL PROCEEDINGS............................................. 29
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........... 29
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS............................... 30
Item 6. SELECTED FINANCIAL DATA....................................... 31
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS................. 32
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.... 56
Item 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...... 62
Item 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE........................ 62
PART III
Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............ 62
Item 11. EXECUTIVE COMPENSATION........................................ 62
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT......................................... 62
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................ 62
PART IV
Item 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS SCHEDULES AND
REPORTS ON FORM 8-K........................................... 62
CONSOLIDATED FINANCIAL STATEMENTS.......................................... F-1
PART I
ITEM 1. BUSINESS
"Safe Harbor" Statement under the Private Securities Litigation Reform
Act of 1995: Certain matters discussed in this 2001 Form 10-K may
constitute forward-looking statements within the meaning of the federal
securities laws that inherently include certain risks and
uncertainties. Actual results and the timing of certain events could
differ materially from those projected in or contemplated by the
forward-looking statements due to a number of factors, including, among
other things, credit results for our earning assets, our cash flows and
liquidity, changes in interest rates and market values on our earning
assets and borrowings, changes in prepayment rates on our earning
assets, general economic conditions, particularly as they affect the
price of earning assets and the credit status of borrowers, and the
level of liquidity in the capital markets, as it affects our ability to
finance our earning asset portfolio, and other risk factors outlined in
this Form 10-K (see "Risk Factors" below).
Throughout this Form 10-K and other company documents, the words
"believe", "expect", "anticipate", "intend", "aim", "will", and similar
words identify "forward-looking" statements.
Other risks, uncertainties and factors that could cause actual results
to differ materially from those projected are detailed from time to
time in reports filed by us with the Securities and Exchange
Commission, or SEC, including Forms 10-Q and 10-K.
We undertake no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information,
future events or otherwise. In light of these risks, uncertainties and
assumptions, the forward-looking events discussed in or incorporated by
reference into this prospectus supplement and the accompanying
prospectus might not occur.
This Form 10-K contains statistics and other data that in some cases
have been obtained from, or compiled from, information made available
by servicing entities and information service providers.
REDWOOD TRUST
Redwood Trust is a real estate finance company. We distribute to our
shareholders as dividends the mortgage payments we receive from our
real estate loans and securities, less interest expenses and operating
costs.
Our primary business is owning, financing, and credit enhancing
high-quality jumbo residential mortgage loans. Jumbo residential loans
have mortgage balances that exceed the financing limit imposed on
Fannie Mae and Freddie Mac, both of which are United States
government-sponsored real estate finance entities. Most of the loans
that we finance have mortgage loan balances between $300,000 and
$600,000.
We acquire high-quality jumbo residential mortgage loans from large,
high-quality mortgage origination companies. We hold these loans on our
balance sheet to earn interest income. We typically fund these loans
with a combination of equity and long-term amortizing non-recourse
debt. At December 31, 2001, our residential mortgage loan portfolio
totaled $1.5 billion.
We also acquire mortgage securities representing subordinated interests
in pools of high-quality residential mortgage loans. By acquiring the
subordinated securities of these loan pools, we provide
credit-enhancement for the more senior securities backed by the pool so
they can be sold to capital market investors. Our total investment in
residential credit-enhancement securities was $191 million at December
31, 2001. The residential mortgage loans in the pools that we credit
enhanced in this manner totaled $52 billion at December 31, 2001. Our
prospective returns from our investment in these credit-enhancement
securities will be driven primarily by the future credit performance of
these mortgages.
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We also own and finance commercial mortgage loans and own a portfolio
of residential and commercial real estate securities. At December 31,
2001, our commercial mortgage loan portfolio totaled $51 million and
our securities portfolio totaled $683 million. We may acquire or create
other types of assets in the future.
We have elected, and anticipate that Redwood Trust will continue to
elect, to be organized as a real estate investment trust, or REIT. As a
REIT, we distribute substantially all of our net taxable earnings
(excluding earnings generated in taxable subsidiaries) to our
stockholders as dividends. As long as we retain our REIT status, we
will not pay most types of corporate income taxes on taxable income
earned in Redwood Trust, Inc.
Redwood Trust, Inc. was incorporated in the State of Maryland on April
11, 1994, and commenced operations on August 19, 1994. Our executive
offices are located at 591 Redwood Highway, Suite 3100, Mill Valley,
California 94941.
At March 21, 2002, Redwood had outstanding 14,623,022 shares of common
stock (New York Stock Exchange, Symbol "RWT") and 902,068 shares of
Class B Cumulative Convertible Preferred Stock (New York Stock
Exchange, Symbol "RWT-PB").
For more information about Redwood, please visit www.redwoodtrust.com.
For a description of important risk factors, among others, that could
affect our actual results and could cause our actual consolidated
results to differ materially from those expressed in any
forward-looking statements made by us, see "Risk Factors" commencing on
Page 13 of this Form 10-K.
COMPANY BUSINESS AND STRATEGY
INDUSTRY OVERVIEW
There are approximately $5.8 trillion of residential mortgage loans
outstanding in the United States. The amount outstanding has grown at a
rate of between 4% and 10% per year for approximately 20 years as home
ownership and housing values have generally increased. New originations
of residential mortgage loans have ranged from $0.9 trillion to $2.1
trillion per year over the last five years. Originations generally
increase in years when refinancing activity is stronger due to declines
in long-term interest and mortgage rates.
Fannie Mae and Freddie Mac are prohibited from owning or guaranteeing
single-family mortgage loans with balances greater than $300,700 for
loans in the continental United States. These loans are commonly
referred to as jumbo mortgage loans. Originations of jumbo mortgage
loans have remained at between 22% and 24% of total new residential
mortgage originations for the last five years. We believe that jumbo
mortgages currently outstanding total over $1.2 trillion, which
represents approximately 20% of the total residential mortgages
outstanding. We also believe that this outstanding balance of jumbo
mortgages has grown at a rate of between 4% and 10% per year along with
the residential mortgage market as a whole. New originations of jumbo
residential mortgage loans have ranged from between approximately $198
billion and $437 billion per year for the last five years.
Each year the amount of jumbo mortgages that require new financing
consists of new originations in addition to the seasoned loans that are
sold into the secondary mortgage market by financial institutions from
their portfolios. The size of the financing market for jumbo mortgages
each year thus depends on the economic conditions and other factors
that determine the level of new originations and the attractiveness to
financial institutions of selling loans.
Historically, jumbo residential mortgages have been financed by
financial institutions, such as banks and thrifts, holding loans in
portfolio on their balance sheets. These institutions fund their
mortgage finance activities through deposits and other borrowings.
Increasingly since the mid-1980s, jumbo mortgages have been funded
through mortgage securitization. We estimate that the share of jumbo
mortgages outstanding that have been securitized has been increasing
steadily from approximately 10% in 1990 to approximately 50% in 2001.
We believe that
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mortgage securitization has become the financing method of choice in
the jumbo markets relative to portfolio lending, because securitization
is generally a more efficient form of funding.
Jumbo mortgage securitizations may consist of seasoned loans or newly
originated loans. Seasoned loan securitizations generally contain loans
that are being sold from the retained mortgage portfolios of the larger
banks and thrifts. Securitizations of new originations generally
contain loans sold by the larger originators of jumbo mortgage loans or
by conduits. Conduits acquire individual loans or small mortgage
portfolios in order to aggregate mortgage pools for securitization.
Virtually all of the demand for mortgage-backed securities comes from
investors that desire to hold the cash flows of a mortgage but that are
not able or willing to build the operations necessary to manage the
credit risk of mortgages. These investors demand that mortgage
securities be rated investment grade by the credit rating agencies. In
order to create investment grade mortgage-backed securities from a pool
of residential mortgage loans, credit enhancement for those mortgage
loans must be provided.
In a securitization, a pool of mortgage loans can be credit enhanced
through a number of different methods. The senior/subordinated
structure is the most prevalent method for credit enhancement of jumbo
mortgage loans. This structure establishes a set of senior interests in
the pool of mortgage loans and a set of subordinated interests in the
pool. The set of subordinated interests is acquired by one or more
entities that provide credit enhancement to the underlying mortgage
loans. Credit losses in the mortgage pool reduce the principal of the
subordinated interests first, thus allowing the senior interests to be
rated investment grade. Other forms of credit enhancement, such as pool
insurance provided by mortgage insurance companies, bond insurance
provided by bond insurance companies, and corporate guarantees are
often less efficient than the senior/subordinated structure due to
regulation and rating agency requirements, among other factors.
Credit enhancers of jumbo mortgage loans profit from cash flows
generated from the ownership of the subordinated credit-enhancement
interests. The amount and timing of credit losses in the underlying
mortgage pools affect the yields generated by these assets. These
interests are generally purchased at a discount to the principal value
of the interest, and much of the potential return is generated through
the ultimate return of the remaining principal after realized credit
losses.
The business of enabling the securitization of jumbo residential
mortgages by assuming credit risk on the underlying mortgage loans is
highly fragmented. There are no industry statistics known to us that
identify participants or market shares. Credit enhancers of jumbo
mortgage securitizations include banks and thrifts (generally credit
enhancing their own originations), insurance companies, Wall Street
broker-dealers, hedge funds, private investment firms, mortgage REITs,
and others.
The liquidity crisis in the financial markets in 1998 caused many of
the participants in this market to withdraw. With reduced demand
stemming from reduced competition, and increased supply as a result of
increased originations and mortgage portfolio sales, prices of
residential credit-enhancement interests declined and the acquisition
of these interests became more attractive. Prices further declined in
1999 as financial turmoil continued and financial institutions
reorganized themselves to focus on their core businesses.
In 2000, 2001, and thus far in 2002, the prices of assets and the
margins available in the jumbo residential credit-enhancement business
have generally remained attractive. In general, we believe that few new
competitors have entered the market, so demand for credit-enhancement
interests has remained subdued. At the same time, the supply of
credit-enhancement opportunities has increased as jumbo mortgage
securitizations have increased. In addition, a significant supply of
seasoned jumbo mortgage loan portfolios has been securitized by banks
that have origination capacities that far exceed both their balance
sheet capacities and their desires to hold loans in portfolio.
OUR SOLUTION
Over the past seven years, we have built a business model that allows
us to compete effectively in the high-quality jumbo mortgage finance
market in the United States. The key aspects of our solution are as
follows:
5
FOCUSED BUSINESS MODEL. We have a focused business model targeting the
ownership and credit enhancement of jumbo residential mortgage loans.
We specialize in funding jumbo mortgage loans through securitization.
Securitization of mortgages is either undertaken by us to fund our
residential mortgage loan portfolio or by others with credit
enhancement provided by us via our investment in residential
credit-enhancement securities. At December 31, 2001, we enabled
securitizations for a total of approximately $53 billion of jumbo
mortgage loans ($52 billion securitized by others and $1 billion
securitized by us) for an approximate market share of 5% of all jumbo
mortgage loans outstanding and 10% of all securitized jumbo mortgage
loans outstanding. We believe securitization has and will continue to
prove to be a more efficient form of financing jumbo mortgage loans
than funding through deposits on the balance sheets of depository
institutions such as banks and thrifts. By focusing on this form of
financing mortgages, we believe our long-term growth opportunities will
continue to be attractive. We believe that opportunities will be
particularly attractive if an increasing share of jumbo mortgage loans
continues to be securitized and if the jumbo residential market as a
whole continues to grow at the historical rate of between 4% and 10%
per year.
SPECIALIZED EXPERTISE AND SCALABLE OPERATIONS. We have developed all of
the specialized expertise necessary to efficiently and economically
credit enhance and own jumbo residential mortgage loans. Our
accumulated market knowledge, relationships with mortgage originators
and others, sophisticated risk-adjusted capital policies, strict
underwriting procedures, and successful experience with shifting
financial market conditions allow us to acquire and securitize mortgage
assets and effectively mitigate the risks inherent with those
businesses. We build and maintain relationships with large mortgage
originators, banks that are likely to sell mortgage loan portfolios,
and Wall Street firms that broker mortgage assets. We continue to
develop our staff, our analytics, our models, and other capabilities
that help us structure transactions and cash flows, evaluate credit
quality of individual loans and pools of loans, underwrite loans
effectively, and monitor trends in credit quality and expected losses
in our existing portfolios. We establish relationships with our
servicing companies to assist with monthly surveillance, loss
mitigation efforts, delinquent loan work-out strategies, and REO
liquidation. Aside from collaborating on these issues, we insist that
specific foreclosure time-lines are followed and that representations
and warranties made to us by sellers are enforced. For balance sheet
management, we work to project cash flows and earnings, determine
capital requirements, source borrowings efficiently, preserve
liquidity, and monitor and manage risks.
Even as we continue to develop our capabilities, we believe that our
operations are highly scalable. We do not expect our operating costs to
grow at the same rate as our net interest income should we expand our
capital base and our portfolios. Thus, other factors being equal,
growth in capital could be materially accretive to earnings and
dividends per share.
EMPHASIS ON LONG-TERM ASSET PORTFOLIO. Through our operations, we seek
to structure and build a unique portfolio of valuable mortgage assets.
For our residential loan portfolios, we seek to structure long-term
assets with expected average lives of five to fifteen years. The
long-term nature of these assets reduces reinvestment risk and provides
us with more stable, proprietary cash flows.
COMPETITIVE ADVANTAGE OF OUR CORPORATE STRUCTURE. As a REIT, we pay
only limited income taxes, traditionally one of the largest costs of
doing business. In addition, we are not subject to the extensive
regulations applicable to banks, thrifts, insurance companies, and
mortgage banking companies; nor are we subject to the rules governing
regulated investment companies. The absence of regulations in our
market sector is a competitive advantage for us. The regulations
applicable to competitive financial companies can cause capital
inefficiencies and higher operating costs for certain of our
competitors. Our structure enables us to finance loans of higher
quality than our competitors typically do while earning an attractive
return for stockholders.
FLEXIBILITY IN MORTGAGE LOAN PORTFOLIO ORIENTATION. We are open to
other areas of opportunity within real estate finance and related
fields that may compliment and benefit our core business activity of
jumbo residential mortgage loan finance. In addition to our jumbo
residential loan operations, we currently finance U.S. real estate
through our securities portfolio (mostly mortgage securities) and our
commercial mortgage loan portfolio. Depending on the relative
attractiveness of the opportunities in these or new product lines, we
may increase or decrease the asset size and capital allocation of these
portfolios over time.
6
We also generally look for product lines that fit our value
orientation, that take advantage of the structural advantages of our
balance sheet, that do not put us in competition with Fannie Mae and
Freddie Mac, and that allow us to develop a competitive advantage over
our competitors.
OUR STRATEGY
Our objective is to produce attractive growth in earnings per share and
dividends per share for shareholders primarily through the efficient
financing and management of high-quality jumbo residential mortgage
loans and other real estate assets.
The key aspects of our strategy are as follows:
PRESERVE PORTFOLIO QUALITY. In our experience, the highest long-term
risk-adjusted returns in the lending business come from the highest
quality assets. For this reason, we have focused only on "A," or prime,
quality jumbo residential mortgage loans. Within the prime mortgage
loan category, there are degrees of quality: "A," "Alt-A" and "A-." As
compared to the market as a whole, we believe our portfolio is
generally concentrated in the top quality end of the "A" mortgage loan
category. We generally review and acquire mortgage loans from the
large, high-quality, national origination companies, and we have the
top quality servicing companies processing our loan payments and
assisting with loss mitigation. While we may acquire or credit enhance
loans that are less than "A" quality, we currently intend to do so for
seasoned loans of this type that may have less risk than
newly-originated loans. We do own, and intend to acquire additional A-,
Alt-A, and sub-prime residential mortgage securities that, for the most
part, are rated investment-grade because they are credit enhanced in
some form by others; with this credit-enhancement, the risk of
credit-loss from these securities is mitigated. We believe we have
booked credit reserves for our jumbo mortgage loans that exceed the
level of reserves, as a percentage of principal balances, of most bank
and thrift portfolio lenders. We do so because of the cyclical nature
of the U.S. economy and to mitigate the risk of potential mortgage
asset defaults.
MAINTAIN GEOGRAPHIC DIVERSITY. Our jumbo mortgage loan portfolio is as
diverse with respect to geography as is the U.S. jumbo mortgage market
as a whole. We finance loans in all 50 states. With the exception of
California, no one state represented more than 5% of the portfolio at
December 31, 2001. Our exposure to California mortgage loans was 52% of
our portfolio at December 31, 2001; approximately one-half of the jumbo
mortgage loans outstanding in the United States are in California.
EFFECTIVELY MATCH-FUND. We focus on the expert management of jumbo
mortgage loan credit risk. In the course of our business, we do not
generally seek to put ourselves in a position where the anticipation of
interest rates or mortgage prepayment rates is material to meeting our
long-term goals. Accordingly, we generally match the interest rate,
prepayment rate, and cash flow characteristics of our on-balance sheet
assets to our liabilities. Adjustable rate assets are funded with
floating rate debt. Fixed and hybrid assets are funded with matching
debt that amortizes at the same rate as the assets. The amount of
unhedged or unmatched hybrid and fixed-rate assets we own generally
does not materially exceed our equity base. In the past, we have used
interest rate agreements to help us achieve our desired asset/liability
mix. We currently believe we are meeting our asset/liability goals
on-balance sheet, and thus we do not need to use interest rate
agreements. Nevertheless, our earnings are still sensitive to interest
rate factors to a degree. Our current plan is to continue to reduce,
over several years, the relative importance of our short-term funded
securities portfolio on our balance sheet (although we may increase the
size of the short-term funded securities portfolio on a temporary basis
and increase the size of our total securities portfolio when it can be
profitably funded with long-term debt). Reducing our short-term funded
securities portfolio should help further reduce our on-balance sheet
leverage and the sensitivity of our earnings to changes in interest
rates, prepayment rates, and market value changes. We intend to retain
some short-term interest rate mis-matches in our residential whole loan
portfolio and other parts of our balance sheet. Although these assets
and liabilities are effectively match-funded, some variation in
earnings may still result from changes in short-term interest rates.
MANAGE CAPITAL LEVELS. We manage our capital levels, and thus our
access to borrowings and liquidity, through sophisticated risk-adjusted
capital policies supervised by our senior executives. We believe these
conservative and well-developed guidelines are an important tool to
helping us achieve our goals and mitigate the risks of our business,
even when the market value of our assets securing short-term borrowings
decline. Through these
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policies, we assign a capital adequacy guideline amount, expressed as
an equity-to-assets ratio, to each of our 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, residential credit-enhancement
interests, retained interests from our securitizations of our whole
loans, commercial mortgage whole loans, and most other types of assets
we may acquire in the future 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. The sum of the capital adequacy amounts for all of
our assets is our aggregate capital adequacy guideline amount. In most
circumstances in which our actual capital levels decreased below our
capital adequacy guideline amount, we would generally expect to cease
the acquisition of new assets until capital balance was restored
through mortgage prepayments, interest rate changes, or other means.
PURSUE GROWTH. We intend to pursue a growth strategy over time,
increasing our market share of the high quality jumbo residential
market and increasing our capital base and the size of our portfolios.
As we increase our market share, we believe we will be able to deepen
our relationships with our customers, thus potentially giving us
certain pricing, cost and other competitive advantages. As we increase
the size of our capital base, we believe that we may benefit from
improved operating expense ratios, lower borrowing expenses, improved
capital efficiencies, and related factors that may improve earnings and
dividends per share. We will also pursue growth in assets other than
high quality residential jumbo loans in order to provide
diversification of risk and opportunity.
PRODUCT LINES
At December 31, 2001, we had four basic product lines; residential
mortgage loans, residential credit-enhancement securities, commercial
mortgage loans, and securities portfolio. Our current intention is to
focus on the management and growth of these four existing product lines
as well as to expand our investment in other, primarily real estate
related, assets. We operate our four current product lines as a single
business segment, with common staff and management, joint financing
arrangements, and flexible capital allocations between product lines.
RESIDENTIAL MORTGAGE LOANS
We acquire high-quality jumbo residential mortgage loans and hold them
as a long-term investment. We generally fund these acquisitions with
our equity and through the issuance of non-recourse, long-term
securitized debt that closely matches the interest-rate, prepayment,
and maturity characteristics of the loans. We show on our balance sheet
both the underlying residential mortgage loans that we have securitized
and the non-recourse long-term debt that we issue to fund the loans.
The net interest income we earn from these assets equals the interest
income we earn on our loans, less amortization expenses incurred as we
write-off the premium we pay to acquire these assets in excess of the
principal amount of the loan, less credit provision expenses incurred
to build a credit reserve for future expected credit losses, less
interest expense on borrowed funds.
The process of adding to our mortgage loan portfolio commences when we
underwrite and acquire mortgage loans from sellers. We generally seek
to quickly build a portfolio large enough, usually $200 million or
more, to support an efficient issuance of long-term debt. We source our
loan acquisitions primarily from large, well-established mortgage
originators and the larger banks and thrifts.
We are always seeking bulk sales of residential whole loan portfolios
that meet our acquisition criteria and that are priced attractively
relative to our long-term debt issuance levels. In addition, we acquire
new loans on a continuous or "flow" basis from originators that have
loan programs that meet our desired quality standards and loan type.
8
We fund our mortgage loan acquisitions initially with short-term debt.
When we are ready to issue long-term debt, we contribute these loans to
our wholly-owned, special purpose financing subsidiary, Sequoia
Mortgage Funding Corporation, or Sequoia. Sequoia, through a trust,
then issues mostly investment grade rated long-term debt that generally
matches the interest rate, prepayment, and maturity characteristics of
the loans and remits the proceeds of this offering back to us. Our net
investment equals our basis in the loans less the proceeds that we
received from the sale of long-term debt. The amount of equity that we
invest in these trusts to support our long-term debt issuance is
determined by the credit rating agencies, based on their review of the
loans and the structure of the transaction.
We plan to accumulate more high-quality jumbo residential loans when
loans are available on attractive terms relative to our anticipated
costs of issuing long-term debt.
RESIDENTIAL CREDIT-ENHANCEMENT SECURITIES
In addition to acquiring and owning residential mortgage loans, we also
credit enhance pools of high-quality jumbo residential mortgage loans
that have been securitized by others. We do this by acquiring
subordinated securities in third-party securitizations. The
subordinated interests in a securitization transaction bear the bulk of
the potential credit risk for the securitized pool of mortgages, thus
allowing the more senior securitized interests to qualify for
investment grade ratings and to be sold to the world's capital markets.
In effect, we commit our capital to form a "guarantee" or "insurance"
of these securitized pool of mortgages.
Generally, we credit enhance mortgage loans from the top 15
high-quality national mortgage origination firms and certain other
smaller firms that specialize in high-quality jumbo residential
mortgage loan originations. We also work with large banks that are
sellers of seasoned portfolios of high-quality jumbo mortgage loans. We
either work directly with these customers or we work in conjunction
with an investment bank on these transactions.
The principal value of the credit-enhancement securities in any rated
senior/subordinated securitization is determined by the credit rating
agencies: Moody's Investors Service, Standard & Poor's Rating Services,
and Fitch Ratings. These credit agencies examine each pool of mortgage
loans in detail. Based on their review of individual mortgage loan
characteristics, they determine the credit-enhancement levels necessary
to award investment grade ratings to the bulk of the securities formed
from these mortgage loans.
Our actual investment, and our risk, is less than the principal value
of our credit-enhancement securities since we acquire these interests
at a discount to principal value. A portion of this discount we
designate as our credit reserve for future losses; the remainder we
amortize into income over time.
Our first defense against credit loss is the quality of the mortgage
loans we acquire or otherwise credit enhance. Our mortgage loans are
generally in the high-quality range for loan factors such as
loan-to-value ratios, debt to income ratios, credit quality of the
borrower, and completeness of documentation. Our mortgage loans are
secured by the borrowers' homes. Compared to most corporate and
consumer loans, the mortgage loans that we credit enhance have a much
lower loss frequency and a much lower loss severity (the percentage of
the loan principal and accrued interest that we lose upon default).
Our exposure to credit risks of the mortgage loans that we credit
enhance is further limited in a number of respects as follows:
RISK TRANCHING. A typical mortgage securitization has three
credit-enhancement interests -- a "first loss" security and securities
that are second and third in line to absorb credit losses. Of our net
investment in credit-enhancement assets, approximately $30 million, or
16%, was directly exposed to the risk of mortgage loan default at
December 31, 2001. The remainder of our net investment, approximately
$161 million, was in the second or third loss position and benefited
from credit enhancement provided by others through their ownership of
credit-enhancement interests junior to our positions, which totaled $90
million. Credit enhancement varies by specific asset.
LIMITED MAXIMUM LOSS. Our potential credit exposure to the mortgage
loans that we credit enhance is limited to our investment in the
credit-enhancement securities that we acquire.
9
CREDIT RESERVE ESTABLISHED AT ACQUISITION. We acquire
credit-enhancement interests at a discount to their principal value. We
set aside a portion of this discount as a credit reserve to provide for
future credit losses. In most economic environments, we believe that
this reserve should be large enough to absorb future losses. Thus,
typically, most of our credit reserves are established at acquisition
and are, in effect, paid for by the seller of the credit-enhancement
interest. If future credit results are satisfactory, we may not need
all of the amounts designated as reserves. In such event, we may then
redesignate some of these reserves into unamortized discount to be
amortized into income over time.
ACQUISITION DISCOUNT. For many of our credit-enhancement interests, the
discount that we receive upon our acquisition exceeds our designated
credit reserve. Since we own these assets at a discount to our credit
reserve adjusted value, the income statement effect of any credit
losses in excess of our reserve would be mitigated.
MORTGAGE INSURANCE. A portion of our credit-enhanced portfolio consists
of mortgage loans with initial loan-to-value, or LTV, ratios in excess
of 80%. For the vast majority of these higher LTV ratio loans, we
benefit from primary mortgage insurance provided on our behalf by the
mortgage insurance companies or from pledged asset accounts. Thus, for
what would otherwise be our most risky mortgage loans, we have passed
much of the risk on to third parties and our effective loan-to-value
ratios are lower than 80%.
REPRESENTATIONS AND WARRANTIES. As the credit enhancer of a mortgage
securitization, we benefit from representations and warranties received
from the sellers of the mortgage loans. In limited circumstances, the
sellers are obligated to repurchase delinquent mortgage loans from our
credit-enhanced pools, thus reducing our potential exposure.
We believe that the outlook for our jumbo mortgage credit-enhancement
product line in 2002 is excellent. The supply of credit-enhancement
opportunities is expected to be substantial as mortgage originations
and mortgage securitizations remain at relatively high levels. We
expect pricing to remain favorable, as we currently expect demand from
competitors will remain subdued. We expect to achieve continued growth
with attractive pricing in this product line.
COMMERCIAL MORTGAGE LOANS
Our primary business focus is on residential mortgage loan finance. We
also pursue opportunities in the commercial mortgage loan market. For
several years, we have been originating commercial real estate mortgage
loans. Currently, our goal is to increase the size of our commercial
loan portfolio through acquisition rather than origination. We finance
our commercial portfolio with committed bank lines and through selling
senior participations in our mortgage loans. We intend to acquire
commercial mortgage loans, loan participations, and commercial
mortgage-backed securities in the future. Total commercial loans were
$51 million at December 31, 2001.
To date, we have not experienced delinquencies or credit losses in our
commercial mortgage loan portfolio, nor do we anticipate any material
credit problems at this time. We have not established a credit reserve
for commercial loans, although we may do so in the future. A slowing
economy, and factors particular to each mortgage loan, could cause
credit issues in the future. If this occurs, we may need to provide for
future losses and create a specific credit reserve on an asset-by-asset
basis for our commercial mortgage loans held for investment or reduce
the reported market value for our commercial loans held for sale. The
market value of our loans may vary due to the changes in a variety of
other factors.
10
SECURITIES PORTFOLIO
In our securities portfolio, we finance real estate through acquiring
and funding securities. Our securities portfolio contains all of the
securities we own except residential credit-enhancement securities
(below-investment-grade securities with residential prime quality
collateral) which are described separately. At December 31, 2001, we
owned $683 million of securities in this portfolio. The substantial
majority of this portfolio is currently rated AAA or AA, or effectively
has a AAA rating through a corporate guarantee from Fannie Mae or
Freddie Mac.
Since we have an efficient, unregulated tax-advantaged corporate
structure, we believe that we have some advantages in the real estate
securities market relative to other capital market investors.
The maintenance of a securities portfolio serves several functions for
us:
o given our balance sheet characteristics, tax status, and the
capabilities of our staff, real estate securities investments can
earn an attractive return on equity;
o using a portion of our capital to fund additional types of real
estate assets acts as a diversification of risk and opportunity
for our balance sheet;
o the high level of current cash flow from these securities,
including principal receipts from mortgage prepayments, and the
general ability to sell these assets into active trading markets
can have attractive liquidity characteristics for asset/liability
management purposes; and
o our securities portfolio can be an attractive place to employ
capital, and earn rates of return that are higher than cash, when
our capital is not immediately needed to support our
credit-related product lines or when we need flexibility to
adjust our capital allocations.
The bulk of our securities portfolio currently consists of adjustable
rate and floating rate mortgage securities funded with floating rate
short-term debt. We do own some fixed-rate assets in this portfolio
that are either hedged or that we hold unhedged to counter-balance
certain characteristics of our balance sheet.
The substantial majority of our current securities portfolio is backed
by high-quality residential mortgage loans. We do have smaller
positions in residential securities backed by less than high-quality
mortgage loans; most of these securities are substantially credit
enhanced relative to the risks of the loans and thus qualify for
investment grade debt ratings. We also intend to acquire commercial
mortgage securities, corporate debt issued by REITs and other real
estate companies, non-real estate asset-backed securities, corporate
debt of non-real estate companies, interests in collateralized bond
obligations and collateralized debt obligations, and other types of
assets. Assets acquired for our securities portfolio may or may not
have investment-grade credit ratings.
Although we have the ability to hold these mortgage securities to
maturity, and our average holding period is quite long, we do sell
securities from time to time. We do this either as part of our
management of this portfolio or in order to free capital for other
uses. Because of this flexible approach, we manage this portfolio on a
total-rate-of-return basis, taking into account both prospective income
and prospective market value trends in our investment analysis. We use
mark-to-market accounting for this portfolio with a portion of such
adjustments flowing through our income statement, and the other portion
flowing through our balance sheet. As a result of market value
fluctuations, quarterly reported earnings from our securities portfolio
can be variable.
Our current long-term plan is to reduce short-term debt utilized to
fund our securities portfolio. We may reduce the size of our securities
portfolio or we may issue long-term debt or asset-backed securities in
the form of REMICs or collateralized bond obligations in order to fund
a portion of our securities portfolio on a long-term basis. Despite our
long-term plan, we may acquire securities using short-term debt funding
on a temporary basis when we raise new equity capital, or when
prospective returns from investing in short-term funded securities are
attractive relative to our other opportunities.
11
OPERATIONS
Our portfolio management staff forms flexible interdisciplinary product
management teams that work to develop our four product lines, develop
new product lines, and increase our profitability over time. Our
finance staff participates on these teams, and manages our overall
balance sheet, borrowings, cash position, accounting, finance, tax,
equity issuance, and investor relations.
We build and maintain relationships with mortgage originators, banks
that are likely to sell mortgage loan portfolios, Wall Street firms
that broker mortgage product, mortgage servicing companies that process
payments for us and assist with loss mitigation, technology and
information providers that can help us conduct our business more
effectively, with the banks and Wall Street firms that provide us
credit and assist with the issuance of our long-term debt, and with
commercial property owners and other participants in the commercial
mortgage market.
We evaluate, underwrite, and execute asset acquisitions. We also
evaluate potential asset sales. Some of the factors that we take into
consideration are: asset yield characteristics; liquidity; anticipated
credit losses; expected prepayment rates; the cost and type of funding
available for that asset; the amount of capital necessary to carry that
investment in a prudent manner and to meet our internal risk-adjusted
capital guidelines; the cost of any hedging that might be employed;
potential market value fluctuations; contribution to our overall
asset/liability goals; potential earnings volatility in adverse
scenarios; and cash flow characteristics.
We monitor and actively manage our credit risks. We work closely with
our residential and commercial mortgage servicers, especially with
respect to all delinquent loans. While procedures for working out
troubled credit situations for residential loans are relatively
standardized, we still find that an intense focus on assisting and
monitoring our servicers in this process yields good results. We work
to enforce the representations and warranties of our sellers, forcing
them to repurchase loans if there is a breach of the conditions
established at purchase. If a mortgage pool starts to under-perform our
expectations, or if a servicer is not fully cooperative with our
monitoring efforts, we will often seek to sell a credit-enhancement
investment at the earliest opportunity before its market value is
diminished.
Prior to acquisition of a credit-enhancement interest, we typically
review origination processes, servicing standards, and individual loan
data. In some cases, we underwrite individual loan files and influence
which loans are included in a securitization. Prior to acquisition of
whole loans for our residential retained loan portfolio, we conduct a
legal document review of the loans, review individual loan
characteristics, and underwrite loans that appear to have higher risk
characteristics.
We actively monitor and adjust the asset/liability characteristics of
our balance sheet. We follow our internal risk-adjusted capital
guidelines, seeking to make sure that we are sufficiently capitalized
to hold our assets to maturity through periods of market fluctuation.
We intensely monitor our cash levels, the liquidity of our assets, the
stability of our borrowings, and our projected cash flows and market
values to make sure that we remain well funded and liquid. We generally
seek to match the interest rate characteristics of our assets and
liabilities within a range. If we cannot achieve our matching
objectives on-balance sheet, we use interest rate hedge agreements to
adjust our overall asset/liability mix. We monitor potential earnings
fluctuations and cash flow changes from prepayments. We project credit
losses and cash flows from our credit sensitive assets, and reassess
our credit provisions and reserves, based on information from our loss
mitigation efforts, borrower credit trends, and housing price trends.
We regularly monitor the market values of our assets and liabilities by
reviewing pricing from external and internal sources.
We initiate new short-term borrowings on a regular basis with a variety
of counter-parties. We structure long-term debt issuance. We model
potential securitizations, allowing us to price potential loan
acquisitions intended to be funded via long-term debt in our retained
loan portfolio. We work with the credit rating agencies to determine
credit-enhancement levels required to issue new long-term debt. In
cases where we intend to acquire a credit-enhancement interest in a
securitization performed by others, we sometimes assist them with
maximizing the efficiency of the structuring of their securitization.
12
RISK FACTORS
The following is a summary of the risk factors that we currently
believe are important and that could cause our results to differ from
expectations. This is not an exhaustive list; other factors not listed
below could be material to our results.
We can provide no assurances with respect to projections or
forward-looking statements made by us or by others with respect to our
future results. Any one of the risk factors listed below, or other
factors not so listed, could cause actual results to differ materially
from expectations. It is not possible to accurately project future
trends with respect to these risk factors, to project which risk
factors will be most important in determining our results, or to
project what our future results will be.
Throughout this Form 10-K and other documents we release or statements
we make, the words "believe," "expect," "anticipate," "intend," "aim,"
"will," and similar words identify "forward-looking" statements.
MORTGAGE LOAN DELINQUENCIES, DEFAULTS, AND CREDIT LOSSES COULD REDUCE
OUR EARNINGS. CREDIT LOSSES COULD REDUCE OUR CASH FLOW AND ACCESS TO
LIQUIDITY.
As a core part of our business, we assume the credit risk of mortgage
loans. We do this in each of our portfolios. We may add other product
lines over time that may have different types of credit risk than are
described herein. We are generally not limited in the types of assets
that we can own or in the types of credit risk or other types of risk
that we can undertake.
We generally intend to increase our credit risk exposure over time
through net acquisitions of credit-sensitive loans and securities and
through net dispositions of more highly-rated securities.
Tax and GAAP accounting for credit losses differ. We have not been able
to reduce our past and current taxable income to provide for a reserve
for future credit losses. Thus, if credit losses occur in the future,
taxable income may be reduced relative to GAAP income. When taxable
income is reduced, our minimum dividend distribution requirements under
the REIT tax rules are reduced. We could reduce our dividend rate in
such a circumstance. Alternatively, credit losses in some assets may be
capital losses for tax. Unless we had offsetting capital gains, our
minimum dividend distribution requirement would not be reduced by these
credit losses, but eventually our cash flow would be. This could reduce
our free cash flow and liquidity.
If the recent slowdown in the U.S. economy should persist, or worsen,
our credit losses could be increased beyond levels that we have
anticipated. If we incur increased credit losses, our earnings might be
reduced, and our cash flows, asset market values, and access to
borrowings might be adversely affected. The amount of capital and cash
reserves that we hold to help us manage credit and other risks may
prove to be insufficient to protect us from earnings volatility,
dividend cuts, liquidity, and solvency issues.
WE ASSUME DIRECT CREDIT RISK IN OUR RESIDENTIAL MORTGAGE LOANS, AND
REALIZED CREDIT LOSSES MAY REDUCE OUR EARNINGS AND FUTURE CASH FLOW.
In our residential mortgage loan portfolio, we assume the direct credit
risk of residential mortgages. Realized credit losses will reduce our
earnings and future cash flow. We have a credit reserve for these loans
and we may continue to add to this reserve in the future. There can be
no assurance that our credit reserve will be sufficient to cover future
losses. We may need to reduce earnings by increasing our
credit-provisioning expenses in the future.
Credit losses on residential mortgage loans can occur for many reasons,
including: poor origination practices -- leading to losses from fraud,
faulty appraisals, documentation errors, poor underwriting, legal
errors, etc.; poor servicing practices; weak economic conditions;
declines in the values of homes; special hazards; earthquakes and other
natural events; over-leveraging of the borrower; changes in legal
protections for lenders; reduction in personal incomes; job loss; and
personal events such as divorce or health problems.
13
Despite our efforts to manage our credit risk, there are many aspects
of credit that we cannot control, and there can be no assurance that
our quality control and loss mitigation operations will be successful
in limiting future delinquencies, defaults, and losses. Our
underwriting reviews may not be effective. The representations and
warranties that we receive from sellers may not be enforceable. We may
not receive funds that we believe are due to us from mortgage insurance
companies. We rely on our servicers; they may not cooperate with our
loss mitigation efforts, or such efforts may otherwise be ineffective.
Various service providers to securitizations, such as trustees, bond
insurance providers and custodians, may not perform in a manner that
promotes our interests. The value of the homes collateralizing our
loans may decline. The frequency of default, and the loss severity on
our loans upon default, may be greater than we anticipated.
Interest-only loans, negative amortization loans, loans with balances
over $1 million, and loans that are partially collateralized by
non-real estate assets may have special risks. Our geographical
diversification may be ineffective in reducing losses. If loans become
"real estate owned," or REO, we, or our agents, will have to manage
these properties and may not be able to sell them. Changes in consumer
behavior, bankruptcy laws and the like may exacerbate our losses. In
some states and circumstances, we have recourse against the borrower's
other assets and income; but, nevertheless, we may only be able to look
to the value of the underlying property for any recoveries. Expanded
loss mitigation efforts in the event that defaults increase could be
costly.
WE HAVE CREDIT RISKS IN OUR CREDIT-ENHANCEMENT SECURITIES RELATED TO
THE UNDERLYING LOANS.
Of our total net investment in residential credit-enhancement
securities at December 31, 2001, $30 million, or 16%, was in a first
loss position with respect to the underlying loans. We generally expect
that the entire amount of these first loss investments will be subject
to credit loss, potentially even in healthy economic environments. Our
ability to make an attractive return on these investments depends on
how quickly these expected losses occur. If the losses occur more
quickly than we anticipate, we may not recover our investment and/or
our rates of return may suffer.
Second loss credit-enhancement securities, which are subject to credit
loss when the entire first loss investment (whether owned by us or by
others) has been eliminated by credit losses, made up 31%, or $60
million, of our net investment in credit-enhancement securities at
December 31, 2001. Third loss credit-enhancement securities, or other
investments that themselves enjoy various forms of material credit
enhancement, made up 53%, or $101 million, of our net investment in
credit-enhancement interests at December 31, 2001. Given our normal
expectations for credit losses, we would anticipate some future losses
on many of our second loss interests but no losses on investments in
the third loss or similar position. If credit losses are greater than,
or occur sooner than, expected, our expected future cash flows will be
reduced and our earnings will be negatively affected. Credit losses and
delinquencies could also affect the cash flow dynamics of these
securitizations and thus extend the period over which we will receive a
return of principal from these investments. In most cases, adverse
changes in anticipated cash flows would reduce our economic and
accounting returns and may also precipitate mark-to-market charges to
earnings. From time to time, we may pledge these interests as
collateral for borrowings; a deterioration of credit results in this
portfolio may adversely affect the terms or availability of these
borrowings and, thus, our liquidity. We generally expect to increase
our net acquisitions of first loss and second loss investments relative
to third loss investments. This may result in increased risk with
respect to the credit results of the residential loans we credit
enhance.
In our credit-enhancement securities portfolio, we may benefit from
credit rating upgrades or restructuring opportunities through
re-securitizations or other means in the future. If credit results
deteriorate, these opportunities may not be available to us or may be
delayed. It is likely, in many instances, that we will not be able to
anticipate increased credit losses in a pool soon enough to allow us to
sell such credit-enhancement interests at a reasonable price.
In anticipation of future credit losses, we designate a portion of the
purchase discount associated with many of our credit-enhancement
securities as a form of credit reserve. The remaining discount is
amortized into income over time via the effective yield method. If the
credit reserve we set aside at acquisition proves to be insufficient,
we may need to reduce our effective yield income recognition in the
future or we may adjust our basis in these interests, thus reducing
earnings.
14
We adopted EITF 99-20 in the first quarter of 2001. Generally, under
EITF 99-20, if prospective cash flows from certain investments
deteriorate even slightly from original expectations -- due to changes
in anticipated credit losses, prepayment rates, and otherwise -- then
the asset will be marked-to-market if the market value is lower than
our basis. Any mark-to-market adjustments under EITF 99-20 reduce
earnings in that period. Since we do not expect every asset we own to
always perform equal to or better than our expectations, we expect to
make negative EITF 99-20 adjustments to earnings from time to time. Any
positive adjustments to future cash flows are generally reflected in a
higher yield over the remaining life of such asset.
WE MAY HAVE CREDIT LOSSES IN OUR SECURITIES PORTFOLIO.
Most of our securities (excluding our residential credit-enhancement
securities) are currently rated AAA or AA (99% at December 31, 2001).
These assets benefit from various forms of corporate guarantees from
Fannie Mae, Freddie Mac, and other companies, and/or from credit
enhancement provided by third parties, usually through their ownership
of subordinated credit-enhancement interests. Thus, the bulk of our
existing securities are protected from currently expected levels of
credit losses. However, in the event of greater than expected future
delinquencies, defaults, or credit losses, or a substantial
deterioration in the financial strength of Fannie Mae, Freddie Mac, or
other corporate guarantors, our results would likely be adversely
affected. We may experience credit losses in our securities portfolio.
Deterioration of the credit results or guarantees of these assets may
reduce the market value of these assets, thus limiting our borrowing
capabilities and access to liquidity. Generally, we do not control or
influence the underwriting, servicing, management, or loss mitigation
efforts with respect to these assets. Results could be affected through
credit rating downgrades, market value losses, reduced liquidity,
adverse financing terms, reduced cash flow, experienced credit losses,
or in other ways. For the non-investment grade assets in our securities
portfolio, representing 1% of our securities portfolio at December 31,
2001, our protection against credit loss is smaller and our credit
risks and liquidity risks are increased. If we acquire equity
securities, results may be volatile. We intend to increase the
percentage of our securities portfolio that is rated below AA and that
is rated below investment grade, and we intend to expand the range of
types of securities that we acquire; these trends may increase the
potential credit risks in our securities portfolio.
WE ASSUME DIRECT CREDIT RISK IN OUR COMMERCIAL MORTGAGE LOANS.
The loans in our commercial mortgage loan portfolio may have higher
degrees of credit and other risks than do our residential mortgage
loans, including various environmental and legal risks. The net
operating income and market values of income-producing properties may
vary with economic cycles and as a result of other factors, so that
debt service coverage is unstable. The value of the property may not
protect the value of the loan if there is a default. Our commercial
loans are not geographically diverse, so we are at risk for regional
factors: at December 31, 2001, $30 million, or 59%, of our commercial
loan balances were on commercial properties located in California. Many
of our commercial loans are not fully amortizing, so the timely
recovery of our principal is dependent on the borrower's ability to
refinance at maturity. We generally lend against income-properties that
are in transition. Such lending entails higher risks than traditional
commercial property lending against stabilized properties. Initial debt
service coverage ratios, loan-to-value ratios, and other indicators of
credit quality may not meet standard commercial mortgage market
criteria for stabilized loans. The underlying properties may not
transition or stabilize as we expected. The personal guarantees and
forms of cross-collateralization that we receive on some loans may not
be effective. We generally do not service our loans; we rely on our
servicers to a great extent to manage our commercial assets and
work-out loans and properties if there are delinquencies or defaults.
This may not work to our advantage. As part of the work-out process of
a troubled commercial loan, we may assume ownership of the property,
and the ultimate value of this asset would depend on our management of,
and eventual sale of, the property which secured the loan. Our loans
are illiquid; if we choose to sell them, we may not be able to do so in
a timely manner or for a reasonable price. Financing these loans may be
difficult, and may become more difficult if credit quality
deteriorates. We have sold senior loan participations on some of our
loans, so that the asset we retain is junior and has concentrated
credit and other risks. We have directly originated our commercial
loans. This may expose us to certain credit, legal, and other risks
that may be greater than is usually present with acquired loans. We
have sold commercial mortgage loans. The representations and warranties
we made on these sales are limited, but could cause losses and claims
in some circumstances.
15
WE MAY INVEST IN OTHER TYPES OF CREDIT RISKS THAT COULD ALSO CAUSE
LOSSES.
We intend to invest in other types of commercial loan assets, such as
mezzanine loans, second liens, credit-enhancement interests of
commercial loan securitizations, junior participations, among others,
that may entail other types of risks. In addition, we intend to invest
in other assets with material credit risk, including the equity and
debt of collateralized bond obligations (CBOs), corporate debt and
equity of REITs and non-real estate companies, real estate and non-real
estate asset-backed securities, and other financial and real property
assets.
OUR RESULTS COULD ALSO BE ADVERSELY AFFECTED BY COUNTER-PARTY CREDIT
RISK.
We have other credit risks that are generally related to the
counter-parties with which we do business. In the event a counter-party
to our short-term borrowings becomes insolvent, we may fail in
recovering the full value of our collateral, thus reducing our earnings
and liquidity. In the event a counter-party to our interest rate
agreements becomes insolvent, our ability to realize benefits from
hedging may be diminished, and any cash or collateral that we pledged
to these counter-parties may be unrecoverable. We may be forced to
unwind these agreements at a loss. In the event that one of our
servicers becomes insolvent or fails to perform, loan delinquencies and
credit losses may increase. We may not receive funds to which we are
entitled. In various other aspects of our business, we depend on the
performance of third parties that we do not control. We attempt to
diversify our counter-party exposure and to limit our counter-party
exposure to strong companies with investment-grade credit ratings, but
we are not always able to do so. Our counter-party risk management
strategy may prove ineffective.
FLUCTUATIONS IN OUR RESULTS MAY BE EXACERBATED BY THE LEVERAGE THAT WE
EMPLOY AND BY LIQUIDITY RISKS.
We employ substantial financial leverage on our balance sheet relative
to many non-financial companies, although we believe we employ less
leverage than most banks, thrifts, and other financial institutions. In
addition, the bulk of our financing is typically in the form of
non-recourse debt issued through asset securitization. We believe this
is generally an effective and low-risk form of financing compared to
many other forms of debt utilized by financial companies. We believe
the amount of leverage that we employ is appropriate, given the risks
in our balance sheet, the non-recourse nature of the long-term
financing structures that we typically employ, and our management
policies. However, in order to operate our business successfully, we
require continued access to debt on favorable terms with respect to
financing costs, capital efficiency, covenants, and other factors. We
may not be able to achieve the optimal amount of leverage.
Given the degree of leverage that we employ, earnings fluctuations, and
liquidity and financial soundness issues could arise in the future. Due
to our leverage, relatively small changes in asset quality, asset
yield, cost of borrowed funds, and other factors could have relatively
large effects on us and our stockholders. Our use of leverage may not
enhance our returns.
Although we do not have a corporate debt rating, the
nationally-recognized credit rating agencies have a strong influence on
the amount of capital that we hold relative to the amount of credit
risk we take. The rating agencies determine the amount of net
investment we must make to credit enhance the long-term debt, mostly
rated AAA, that we issue to fund our residential retained loan
portfolio. They also determine the amount of principal value required
for the credit-enhancement interests we acquire. The rating agencies,
however, do not have influence over how we fund our net credit
investments nor do they determine or influence many of our other
capital and leverage policies. With respect to our short-term debt, our
lenders, typically large commercial banks and Wall Street firms, limit
the amount of funds that they will advance versus our collateral. We
typically use far less leverage than would be permitted by our lenders.
However, lenders can reduce the amount of leverage that they will
permit us to undertake, or the value of our collateral may decline,
thus reducing our liquidity.
Unlike banks, thrifts, and the government-sponsored mortgage finance
companies, we are not regulated by national regulatory bodies. Thus,
the amount of financial leverage that we employ is largely controlled
by management, and by the risk-adjusted capital policies approved by
our Board of Directors.
In the period in which we are accumulating residential whole loans or
other debt in order to build a portfolio of efficient size to issue
long-term debt, variations in the market for these assets or for
long-term debt issuance could
16
affect our results. Ultimately we may not be able to issue long term
debt, the cost of such debt could be greater than we anticipated, the
net investment in our financing trust required by the rating agencies
could be greater than anticipated, certain of our loans could not be
accepted into the financing trust, the market value of our assets to be
sold into the financing trust may have changed, our hedging activities
may have been ineffective, or other negative effects could occur.
We borrow on a short-term basis to fund the bulk of our securities
portfolio, to fund residential loans or other assets prior to the
issuance of long-term debt, to use a certain amount of leverage with
respect to our net investments in credit-enhancement interests, to fund
a portion of our commercial loan portfolio, to fund working capital and
general corporate needs, and for other reasons. We borrow short-term by
pledging our mortgage assets as collateral. We usually borrow via
uncommitted borrowing facilities for the substantial majority of our
short-term debt funded assets that are generally liquid, have active
trading markets, and have readily discernable market prices. The term
of these borrowings can range from one day to one year. To fund less
liquid or more specialized assets, we typically utilize committed
credit lines from commercial banks and finance companies with a one to
two year term. Whether committed or not, we need to roll over
short-term debt on a frequent basis; our ability to borrow is dependent
on our ability to deliver sufficient market value of collateral to meet
lender requirements. Our payment of commitment fees and other expenses
to secure committed borrowing lines may not protect us from liquidity
issues or losses. Variations in lenders' ability to access funds,
lender confidence in us, lender collateral requirements, available
borrowing rates, the acceptability and market values of our collateral,
and other factors could force us to utilize our liquidity reserves or
to sell assets, and, thus, affect our liquidity, financial soundness,
and earnings. In recent years, we believe that the marketplace for our
type of secured short-term borrowing has been more stable than the
commercial paper market, or corporate unsecured short-term borrowing,
utilized by many in corporate America, but there is no assurance that
such stability will continue. Our current intention is to reduce our
short-term debt levels over time, with the exception of short-term debt
used to fund assets under accumulation for a securitization. There can
be no assurance that such debt reduction will be achieved. In the
future, we may borrow on an unsecured basis through bank loans,
issuance of corporate debt, and other means.
Various of our borrowing arrangements subject us to debt covenants.
While these covenants have not meaningfully restricted our operations
through December 31, 2001, they could be restrictive or harmful to us
and our stockholder interests in the future. Should we violate debt
covenants, we may incur expenses, losses, or reduced ability to access
debt.
Preferred stock makes up a portion of our equity capital base,
representing 9% at December 31, 2001. Our Class B Preferred Stock has a
dividend rate of at least $0.755 per share per quarter, and has certain
rights to dividend distributions and preferences in liquidation that
are senior to common stockholders. Having preferred stock in our
capital structure is a form of leverage, and such leverage may or may
not work to the advantage of common stockholders.
CHANGES IN THE MARKET VALUES OF OUR ASSETS AND LIABILITIES CAN
ADVERSELY AFFECT OUR EARNINGS, STOCKHOLDERS' EQUITY, AND LIQUIDITY.
The market values of our assets, liabilities, and hedges are affected
by interest rates, the shape of yield curves, volatility, credit
quality trends, mortgage prepayment rates, supply and demand, capital
markets trends and liquidity, general economic trends, expectations
about the future, and other factors. For the assets that we
mark-to-market through our income statement or balance sheet, such
market value fluctuations will affect our earnings and book value. To
the extent that our basis in our assets is thus changed, future
reported income will be affected as well. If we sell an asset that has
not been marked-to-market through our income statement at a reduced
market price relative to our basis, our earnings will be reduced.
Market value reductions of the assets that we pledge for short-term
borrowings may reduce our access to liquidity.
Generally, reduced asset market values for the assets that we own may
have negative effects, but might improve our opportunities to acquire
new assets at attractive pricing levels. Conversely, increases in the
market values of our existing assets may have positive effects, but may
mean that acquiring new assets at attractive prices becomes more
difficult.
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CHANGES IN MORTGAGE PREPAYMENT RATES MAY AFFECT OUR EARNINGS,
LIQUIDITY, AND THE MARKET VALUES OF OUR ASSETS.
Mortgage prepayment rates are affected by interest rates, consumer
behavior and confidence, seasoning of loans, the amount of equity in
the underlying properties, prepayment terms of the mortgages, the ease
and cost of refinancing, the housing turnover rate, media awareness of
refinancing opportunities, and many other factors.
Changes in prepayment rates may have multiple effects on our
operations. Faster mortgage prepayment rates may lead to increased
premium amortization expenses for premium assets, increased working
capital requirements, reduced market values for certain types of
assets, adverse reductions in the average life of certain assets, and
an increase in the need to reinvest cash to maintain operations.
Premium assets may experience faster rates of prepayments than discount
assets. Slower prepayment rates may lead to reduced discount
amortization income for discount assets, reduced market values for
discount and other types of assets, extension of the average life of
certain investments at a time when this would be contrary to our
interests, a reduction in cash flow available to support operations and
make new investments, and a reduction in new investment opportunities,
since the volume of new origination and securitizations would likely
decline. Slower prepayment rates may lead to increased credit losses.
The amount of premium and discount we have on our books, and thus our
net amortization expenses, can change over time as we mark-to-market
assets or as our asset composition changes through principal repayments
and asset purchases and sales.
INTEREST RATE FLUCTUATIONS CAN HAVE VARIOUS EFFECTS ON OUR COMPANY, AND
COULD LEAD TO REDUCED EARNINGS AND/OR INCREASED EARNINGS VOLATILITY.
Our balance sheet and asset/liability operations are complex and
diverse with respect to interest rate movements, so we cannot fully
describe all the possible effects of changing interest rates. We do not
seek to eliminate all interest rate risk. Changes in interest rates,
and in the interrelationships between various interest rates, could
have negative effects on our earnings, the market value of our assets
and liabilities, mortgage prepayment rates, and our access to
liquidity. Changes in interest rates can also affect our credit
results.
Generally, rising interest rates could lead to reduced asset market
values and slower prepayment rates. Initially, our net interest income
may be reduced if short-term interest rates increase, as our cost of
funds would likely respond to this increase more quickly than would our
asset yields. Within three to twelve months of a rate change, however,
asset yields for our adjustable rate mortgages may increase
commensurately with the rate increase. Higher short-term interest rates
may reduce earnings in the short-term, but could lead to higher
long-term earnings, as we earn more on the equity-funded portion of our
balance sheet. To the extent that we own fixed-rate assets that are
funded with floating rate debt, our net interest income from this
portion of our balance sheet would be unlikely to recover until
interest rates dropped again or the assets matured. Some of our
adjustable-rate mortgages have periodic caps that limit the extent to
which the coupon we earn can rise or fall, usually 2% annual caps, and
life caps that set a maximum coupon. If short-term interest rates rise
rapidly or rise so that our mortgage coupons reach their life caps, the
ability of our asset yields to rise along with market rates would be
limited, but there may be no such limits on the increase in our
liability costs.
Falling interest rates can also lead to reduced asset market values in
some circumstances, particularly for prepayment sensitive assets and
for many types of interest rate agreement hedges. Decreases in
short-term interest rates can be positive for earnings in the
near-term, as our cost of funds may decline more quickly than our asset
yields would. For longer time horizons, falling short-term interest
rates can reduce our earnings, as we may earn lower yields from the
assets that are equity-funded on our balance sheet.
Changes in the interrelationships between various interest rates can
reduce our net interest income even in the absence of a clearly defined
interest rate trend. If the short-term interest rate indices that drive
our asset yields were to decline relative to the short-term interest
rate indices that determine our cost of funds, our net interest income
would be reduced.
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HEDGING ACTIVITIES MAY REDUCE LONG-TERM EARNINGS AND MAY FAIL TO REDUCE
EARNINGS VOLATILITY OR TO PROTECT OUR CAPITAL IN DIFFICULT ECONOMIC
ENVIRONMENTS; FAILURE TO HEDGE MAY ALSO HAVE ADVERSE EFFECTS ON OUR
RESULTS.
Hedging against interest rate movements using interest rate agreements
and other instruments usually has the effect over long periods of time
of lowering long-term earnings. To the extent that we hedge, it is
usually to protect us from some of the effects of a rapid or prolonged
increase in short-term interest rates or to lower short-term earnings
volatility. Such hedging may not be in the long-term interest of
stockholders, and may not achieve its desired goals. For instance,
hedging costs may rise as interest rates increase, without an
offsetting increase in hedging income. In a rapidly rising interest
rate environment, the market values of hedges may not increase as
predicted. Using interest rate agreements to hedge may increase
short-term earnings volatility, particularly since we currently employ
mark-to-market accounting for all our hedges. Reductions in market
values of interest rate agreements may not be offset by increases in
market values of the assets or liabilities being hedged. Conversely,
increases in market values of interest rate agreements may not fully
offset declines in market values of assets or liabilities being hedged.
Changes in market values of interest rate agreements may require us to
pledge collateral or cash.
At December 31, 2001, we had no hedges in place that would materially
affect our results and operations. We reduced our hedging operations as
we believe we have generally achieved our asset/liability goals with
our existing on-balance sheet assets and liabilities. The absence of
hedging, however, may not prove to be in the best interests of our
stockholders.
MAINTAINING REIT STATUS MAY REDUCE OUR FLEXIBILITY.
To maintain REIT status, we must follow rules and meet certain tests.
In doing so, our flexibility to manage our operations may be reduced.
Frequent asset sales could result in Redwood Trust being viewed as a
"dealer," and thus subject to entity level taxes. Certain types of
hedging may produce income that is limited under the REIT rules. Our
ability to own non-real estate related assets and earn non-real estate
related income is limited. Meeting minimum REIT dividend distribution
requirements may reduce our liquidity. Because we will generally
distribute all our taxable earnings as dividends, we may need to raise
new equity capital if we wish to grow operations at a rapid pace. Stock
ownership tests may limit our ability to raise significant amounts of
equity capital from one source. Failure to meet REIT requirements may
subject us to taxation, penalties, and/or loss of REIT status. REIT
laws and taxation could change in a manner adverse to our operations.
To pursue our business plan as a REIT, we generally need to avoid
becoming a Registered Investment Company, or RIC. To avoid RIC
restrictions, we generally need to maintain at least 55% of our assets
in whole loan form or in other related forms of assets that qualify for
this test. Meeting this test may restrict our flexibility. Failure to
meet this test would limit our ability to leverage and would impose
other restrictions on our operations. Our ability to operate a taxable
subsidiary is limited under the REIT rules. Our REIT status affords us
certain protections against take-over attempts. These take-over
restrictions may not always work to the advantage of stockholders. Our
stated goal is to not generate income that would be taxable as
unrelated business taxable income, or UBTI, to our tax-exempt
shareholders. Achieving this goal may limit our flexibility in pursuing
certain transactions.
OUR CASH BALANCES AND CASH FLOWS MAY BECOME LIMITED RELATIVE TO OUR
CASH NEEDS.
We need cash to meet our working capital needs, preferred stock
dividend, and minimum REIT dividend distribution requirements. Cash
could be required to pay-down our borrowings in the event that the
market values of our assets that collateralize our debt decline, the
terms of short-term debt become less attractive, or for other reasons.
Cash flows from principal repayments could be reduced should
prepayments slow or should credit quality trends deteriorate, in the
latter case since for certain of our assets, credit tests must be met
for us to receive cash flows. For some of our assets, cash flows are
"locked-out" and we receive less than our pro rata share of principal
payment cash flows in the early years of the investment. Operating cash
flow generation could be reduced if earnings are reduced, if discount
amortization income significantly exceeds premium amortization expense,
or for other reasons. Our minimum dividend distribution requirements
could become large relative to our cash flow if our income as
calculated for tax purposes significantly exceeds our cash flow from
operations. Generally, our cash flow has materially exceeded our cash
requirements; this situation could be reversed, however, with
corresponding adverse consequences to us. We generally maintain what we
believe are ample cash balances and access to borrowings to meet
projected cash needs. In the event, however, that our liquidity needs
exceed our access to
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liquidity, we may need to sell assets at an inopportune time, thus
reducing our earnings. In a serious situation, our REIT status or our
solvency could be threatened.
INCREASED COMPETITION COULD REDUCE OUR ACQUISITION OPPORTUNITIES OR
AFFECT OUR OPERATIONS IN A NEGATIVE MANNER.
We believe that our principal competitors in our business of real
estate finance are depositories such as banks and thrifts, mortgage and
bond insurance companies, other mortgage REITs, hedge funds and private
investment partnerships, life insurance companies, government entities
such as Fannie Mae, Freddie Mac, Ginnie Mae, and the Federal Home Loan
Banks, mutual funds, pension funds, mortgage originators, and other
financial institutions. We anticipate that we will be able to compete
effectively due to our relatively low level of operating costs,
relative freedom to securitize our assets, our ability to utilize
leverage, freedom from certain forms of regulation, focus on our core
business, and the tax advantages of our REIT status. Nevertheless, many
of our competitors have greater operating and financial resources than
we do. Competition from these entities, or new entrants, could raise
prices on mortgages and other assets, reduce our acquisition
opportunities, or otherwise materially affect our operations in a
negative manner.
NEW ASSETS MAY NOT BE AVAILABLE AT ATTRACTIVE PRICES, THUS LIMITING OUR
GROWTH AND/OR EARNINGS.
In order to reinvest proceeds from mortgage principal repayments, or to
deploy new equity capital that we may raise in the future, we need to
acquire new assets. If pricing of new assets is unattractive, or if the
availability of new assets is much reduced, we may not be able to
acquire new assets at attractive prices. Our new assets may generate
lower returns than the assets that we have on our balance sheet.
Generally, unattractive pricing and availability of new assets is a
function of reduced supply and/or increased demand. Supply can be
reduced if originations of a particular product are reduced, or if
there are few sales in the secondary market of seasoned product from
existing portfolios. The supply of new securitized assets appropriate
for our balance sheet could be reduced if the economics of
securitization become unattractive or if a form of securitization that
is not favorable for our balance sheet predominates. Also, assets with
a favorable risk/reward ratio may not be available if the risks of
owning such assets increase substantially relative to market pricing
levels. Increased competition could raise prices to unattractive
levels.
ACCOUNTING CONVENTIONS AND ESTIMATES CAN CHANGE, AFFECTING OUR REPORTED
RESULTS AND OPERATIONS.
Accounting rules for the various aspects of our business change from
time to time. While we believe we apply the highest quality accounting
principles and practices, changes in accounting rules can nevertheless
affect our reported income and stockholders' equity. Our revenue
recognition and other aspects of our reported results are based on
estimates of future events. These estimates can change in a manner that
adversely affects our results.
OUR POLICIES, PROCEDURES, PRACTICES, PRODUCT LINES, RISKS, AND INTERNAL
RISK-ADJUSTED CAPITAL GUIDELINES ARE SUBJECT TO CHANGE.
In general, we are free to alter our policies, procedures, practices,
product lines, leverage, risks, internal risk-adjusted capital
guidelines, and other aspects of our business. We can enter new
businesses or pursue acquisitions of other companies. In most cases, we
do not need to seek stockholder approval to make such changes. We will
not necessarily notify stockholders of such changes.
WE DEPEND ON KEY PERSONNEL FOR SUCCESSFUL OPERATIONS.
We depend significantly on the contributions of our executive officers
and staff. Many of our officers and employees would be difficult to
replace. The loss of any key personnel could materially affect our
results.
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INVESTORS IN OUR COMMON STOCK MAY EXPERIENCE LOSSES, VOLATILITY, AND
POOR LIQUIDITY, AND WE MAY REDUCE OUR DIVIDENDS IN A VARIETY OF
CIRCUMSTANCES.
Our earnings, cash flow, book value, and dividends can be volatile and
difficult to predict. Investors should not rely on predictions or
management beliefs. Although we seek to pay a regular common stock
dividend rate that is sustainable, we may cut our dividend rate in the
future for a variety of reasons. We may not provide public warnings of
such dividend reductions prior to their occurrence. Fluctuations in our
current and prospective earnings, cash flow, and dividends, as well as
many other factors such as perceptions, economic conditions, stock
market conditions, and the like, can affect our stock price. Investors
may experience volatile returns and material losses. In addition,
liquidity in the trading of our stock may be insufficient to allow
investors to sell their stock in a timely manner or at a reasonable
price.
CERTAIN FEDERAL INCOME TAX CONSIDERATIONS
The following discussion summarizes certain Federal income tax
considerations to Redwood Trust and its stockholders. This discussion
is based on existing Federal income tax law, which is subject to
change, possibly retroactively. This discussion does not address all
aspects of Federal income taxation that may be relevant to a particular
stockholder in light of its personal investment circumstances or to
certain types of investors subject to special treatment under the
Federal income tax laws (including financial institutions, insurance
companies, broker-dealers and, except to the extent discussed below,
tax-exempt entities and foreign taxpayers) and it does not discuss any
aspects of state, local or foreign tax law. This discussion assumes
that stockholders will hold their Common Stock as a "capital asset"
(generally, property held for investment) under the Code. Stockholders
are advised to consult their tax advisors as to the specific tax
consequences to them of purchasing, holding and disposing of the Common
Stock, including the application and effect of Federal, state, local
and foreign income and other tax laws.
GENERAL
Redwood Trust has elected to become subject to tax as a REIT, for
Federal income tax purposes, commencing with the taxable year ending
December 31, 1994. Management believes that Redwood Trust has operated
and expects that it will continue to operate in a manner that permits
Redwood Trust to maintain its qualifications as a REIT. This treatment
permits Redwood Trust to deduct dividend distributions to its
stockholders for Federal income tax purposes, thus generally
eliminating the "double taxation" that typically results when a
corporation earns income and distributes that income to its
stockholders.
There can be no assurance that Redwood Trust will continue to qualify
as a REIT in any particular taxable year, given the highly complex
nature of the rules governing REITs, the ongoing importance of factual
determinations and the possibility of future changes in the
circumstances of Redwood Trust. If Redwood Trust failed to qualify as a
REIT in any particular year, it would be subject to Federal income tax
as a regular, domestic corporation, and its stockholders would be
subject to tax in the same manner as stockholders of such corporation.
In this event, Redwood Trust could be subject to potentially
substantial income tax liability in respect of each taxable year that
it fails to qualify as a REIT and the amount of earnings and cash
available for distribution to its stockholders could be significantly
reduced or eliminated.
The following is a brief summary of certain technical requirements that
Redwood Trust must meet on an ongoing basis in order to qualify, and
remain qualified, as a REIT under the Code.
STOCK OWNERSHIP TESTS
The capital stock of Redwood Trust must be held by at least 100 persons
for at least 335 days of a twelve-month year, or a proportionate part
of a short tax year. In addition, no more than 50% of the value of
Redwood Trust's capital stock may be owned, directly or indirectly, by
five or fewer individuals at all times during the last half of the
taxable year. Under the Code, most tax-exempt entities including
employee benefit trusts and charitable trusts (but excluding trusts
described in 401(a) and exempt under 501(a)) are generally treated as
individuals for these purposes. Redwood Trust must satisfy these stock
ownership requirements each taxable year. Redwood Trust
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must solicit information from certain of its stockholders to verify
ownership levels and its Articles of Incorporation impose certain
repurchase obligations and restrictions regarding the transfer of
Redwood Trust's shares in order to aid in meeting the stock ownership
requirements. If Redwood Trust were to fail either of the stock
ownership tests, it would generally be disqualified from REIT status,
unless, in the case of the "five or fewer" requirement, the "good
faith" exemption is available.
ASSET TESTS
For tax years beginning before December 31, 2000, Redwood Trust must
generally meet the following asset tests (REIT Asset Tests) at the
close of each quarter of each taxable year:
(a) at least 75% of the value of Redwood Trust's total assets
must consist of Qualified REIT Real Estate Assets, government
securities, cash, and cash items (75% Asset Test); and
(b) the value of securities held by Redwood Trust but not taken
into account for purposes of the 75% Asset Test must not exceed
either (i) 5% of the value of Redwood Trust's total assets in the
case of securities of any one non-government issuer, or (ii) 10%
of the outstanding voting securities of any such issuer.
For tax years beginning after December 31, 2000, Redwood Trust must
generally meet the following REIT Asset Tests at the close of each
quarter of each taxable year:
(a) the 75% Asset Test;
(b) not more than 25% of the value of Redwood Trust's total
assets is represented by securities (other than those includible
under the 75% Asset Test);
(c) not more than 20% of the value of Redwood Trust's total
assets is represented by securities of one or more taxable REIT
subsidiary; and
(d) the value of securities held by Redwood Trust, other than
those of a taxable REIT subsidiary or taken into account for
purposes of the 75% Asset Test, must not exceed either (i) 5% of
the value of Redwood Trust's total assets in the case of
securities of any one non-government issuer, or (ii) 10% of the
outstanding vote or value of any such issuer's securities.
Redwood Trust intends to monitor closely the purchase, holding and
disposition of its assets in order to comply with the REIT Asset Tests.
Redwood Trust expects that substantially all of its assets will be
Qualified REIT Real Estate Assets and intends to limit and diversify
its ownership of any assets not qualifying as Qualified REIT Real
Estate Assets to less than 25% of the value of Redwood Trust's assets,
to less than 5%, by value, of any single issuer and to less than 20%,
by value, of any taxable REIT subsidiaries. In addition, Redwood Trust
does not expect to own more than 10% of the vote or value of any one
issuer's securities. If it is anticipated that these limits would be
exceeded, Redwood Trust intends to take appropriate measures, including
the disposition of non-qualifying assets, to avoid exceeding such
limits.
GROSS INCOME TESTS
Redwood Trust must generally meet the following gross income tests
(REIT Gross Income Tests) for each taxable year:
(a) at least 75% of Redwood Trust's gross income must be derived
from certain specified real estate sources including interest income
and gain from the disposition of Qualified REIT Real Estate Assets,
foreclosure property or "qualified temporary investment income" (i.e.,
income derived from "new capital" within one year of the receipt of
such capital) (75% Gross Income Test); and,
(b) at least 95% of Redwood Trust's gross income for each taxable
year must be derived from sources of
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income qualifying for the 75% Gross Income Test, or from dividends,
interest, and gains from the sale of stock or other securities
(including certain interest rate swap and cap agreements, options,
futures and forward contracts entered into to hedge variable rate debt
incurred to acquire Qualified REIT Real Estate Assets) not held for
sale in the ordinary course of business (95% Gross Income Test).
Redwood Trust intends to maintain its REIT status by carefully
monitoring its income, including income from hedging transactions and
sales of mortgage assets, to comply with the REIT Gross Income Tests.
In accordance with the code, Redwood Trust will treat income generated
by its interest rate caps and other hedging instruments as qualifying
income for purposes of the 95% Gross Income Tests to the extent the
interest rate cap or other hedging instrument was acquired to reduce
the interest rate risks with respect to any indebtedness incurred or to
be incurred by Redwood Trust to acquire or carry real estate assets. In
addition, Redwood Trust will treat income generated by other hedging
instruments as qualifying or non-qualifying income for purposes of the
95% Gross Income Test depending on whether the income constitutes gains
from the sale of securities as defined by the Investment Company Act of
1940. Under certain circumstances, for example, (i) the sale of a
substantial amount of mortgage assets to repay borrowings in the event
that other credit is unavailable or (ii) unanticipated decrease in the
qualifying income of Redwood Trust which results in the non-qualifying
income exceeding 5% of gross income, Redwood Trust may be unable to
comply with certain of the REIT Gross Income Tests. See "-- Taxation of
Redwood Trust" below for a discussion of the tax consequences of
failure to comply with the REIT Provisions of the Code.
DISTRIBUTION REQUIREMENT
For tax years before 2001, Redwood Trust was generally required to
distribute to its stockholders an amount equal to at least 95% of
Redwood Trust's REIT taxable income before deduction of dividends paid
and exclusion of net capital gain. Beginning with the 2001 tax year,
this REIT distribution requirement is reduced to 90%. Such
distributions must be made in the taxable year to which they relate or,
if declared before the timely filing of Redwood Trust's tax return for
such year and paid not later than the first regular dividend payment
after such declaration, in the following taxable year.
The IRS has ruled generally that if a REIT's dividend reinvestment plan
allows stockholders of the REIT to elect to have cash distributions
reinvested in shares of the REIT at a purchase price equal to at least
95% of the fair market value of such shares on the distribution date,
then such distributions qualify under the distribution requirement.
Redwood Trust maintains a Dividend Reinvestment and Stock Purchase Plan
(DRP) and intends that the terms of its DRP will comply with the IRS
public ruling guidelines for such plans.
If Redwood Trust fails to meet the distribution test as a result of an
adjustment to Redwood Trust's tax returns by the Internal Revenue
Service, Redwood Trust, by following certain requirements set forth in
the Code, may pay a deficiency dividend within a specified period which
will be permitted as a deduction in the taxable year to which the
adjustment is made. Redwood Trust would be liable for interest based on
the amount of the deficiency dividend. A deficiency dividend is not
permitted if the deficiency is due to fraud with intent to evade tax or
to a willful failure to file timely tax return.
QUALIFIED REIT SUBSIDIARIES
Redwood Trust currently holds some of its assets through Sequoia
Mortgage Funding Corporation, a wholly-owned subsidiary, which is
treated as a Qualified REIT Subsidiary. As such its assets, liabilities
and income are generally treated as assets, liabilities and income of
Redwood Trust for purposes of each of the above REIT qualification
tests. Redwood Trust does not currently have, nor intends to invest in,
any affiliates other than Qualified REIT Subsidiaries and Taxable REIT
Subsidiaries.
TAXABLE REIT SUBSIDIARIES
Effective January 1, 2001, RWT Holdings, Inc. (Holdings) and Redwood
Trust elected to treat Holdings as a Taxable REIT Subsidiary of Redwood
Trust. As a Taxable REIT Subsidiary, Holdings is not subject to the
asset, income and distribution requirements of Redwood Trust nor are
its assets, liabilities or income treated as assets,
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liabilities or income of Redwood Trust for purposes of each of the
above REIT qualification tests. However, the aggregate value of Redwood
Trust's taxable REIT subsidiaries must be limited to 20% of the total
value of Redwood Trust's assets. Taxable REIT subsidiaries are
prohibited from, directly or indirectly, operating or managing a
lodging or healthcare facility or providing to any person, under
franchise, license or otherwise, rights to any lodging or healthcare
facility brand name. In addition, Redwood Trust will be subject to a
100% penalty tax on any rent or other charges that it imposes on any
taxable REIT subsidiary in excess of an arm's length price for
comparable services. Redwood Trust expects that any rents and charges
imposed on Holdings or any other taxable REIT subsidiary will be at
arm's length prices.
Redwood Trust will derive income from its taxable REIT subsidiaries by
way of dividends. Such dividends are non-real estate source income for
purposes of the 75% Gross Income Test. Therefore, when aggregated with
Redwood Trust's other non-real estate source income, such dividends
must be limited to 25% of Redwood Trust's gross income each year.
Redwood Trust will monitor the value of its investment in its taxable
REIT subsidiaries to ensure compliance with all applicable income and
asset tests.
Redwood Trust's taxable REIT subsidiaries are generally subject to
corporate level tax on their net income and will generally be able to
distribute only net after-tax earnings to its stockholders, including
Redwood Trust, as dividend distributions.
TAXATION OF REDWOOD TRUST
In any year in which Redwood Trust qualifies as a REIT, Redwood Trust
will generally not be subject to Federal income tax on that portion of
its REIT taxable income or capital gain that is distributed to its
stockholders. Redwood Trust will, however, be subject to Federal income
tax at normal corporate income tax rates upon any undistributed taxable
income or capital gain.
In addition, notwithstanding its qualification as a REIT, Redwood Trust
may also be subject to tax in certain other circumstances. If Redwood
Trust fails to satisfy either the 75% or the 95% Gross Income Test, but
nonetheless maintains its qualification as a REIT because certain other
requirements are met, it will generally be subject to a 100% tax on the
greater of the amount by which Redwood Trust fails either the 75% or
the 95% Gross Income Test. Redwood Trust will also be subject to a tax
of 100% on net income derived from any "prohibited transaction" (which
includes dispositions of property classified as "dealer" property).
Redwood Trust does not believe that it has or will engage in
transactions that would result in it being classified as a dealer,
however, there can be no assurance that the IRS will agree. If Redwood
Trust has (i) net income from the sale or other disposition of
"foreclosure property" which is held primarily for sale to customers in
the ordinary course of business or (ii) other non-qualifying income
from foreclosure property, it will be subject to Federal income tax on
such income at the highest corporate income tax rate. In addition, a
nondeductible excise tax, equal to 4% of the excess of such required
distributions over the amounts actually distributed will be imposed on
Redwood Trust for each calendar year to the extent that dividends paid
during the year, or declared during the last quarter of the year and
paid during January of the succeeding year, are less than the sum of
(1) 85% of Redwood Trust's "ordinary income," (2) 95% of Redwood
Trust's capital gain net income, and (3) income not distributed in
earlier years. Redwood Trust may also be subject to the corporate
alternative minimum tax, as well as other taxes in certain situations
not presently contemplated.
If Redwood Trust fails to qualify as a REIT in any taxable year and
certain relief provisions of the Code do not apply, Redwood Trust would
be subject to Federal income tax (including any applicable alternative
minimum tax) on its taxable income at the regular corporate income tax
rates. Distributions to stockholders in any year in which Redwood Trust
fails to qualify as a REIT would not be deductible by Redwood Trust,
nor would distributions generally be required to be made under the
Code. Further, unless entitled to relief under certain other provisions
of the Code, Redwood Trust would also be disqualified from re-electing
REIT status for the four taxable years following the year in which it
became disqualified.
Redwood Trust may also voluntarily revoke its election, although it has
no intention of doing so, in which event Redwood Trust will be
prohibited, without exception, from electing REIT status for the year
to which the revocation relates and the following four taxable years.
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Redwood Trust intends to monitor on an ongoing basis its compliance
with the REIT requirements described above. In order to maintain its
REIT status, Redwood Trust may be required to limit the types of assets
that Redwood Trust might otherwise acquire, or hold certain assets at
times when Redwood Trust might otherwise have determined that the sale
or other disposition of such assets would have been more prudent.
TAXATION OF STOCKHOLDERS
For any taxable year in which Redwood Trust is treated as a REIT for
Federal income tax purposes, distributions (including constructive
distributions) made to holders of Common Stock other than tax-exempt
entities (and not designated as capital gain dividends) will generally
be subject to tax as ordinary income to the extent of Redwood Trust's
current and accumulated earnings and profits as determined for Federal
income tax purposes. If the amount distributed exceeds a stockholder's
allocable share of such earnings and profits, the excess will be
treated as a return of capital to the extent of the stockholder's
adjusted basis in the Common Stock, which will not be subject to tax,
and thereafter as a taxable gain from the sale or exchange of a capital
asset.
Distributions designated by Redwood Trust as capital gain dividends
will generally be subject to tax as long-term capital gain to
stockholders, to the extent that the distribution does not exceed
Redwood Trust's actual net capital gain for the taxable year.
Distributions by Redwood Trust, whether characterized as ordinary
income or as capital gain, are not eligible for the corporate dividends
received deduction. In the event that Redwood Trust realizes a loss for
the taxable year, stockholders will not be permitted to deduct any
share of that loss. Further, if Redwood Trust (or a portion of its
assets) were to be treated as a taxable mortgage pool, or if it were to
hold residual interests in REMIC's or FASIT's, any "excess inclusion"
income derived therefrom and allocated to a stockholder would not be
allowed to be offset by a net operating loss of such stockholder.
Dividends declared during the last quarter of a taxable year and
actually paid during January of the following taxable year are
generally treated as if received by the stockholder on December 31 of
the taxable year in which they are declared and not on the date
actually received. In addition, Redwood Trust may elect to treat
certain other dividends distributed after the close of the taxable year
as having been paid during such taxable year, but stockholders will be
treated as having received such dividend in the taxable year in which
the distribution is made.
Generally, a dividend distribution of earnings from a REIT is
considered for estimated tax purposes only when the dividend is made.
However, effective December 15, 1999, any person owning at least 10% of
the vote or value of a closely-held REIT must accelerate recognition of
year-end dividends received from the REIT in computing estimated tax
payments. Redwood Trust is not currently, and does not intend to be, a
closely-held REIT.
Upon a sale or other disposition of the Common Stock, a stockholder
will generally recognize a capital gain or loss in an amount equal to
the difference between the amount realized and the stockholder's
adjusted basis in such stock, which gain or loss generally will be
long-term if the stock was held for more than twelve months. Any loss
on the sale or exchange of Common Stock held by a stockholder for six
months or less will generally be treated as a long-term capital loss to
the extent of designated capital gain dividends received by such
stockholder. If either common or preferred stock is sold after a record
date but before a payment date for declared dividends on such stock, a
stockholder will nonetheless be required to include such dividend in
income in accordance with the rules above for distributions, whether or
not such dividend is required to be paid over to the purchaser.
DRP participants will generally be treated as having received a
dividend distribution, subject to tax as ordinary income, in an amount
equal to the fair market value of the Common Stock purchased with the
reinvested dividends generally on the date Redwood Trust credits such
Common Stock to the DRP participant's account, plus brokerage
commissions, if any, allocable to the purchase of such Common Stock.
DRP participants will have a tax basis in the shares equal to such
value. DRP participants may not, however, receive any cash with which
to pay the resulting tax liability. Shares received pursuant to the DRP
will have a holding period beginning on the day after their purchase by
the plan administrator.
Distributions, including constructive distributions, made to holders of
Preferred Stock, other than tax-exempt entities, will generally be
subject to tax as described above. For federal income tax purposes,
earnings and profits
25
will be allocated to distributions with respect to the Preferred Stock
before they are allocated to distributions with respect to Common
Stock.
In general, no gain or loss will be recognized for Federal income tax
purposes upon conversion of the Preferred Stock solely into shares of
Common Stock. The basis that a holder will have for tax purposes in the
shares of Common Stock received upon conversion will be equal to the
adjusted basis of the holder in the shares of Preferred Stock so
converted, and provided that the shares of Preferred Stock were held as
a capital asset, the holding period for the shares of Common Stock
received would include the holding period for the shares of Preferred
Stock converted. A holder, however, generally will recognize gain or
loss on the receipt of cash in lieu of fractional shares of Common
Stock in an amount equal to the difference between the amount of cash
received and the holder's adjusted basis for tax purposes in the
fractional share of Preferred Stock for which cash was received.
Furthermore, under certain circumstances, a holder of shares of
Preferred Stock may recognize gain or dividend income to the extent
that there are dividends in arrears on the shares at the time of
conversion into Common Stock.
Adjustments in the conversion price, or the failure to make such
adjustments, pursuant to the anti-dilution provisions of the Preferred
Stock or otherwise, may result in constructive distributions to the
holders of Preferred Stock that could, under certain circumstances, be
taxable to them as dividends pursuant to Section 305 of the Code. If
such a constructive distribution were to occur, a holder of Preferred
Stock could be required to recognize ordinary income for tax purposes
without receiving a corresponding distribution of cash.
If Redwood Trust makes a distribution of stockholder rights with
respect to its Common Stock, such distribution will be zero. If the
fair market value of the rights on the date of issuance is 15% or more
of the value of the Common Stock, or if the stockholder so elects
regardless of the value of the rights, the stockholder will make an
allocation between the relative fair market values of the rights and
the Common Stock on the date of the issuance of the rights. On the
exercise of the rights, the stockholder will generally not recognize
gain or loss. The stockholder's basis in the shares received from the
exercise of the rights will be the amount paid for the shares plus the
basis, if any, of the rights exercised. Distribution of stockholder
rights with respect to other classes of securities holders generally
would be taxable.
Redwood Trust is required under Treasury Department regulations to
demand annual written statements from the record holders of designated
percentages of its Capital Stock disclosing the actual and constructive
ownership of such stock and to maintain permanent records showing the
information it has received as to the actual and constructive ownership
of such stock and a list of those persons failing or refusing to comply
with such demand.
In any year in which Redwood Trust does not qualify as a REIT,
distributions made to its stockholders would be taxable in the same
manner discussed above, except that no distributions could be
designated as capital gain dividends, distributions would be eligible
for the corporate dividends received deduction, the excess inclusion
income rules would not apply, and stockholders would not receive any
share of Redwood Trust's tax preference items. In such event, however,
Redwood Trust would be subject to potentially substantial Federal
income tax liability, and the amount of earnings and cash available for
distribution to its stockholders could be significantly reduced or
eliminated.
TAXATION OF TAX-EXEMPT ENTITIES
Subject to the discussion below regarding a "pension-held REIT," a
tax-exempt stockholder is generally not subject to tax on distributions
from Redwood Trust or gain realized on the sale of the Common Stock or
Preferred Stock, provided that such stockholder has not incurred
indebtedness to purchase or hold Redwood Trust's Common Stock or
Preferred Stock, that its shares are not otherwise used in an unrelated
trade or business of such stockholder, and that Redwood Trust,
consistent with its stated intent, does not form taxable mortgage pools
or hold residual interests in REMIC's or FASIT's that give rise to
"excess inclusion" income as defined under the Code. However, if
Redwood Trust was to hold a residual interest in a REMIC or FASIT, or
if a pool of its assets were to be treated as a "taxable mortgage
pool," a portion of the dividends paid to a tax-exempt stockholder may
be subject to tax as unrelated business taxable income (UBTI). Although
Redwood Trust does not intend to acquire such residual interests or
believe that it, or any portion of its assets, will be treated as a
taxable mortgage
26
pool, no assurance can be given that the IRS might not successfully
maintain that such a taxable mortgage pool exists.
If a qualified pension trust (i.e., any pension or other retirement
trust that qualifies under Section 401 (a) of the Code) holds more than
10% by value of the interests in a "pension-held REIT" at any time
during a taxable year, a substantial portion of the dividends paid to
the qualified pension trust by such REIT may constitute UBTI. For these
purposes, a "pension-held REIT" is a REIT (i) that would not have
qualified as a REIT but for the provisions of the Code which look
through qualified pension trust stockholders in determining ownership
of stock of the REIT and (ii) in which at least one qualified pension
trust holds more than 25% by value of the interest of such REIT or one
or more qualified pension trusts (each owning more than a 10% interest
by value in the REIT) hold in the aggregate more than 50% by value of
the interests in such REIT. Assuming compliance with the Ownership
Limit provisions in Redwood Trust's Articles of Incorporation it is
unlikely that pension plans will accumulate sufficient stock to cause
Redwood Trust to be treated as a pension-held REIT.
Distributions to certain types of tax-exempt stockholders exempt from
Federal income taxation under Sections 501 (c)(7), (c)(9), (c)(17), and
(c)(20) of the Code may also constitute UBTI, and such prospective
investors should consult their tax advisors concerning the applicable
"set aside" and reserve requirements.
STATE AND LOCAL TAXES
Redwood Trust and its stockholders may be subject to state or local
taxation in various jurisdictions, including those in which it or they
transact business or reside. The state and local tax treatment of
Redwood Trust and its stockholders may not conform to the Federal
income tax consequences discussed above. Consequently, prospective
stockholders should consult their own tax advisors regarding the effect
of state and local tax laws on an investment in the Common Stock.
CERTAIN UNITED STATES FEDERAL INCOME TAX CONSIDERATIONS APPLICABLE TO
FOREIGN HOLDERS
The following discussion summarizes certain United States Federal tax
consequences of the acquisition, ownership and disposition of Common
Stock or Preferred Stock by an initial purchaser that, for United
States Federal income tax purposes, is a "Non-United States Holder".
Non-United States Holder means: not a citizen or resident of the United
States; not a corporation, partnership, or other entity created or
organized in the United States or under the laws of the United States
or of any political subdivision thereof; or not an estate or trust
whose income is includible in gross income for United States Federal
income tax purposes regardless of its source. This discussion does not
consider any specific facts or circumstances that may apply to
particular non-United States Holder's acquiring, holding and disposing
of Common Stock or Preferred Stock, or any tax consequences that may
arise under the laws of any foreign, state, local or other taxing
jurisdiction.
DIVIDENDS
Dividends paid by Redwood Trust out of earnings and profits, as
determined for United States Federal income tax purposes, to a
Non-United States Holder will generally be subject to withholding of
United States Federal income tax at the rate of 30%, unless reduced or
eliminated by an applicable tax treaty or unless such dividends are
treated as effectively connected with a United States trade or
business. Distributions paid by Redwood Trust in excess of its earnings
and profits will be treated as a tax-free return of capital to the
extent of the holder's adjusted basis in his shares, and thereafter as
gain from the sale or exchange of a capital asset as described below.
If it cannot be determined at the time a distribution is made whether
such distribution will exceed the earnings and profits of Redwood
Trust, the distribution will be subject to withholding at the same rate
as dividends. Amounts so withheld, however, will be refundable or
creditable against the Non-United States Holder's United States Federal
tax liability if it is subsequently determined that such distribution
was, in fact, in excess of the earnings and profits of Redwood Trust.
If the receipt of the dividend is treated as being effectively
connected with the conduct of a trade or business within the United
States by a Non-United States Holder, the dividend received by such
holder will be subject to the United States Federal income tax on net
income that applies to United States persons generally (and, with
respect to corporate holders and under certain circumstances, the
branch profits tax).
27
For any year in which Redwood Trust qualifies as a REIT, distributions
to a Non-United States Holder that are attributable to gain from the
sales or exchanges by Redwood Trust of "United States real property
interests" will be treated as if such gain were effectively connected
with a United States business and will thus be subject to tax at the
normal capital gain rates applicable to United States stockholders
(subject to applicable alternative minimum tax) under the provisions of
the Foreign Investment in Real Property Tax Act of 1980 (FIRPTA). Also,
distributions subject to FIRPTA may be subject to a 30% branch profits
tax in the hands of a foreign corporate stockholder not entitled to a
treaty exemption. Redwood Trust is required to withhold 35% of any
distribution that could be designated by Redwood Trust as a capital
gains dividend. This amount may be credited against the Non-United
States Holder's FIRPTA tax liability. It should be noted that mortgage
loans without substantial equity or shared appreciation features
generally would not be classified as "United States real property
interests."
GAIN ON DISPOSITION
A Non-United States Holder will generally not be subject to United
States Federal income tax on gain recognized on a sale or other
disposition of its shares of either Common or Preferred Stock unless
(i) the gain is effectively connected with the conduct of a trade or
business within the United States by the Non-United States Holder, (ii)
in the case of a Non-United States Holder who is a nonresident alien
individual and holds such shares as a capital asset, such holder is
present in the United States for 183 or more days in the taxable year
and certain other requirements are met, or (iii) the Non-United States
Holder is subject to tax under the FIRPTA rules discussed below. Gain
that is effectively connected with the conduct of a business in the
United States by a U.S. Stockholder will be subject to the United
States Federal income tax on net income that applies to United States
persons generally (and, with respect to corporate holders and under
certain circumstances, the branch profits tax) but will not be subject
to withholding. Non-United States Holders should consult applicable
treaties, which may provide for different rules.
Gain recognized by a Non-United States Holder upon a sale of either
Common Stock or Preferred Stock will generally not be subject to tax
under FIRPTA if Redwood Trust is a "domestically-controlled REIT,"
which is defined generally as a REIT in which at all times during a
specified testing period less than 50% in value of its shares were held
directly or indirectly by non-United States persons. Because only a
minority of Redwood Trust's stockholders are expected to be Non-United
States Holders, Redwood Trust anticipates that it will qualify as a
"domestically-controlled REIT." Accordingly, a Non-United States Holder
should not be subject to United States Federal income tax from gains
recognized upon disposition of its shares.
INFORMATION REPORTING AND BACKUP WITHHOLDING
Redwood Trust will report to its U.S. stockholders and the Internal
Revenue Service the amount of distributions paid during each calendar
year, and the amount of tax withheld, if any. Under the backup
withholding rules, a stockholder may be subject to backup withholding
with respect to distributions paid (at the rate generally equal to the
fourth lowest rate of Federal income tax then in effect) unless such
holder (a) is a corporation or comes within certain other exempt
categories and, when required, demonstrates that fact; or (b) provides
a taxpayer identification number, certifies as to no loss of exemption
from backup withholding, and otherwise complies with applicable
requirements of the backup withholding rules. A stockholder that does
not provide Redwood Trust with its correct taxpayer identification
number may also be subject to penalties imposed by the Internal Revenue
Service. Any amount paid as backup withholding will be creditable
against the stockholder's income tax liability. In addition, Redwood
Trust may be required to withhold a portion of dividends and capital
gain distributions to any stockholders that do not certify under
penalties of perjury their non-foreign status to Redwood Trust.
EMPLOYEES
As of March 21, 2002, we employed 24 people at Redwood and its
subsidiaries.
28
ITEM 2. PROPERTIES
Redwood Trust leases space for their executive and administrative
offices at 591 Redwood Highway, Suite 3100, Mill Valley, California
94941, telephone (415) 389-7373.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 2001, there were no pending legal proceedings to which
Redwood Trust was a party or of which any of its property was subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of Redwood Trust's stockholders
during the fourth quarter of 2001.
29
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Redwood Trust's Common Stock is listed and traded on the New York Stock
Exchange under the symbol RWT. Redwood Trust's Common Stock was held by
approximately 500 holders of record on March 21, 2002 and the total
number of beneficial stockholders holding stock through depository
companies was approximately 6,000. The high and low closing sales
prices of shares of the Common Stock as reported on the New York Stock
Exchange and the cash dividends declared on the Common Stock for the
periods indicated below were as follows:
Common Dividends Declared
Stock Prices -------------------------------------------
-------------------- Record Payable Per Dividend
High Low Date Date Share Type
-------- -------- -------- -------- ----- --------
YEAR ENDED
DECEMBER 31, 2002
First Quarter (through $26.94 $23.76 3/29/02 4/22/02 $0.62 Regular
March 21, 2002)
YEAR ENDED
DECEMBER 31, 2001
Fourth Quarter $25.40 $23.83 12/31/01 1/22/02 $0.60 Regular
11/15/01 11/30/01 $0.15 Special
Third Quarter $25.55 $22.85 9/28/01 10/22/01 $0.57 Regular
8/10/01 8/31/01 $0.18 Special
Second Quarter $23.95 $19.57 6/29/01 7/23/01 $0.55 Regular
First Quarter $20.44 $16.81 3/30/01 4/23/01 $0.50 Regular
YEAR ENDED
DECEMBER 31, 2000
Fourth Quarter $17.94 $15.06 12/29/00 1/22/01 $0.44 Regular
Third Quarter $15.94 $13.63 9/29/00 10/23/00 $0.42 Regular
Second Quarter $14.94 $13.50 6/30/00 7/21/00 $0.40 Regular
First Quarter $14.81 $11.94 3/31/00 4/21/00 $0.35 Regular
YEAR ENDED
DECEMBER 31, 1999
Fourth Quarter $13 1/4 $11 5/16 12/31/99 1/21/00 $0.25 Regular
Third Quarter $17 1/2 $12 3/4 11/8/99 11/22/99 $0.15 Regular
Second Quarter $17 9/16 $14 1/2 -- -- --
First Quarter $17 3/8 $13 1/2 -- -- --
Redwood Trust intends to pay quarterly dividends so long as the minimum
REIT distribution rules require it. Redwood Trust intends to make
distributions to its stockholders of all or substantially all of its
taxable income each year (subject to certain adjustments) so as to
qualify for the tax benefits accorded to a REIT under the Code. All
distributions will be made by Redwood Trust at the discretion of the
Board of Directors and will depend on the taxable earnings of Redwood
Trust, financial condition of Redwood Trust, maintenance of REIT
status, and such other factors as the Board of Directors may deem
relevant from time to time. No dividends may be paid on the Common
Stock unless full cumulative dividends have been paid on the Preferred
Stock. As of December 31, 2001, the full cumulative dividends have been
paid on the Preferred Stock.
30
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data is for the years ended December
31, 2001, 2000, 1999, 1998 and 1997. It is qualified in its entirety
by, and should be read in conjunction with the more detailed
information contained in the Consolidated Financial Statements and
Notes thereto and "Management's Discussion and Analysis of Financial
Condition and Results of Operations" included elsewhere in this Form
10-K.
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEARS ENDED DECEMBER 31,
-------------------------------------------------------------
2001 2000 1999 1998 1997
---------- ---------- ---------- ---------- ----------
STATEMENT OF OPERATIONS DATA:
Interest income $144,539 $169,261 $145,964 $221,684 $195,674
Interest expense (98,069) (138,603) (119,227) (199,638) (164,018)
---------- ---------- ---------- ---------- ----------
Net interest income 46,470 30,658 26,737 22,046 31,656
Operating expenses (11,836) (7,850) (3,835) (5,876) (4,658)
Equity in earnings (losses) of RWT Holdings, Inc. 0 (1,676) (21,633) (4,676) 0
Other income (911) 98 175 139 0
Net unrealized/realized market value gains (losses) (836) (2,296) 284 (38,943) 563
Dividends on Class B preferred stock (2,724) (2,724) (2,741) (2,747) (2,815)
Change in accounting principle 0 0 0 (10,061) 0
---------- ---------- ---------- ---------- ----------
Net income (loss) available to common stockholders $30,163 $16,210 $(1,013) $(40,118) $24,746
Core earnings: GAAP earnings excluding mark-to
market adjustments and non-recurring items(1) $31,910 $18,585 $16,622 $12,666 $24,746
Average common shares -- "diluted" 10,474,764 8,902,069 9,768,345 13,199,819 13,680,410
Net income (loss) per share (diluted) $2.88 $1.82 $(0.10) $(3.04) $1.81
Core earnings per share (diluted)(1) $3.05 $2.08 $1.71 $0.96 $1.81
Dividends declared per Class B preferred share $3.02 $3.02 $3.02 $3.02 $3.02
Regular dividends declared per common share $2.22 $1.61 $0.40 $0.28 $2.15
Special dividends declared per common share $0.33 $0.00 $0.00 $0.00 $0.00
---------- ---------- ---------- ---------- ----------
Total dividends declared per common share $2.55 $1.61 $0.40 $0.28 $2.15
BALANCE SHEET DATA: END OF PERIOD
Earning assets $2,409,271 $2,049,188 $2,387,286 $2,774,499 $3,391,514
Total assets $2,435,644 $2,082,115 $2,419,928 $2,832,448 $3,444,197
Short-term debt $796,811 $756,222 $1,253,565 $1,257,570 $1,914,525
Long-term debt $1,313,715 $1,095,835 $945,270 $1,305,560 $1,172,801
Total liabilities $2,127,871 $1,866,451 $2,209,993 $2,577,658 $3,109,660
Total stockholders' equity $307,773 $215,664 $209,935 $254,790 $334,537
Number of Class B preferred shares outstanding 902,068 902,068 902,068 909,518 909,518
Number of common shares outstanding 12,661,749 8,809,500 8,783,341 11,251,556 14,284,657
Book value per common share $22.21 $21.47 $20.88 $20.27 $21.55
OTHER DATA:
Average assets $2,223,280 $2,296,641 $2,293,238 $3,571,889 $3,036,725
Average borrowings $1,945,820 $2,070,943 $2,046,132 $3,250,914 $2,709,208
Average equity $249,099 $213,938 $237,858 $307,076 $307,029
Interest rate spread after credit expenses 1.67% 0.86% 0.79% 0.28% 0.59%
Net interest margin after credit expenses 2.09% 1.33% 1.17% 0.62% 1.04%
Core earnings/average common equity (Core ROE)(1) 14.3% 9.9% 7.9% 5.5% 8.8%
(1) Core earnings equal net income from ongoing operations as
calculated in accordance with generally accepted accounting principles
in the United States, or GAAP, after excluding mark-to-market
adjustments and non-recurring items. Core earnings is not a measure of
earnings in accordance with GAAP and is not intended to be a substitute
for GAAP earnings.
31
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated Financial Statements and Notes.
SAFE HARBOR STATEMENT
"Safe Harbor" Statement under the Private Securities Litigation Reform
Act of 1995: Certain matters discussed in this Form 10-K may constitute
forward-looking statements within the meaning of the federal securities
laws that inherently include certain risks and uncertainties.
Throughout this Form 10-K and other Company documents, the words
"believe", "expect", "anticipate", "intend", "aim", "will", and similar
words identify "forward-looking" statements. Actual results and the
timing of certain events could differ materially from those projected
in, or contemplated by, the forward-looking statements due to a number
of factors, including, among other things, changes in interest rates
and market values on our earning assets and borrowings, changes in
prepayment rates on our mortgage assets, general economic conditions,
particularly as they affect the price of earning assets and the credit
status of borrowers, and the level of liquidity in the capital markets
as it affects our ability to finance our mortgage asset portfolio, and
other risk factors outlined elsewhere in this Form 10-K (see discussion
of "Risk Factors" beginning on page 13). Other factors not presently
identified may also cause actual results to differ. Future results and
changes in expectations of future results could lead to adverse changes
in our dividend rate. We continuously update and revise our estimates
based on actual conditions experienced. We generally do not intend to
publish such revisions. No one should assume that results projected in
or contemplated by the forward-looking statements included herein will
prove to be accurate in the future.
This Form 10-K contains statistics and other data that in some cases
have been obtained from, or compiled from, information made available
by servicing entities and information service providers. In addition,
some of the historical presentations contained herein have been
restated to conform to current formats.
RESULTS OF OPERATIONS
EARNINGS AND DIVIDEND SUMMARY AND OUTLOOK
Our high-quality residential mortgage loan business continues to drive
our growth and profitability. Our credit results remain excellent and
we continue to increase our market share, gain new customers, and
strengthen our competitive position. In 2001, we also increased our
equity base through three common stock offerings, improved our
operating efficiencies, and further strengthened our balance sheet.
These factors, along with falling short-term interest rates, all
contributed to our record earnings performance.
Core earnings were $0.76 per share for the fourth quarter of 2001, an
increase of 23% over fourth quarter 2000 core earnings of $0.62 per
share. Core earnings were $0.76 per share in the third quarter 2001.
Core earnings for the year 2001 were $3.05 per share, an increase of
47% over core earnings for the year 2000 of $2.08 per share and an
increase of 78% over core earnings per share of $1.71 for 1999. Core
earnings equal GAAP earnings excluding mark-to-market adjustments and
non-recurring items.
GAAP earnings for the fourth quarter of 2001 were $0.69 per share and
for the full year of 2001 were $2.88 per share, in each case
representing a substantial increase over prior year results. See Table
1 for a reconciliation of GAAP earnings and core earnings.
During 2001, a year of falling short-term interest rates, our asset
yield dropped by 0.85% (from 7.56% to 6.71%) while our cost of borrowed
funds dropped by 1.65% (from 6.69% to 5.04%). The spread we earned
between our asset yield and our cost of funds increased from 0.87% in
2000 to 1.67% in 2001.
Our spread increased as we replaced lower-yielding AAA-rated mortgage
securities with higher-yielding mortgage loans and credit-enhancement
securities. We believe this change in portfolio mix -- a change that we
expect will continue in 2002 -- will provide long-term benefits.
32
In 2001, we also benefited -- on a more temporary basis, due to falling
interest rates -- from a slight mismatch we carry between the earning
rate adjustment frequencies of our assets (generally, each six months)
and the borrowing rate adjustment frequencies of our liabilities
(generally, every month).
Ours is a scalable business, so we get more efficient as we grow.
Operating expenses increased by 18% in 2001 while the scale of our
business (as measured by our equity capital base) grew by 43%. This
increase in operating efficiency was a major contributor to our
increase in earnings per share in 2001 and should continue to benefit
us going forward. Future growth in our business should lead to
additional efficiency gains.
Our core net income for 2001 was $31.9 million, an increase of 72% from
the $18.6 million we earned in 2000. Our core return on equity was
14.3% in 2001 and 9.9% in 2000.
We increased our regular quarterly cash dividend rate several times in
2001. Regular dividends for our common shareholders were $0.50 for the
first quarter, $0.55 per share for the second quarter, $0.57 per share
for the third quarter, and $0.60 per share for the fourth quarter of
2001. We also paid a special common stock cash dividend of $0.18 per
common share in the third quarter and $0.15 in the fourth quarter of
2001. Total regular common stock dividends for 2001 were $2.22 per
share. Total common stock dividend distributions, including special
dividends, were $2.55 per share for 2001. On March 21, 2002, our Board
of Directors declared an increase in our regular quarterly cash
dividend rate for the first quarter of 2002 to $0.62 per common share.
We believe we will have a strong year in 2002; we expect to continue to
benefit from healthy origination volume by our customers, asset growth
at Redwood, improvements in asset mix, improved operational
efficiencies, and favorable credit results.
However, earnings per share in 2002 may not reach the exceptional
levels we achieved in 2001, when our earnings received a temporary
boost due to rapidly falling short-term interest rates.
Many market participants expect short-term interest rates to rise
during 2002. Relative to our earnings potential during a period of
stable interest rates, we believe rising interest rates may or may not
have a negative effect on our earnings trends. A rapid or unexpected
increase would be a negative factor for several quarters. Over longer
periods of time, higher interest rates are generally favorable for our
business.
Our first goal in managing Redwood Trust's operations is to do our best
to make sure that our regular dividend rate for common shareholders
remains sustainable in the long run from the cash flows generated by
our assets. We believe the new regular dividend rate of $0.62 per
common share per quarter that we established in the first quarter of
2002 is a sustainable rate, even -- in most circumstances -- if some
business trends become less favorable or interest rates increase.
In the event we earn taxable REIT income in excess of the dividends we
distribute at our regular dividend rate, we may declare one or more
special dividends during 2002.
We believe the longer-term trends that really matter are the strength
of our credit results and the strength of our competitive market
position. If these stay strong, we may be able to increase our cash
flows and increase our regular dividend rate over time.
RECONCILIATION OF GAAP INCOME AND CORE INCOME
The table below reconciles core earnings to reported GAAP earnings. RWT
Holdings, Inc. (Holdings) was an unconsolidated subsidiary through
January 1, 2001. The table below shows Holdings on an
as-if-consolidated basis for 1999 and 2000.
33
TABLE 1
CORE EARNINGS AND GAAP EARNINGS
(PRESENTED AS IF HOLDINGS WAS CONSOLIDATED IN ALL PERIODS)
(ALL DOLLARS IN THOUSANDS)
VARIABLE
STOCK
ASSET OPTION REPORTED
MARK-TO- MARK-TO- CLOSED REPORTED AVERAGE CORE GAAP
CORE MARKET MARKET BUSINESS GAAP DILUTED EARNINGS EARNINGS
EARNINGS ADJUSTMENTS ADJUSTMENTS UNITS EARNINGS SHARES PER SHARE PER SHARE
-------- ----------- ----------- -------- -------- ---------- --------- ---------
Q1: 2000 $ 4,536 $(1,164) $ 0 $ (89) $ 3,283 8,844,606 $0.51 $ 0.37
Q2: 2000 4,495 (1,452) 0 43 3,086 8,883,651 0.51 0.35
Q3: 2000 3,951 927 0 0 4,878 8,908,399 0.44 0.55
Q4: 2000 5,603 (640) 0 0 4,963 8,962,950 0.62 0.55
Q1: 2001 6,563 273 (156) 0 6,680 9,065,221 0.73 0.74
Q2: 2001 7,384 (413) (508) 0 6,463 9,184,195 0.80 0.70
Q3: 2001 8,188 104 (227) 0 8,065 10,752,062 0.76 0.75
Q4: 2001 9,775 (800) (20) 0 8,955 12,888,420 0.76 0.69
1999 $16,622 $ 38 $ 0 $(17,673) $(1,013) 9,768,345 $1.71 $(0.10)
2000 18,585 (2,329) 0 (46) 16,210 8,902,069 2.08 1.82
2001 31,910 (836) (911) 0 30,163 10,474,764 3.05 2.88
Core earnings are not a measure of earnings in accordance with generally
accepted accounting principles (GAAP). It is calculated as GAAP earnings from
ongoing operations less mark-to-market adjustments (on certain assets, hedges,
and variable stock options) and non-recurring items. Management believes that
core earnings provide relevant and useful information regarding our results of
operations in addition to GAAP measures of performance. This is, in part,
because market valuation adjustments on only a portion of our assets and stock
options and none of our liabilities are recognized through our income statement
under GAAP, and these valuation adjustments may not be fully indicative of
changes in market values on our balance sheet or a reliable guide to our current
or future operating performance. Furthermore, gains or losses realized upon
sales of assets and operating results of closed business units are generally
non-recurring and any non-recurring items may also be unrepresentative of our
current or future operating performance. Because all companies and analysts do
not calculate non-GAAP measures such as core earnings in the same fashion, core
earnings as calculated by us may not be comparable to similarly titled measures
reported by other companies.
NET INTEREST INCOME
Net interest income after credit expenses rose to $13.2 million in the fourth
quarter of 2001 from $11.6 million in the third quarter of 2001 and $7.9 million
in the fourth quarter of 2000. Net interest income increased to $46.5 million
for the year 2001 from $30.7 million in 2000 and from $26.7 million in 1999. We
benefited from our continuing strategy of growth in our high-quality jumbo
residential mortgage loan business, a business where we believe we have a solid
competitive position and favorable long-term market trends. We benefited from a
change in asset mix as we added higher yielding assets. We also benefited from
rapidly falling short-term interest rates, as our cost of borrowed funds on
floating-rate liabilities declined faster than the asset yields on our
adjustable-rate mortgage assets.
34
TABLE 2
NET INTEREST INCOME AFTER CREDIT EXPENSES
(ALL DOLLARS IN THOUSANDS)
NET INTEREST INTEREST
INTEREST RATE RATE NET
INTEREST INCOME SPREAD MARGIN INTEREST
INCOME AFTER EARNING COST AFTER AFTER INCOME/
AFTER CREDIT INTEREST CREDIT ASSET OF CREDIT CREDIT AVERAGE
EXPENSES EXPENSE EXPENSES YIELD FUNDS EXPENSES EXPENSES EQUITY
------------ -------- -------- ------- ----- -------- -------- ------
Q1: 2000 $ 42,819 $ (34,931) $ 7,888 7.25% 6.36% 0.89% 1.30% 14.76%
Q2: 2000 43,008 (35,133) 7,875 7.54% 6.62% 0.92% 1.34% 14.78%
Q3: 2000 41,679 (34,694) 6,985 7.62% 6.87% 0.75% 1.25% 13.10%
Q4: 2000 41,755 (33,845) 7,910 7.88% 6.96% 0.92% 1.46% 14.68%
Q1: 2001 41,637 (31,413) 10,224 7.72% 6.34% 1.38% 1.85% 18.83%
Q2: 2001 38,453 (27,010) 11,443 7.18% 5.45% 1.73% 2.06% 20.76%
Q3: 2001 33,172 (21,555) 11,617 6.63% 4.83% 1.80% 2.24% 18.25%
Q4: 2001 31,277 (18,091) 13,186 5.41% 3.56% 1.85% 2.22% 17.40%
1999 $145,964 $(119,227) $26,737 6.63% 5.83% 0.80% 1.17% 11.24%
2000 169,261 (138,603) 30,658 7.56% 6.69% 0.87% 1.33% 14.33%
2001 144,539 (98,069) 46,470 6.71% 5.04% 1.67% 2.09% 18.66%
Redwood's primary source of debt funding is the issuance of non-recourse
long-term collateralized debt through securitization transactions. Despite the
sale of the collateral assets to a special-purpose bankruptcy-remote financing
trust and the non-recourse nature of the securities issued from that trust,
Redwood to date has accounted for its securitizations as financings rather than
as sales. Thus, the securitized assets remain on our reported balance sheet
(residential mortgage loans) and the securities issued remain on our balance
sheet as liabilities (long-term debt). This accounting method avoids
gain-on-sale treatment of our transactions, and we believe it provides greater
transparency to investors regarding our activities.
If we had accounted for our securitizations as sales, our reported balance sheet
(both assets and liabilities) would be substantially smaller. As a result, many
of the ratios one might use to analyze our business would be different. For
instance, our interest rate spread would be wider and our debt-to-equity ratio
lower. Ratios calculated on this basis may be more comparable to those reported
by some other financial institutions. The table below presents our interest
income and interest expense on an "at-risk" basis for assets and a recourse
basis for liability (generally, conforming to the income statement items we
would report if we accounted for our securitizations as sales rather than
financings). Please see also the discussion under "Balance Sheet Leverage" below
for further information.
35
TABLE 3
INCOME ON "AT-RISK" ASSETS AND RECOURSE LIABILITIES BASIS
(ALL DOLLARS IN THOUSANDS)
NET INTEREST INTEREST
TOTAL INTEREST RATE RATE NET
INTEREST INCOME SPREAD MARGIN INTEREST
INCOME AFTER EARNING COST AFTER AFTER INCOME/
AFTER CREDIT INTEREST CREDIT ASSET OF CREDIT CREDIT AVERAGE
EXPENSES EXPENSES EXPENSES YIELD FUNDS EXPENSES EXPENSES EQUITY
------------ -------- -------- ----- ----- -------- -------- --------
Q1: 2000 $27,460 $(19,572) $ 7,888 7.95% 6.39% 1.56% 2.24% 14.76%
Q2: 2000 22,081 (14,206) 7,875 8.72% 6.57% 2.15% 3.01% 14.78%
Q3: 2000 21,230 (14,245) 6,985 8.80% 6.89% 1.91% 2.81% 13.10%
Q4: 2000 22,196 (14,286) 7,910 9.33% 6.98% 2.35% 3.18% 14.68%
Q1: 2001 23,799 (13,575) 10,224 8.51% 5.96% 2.55% 3.60% 18.83%
Q2: 2001 23,286 (11,843) 11,443 7.99% 4.91% 3.08% 3.83% 20.76%
Q3: 2001 20,458 (8,841) 11,617 7.43% 4.15% 3.28% 4.11% 18.25%
Q4: 2001 19,328 (6,142) 13,186 6.70% 2.93% 3.77% 4.49% 17.40%
1999 $80,179 $(53,442) $26,737 7.29% 5.59% 1.70% 2.41% 11.24%
2000 92,967 (62,309) 30,658 8.63% 6.67% 1.96% 2.76% 14.33%
2001 86,871 (40,401) 46,470 7.66% 4.53% 3.13% 4.01% 18.66%
INTEREST INCOME AFTER CREDIT EXPENSES
Although our average reported earning assets increased by 15% during the fourth
quarter of 2001 from the prior quarter, our interest income continued to fall
due to a significant decline in asset yields caused by rapidly falling
short-term interest rates. The fourth quarter decrease in our interest income
and asset yields did not result in a material reduction of our operating
margins, however, as this decline in asset yield was fully offset by a rapid
decrease in our cost of borrowed funds.
The yield on our earning assets, the bulk of which are adjustable-rate
residential mortgage loans, fell from 7.88% in the fourth quarter of 2000 to
6.63% in the third quarter of 2001 and 5.41% in the fourth quarter of 2001. In
addition to falling short-term interest rates, a factor in this decline in asset
yield was an increase in premium amortization expenses caused, in part, by an
increase in long-term mortgage prepayment rate assumptions for certain premium
assets accounted for under the effective yield method.
TABLE 4
TOTAL INTEREST INCOME AND YIELDS
(ALL DOLLARS IN THOUSANDS)
NET
AVERAGE PREMIUM CREDIT TOTAL EARNING
EARNING INTEREST AMORTIZATION PROVISION INTEREST ASSET
ASSETS INCOME EXPENSE EXPENSE INCOME YIELD
---------- -------- ------------ --------- -------- -------
Q1: 2000 $2,363,903 $ 43,460 $ (522) $ (119) $ 42,819 7.25%
Q2: 2000 2,282,889 43,091 45 (128) 43,008 7.54%
Q3: 2000 2,187,936 42,959 (1,040) (240) 41,679 7.62%
Q4: 2000 2,118,952 42,817 (818) (244) 41,755 7.88%
Q1: 2001 2,156,741 42,690 (869) (184) 41,637 7.72%
Q2: 2001 2,142,496 40,502 (1,885) (164) 38,453 7.18%
Q3: 2001 2,001,687 35,300 (1,977) (151) 33,172 6.63%
Q4: 2001 2,310,906 36,399 (4,854) (268) 31,277 5.41%
1999 $2,200,916 $152,472 $(5,162) $(1,346) $145,964 6.63%
2000 2,237,956 172,327 (2,335) (731) 169,261 7.56%
2001 2,152,965 154,891 (9,585) (767) 144,539 6.71%
36
To provide a greater level of detail on our interest income trends, we review
interest income by product line below. Each of our product lines is a component
of our single business segment of real estate finance.
RESIDENTIAL MORTGAGE LOANS
Our residential mortgage loan portfolio increased 30% in 2001 to $1.5 billion.
We acquired $675 million new loans in 2001; fourth quarter acquisitions were
$207 million. These acquisitions were all adjustable rate loans. During 2002, we
plan to expand our customer base and increase our acquisitions of high-quality
jumbo residential mortgage loans.
TABLE 5
RESIDENTIAL MORTGAGE LOANS -- ACTIVITY
(ALL DOLLARS IN THOUSANDS)
DEC. 2001 SEP. 2001 JUN. 2001 MAR. 2001 DEC. 2000
---------- ---------- ---------- ---------- ----------
START OF PERIOD BALANCES $1,354,606 $1,060,470 $1,071,819 $1,130,997 $1,186,799
ACQUISITIONS 207,170 391,328 76,314 0 0
SALES 0 0 0 0 0
PRINCIPAL PAYMENTS (82,676) (96,172) (86,511) (58,539) (54,859)
AMORTIZATION (3,991) (1,180) (1,065) (485) (611)
CREDIT PROVISIONS (268) (151) (164) (184) (242)
NET CHARGE-OFFS 29 311 12 30 0
MARK-TO-MARKET (BALANCE SHEET) 0 0 0 0 0
MARK-TO-MARKET (INCOME STATEMENT) (8) 0 65 0 (90)
---------- ---------- ---------- ---------- ----------
END OF PERIOD BALANCES $1,474,862 $1,354,606 $1,060,470 $1,071,819 $1,130,997
========== ========== ========== ========== ==========
Most of our residential loans have coupon rates that adjust each month or each
six months as a function of the one or six month LIBOR short-term interest rate.
Due to the rapid decline in these interest rates during 2001, plus an increase
in premium amortization expense, the yield on our residential loan portfolio
fell from 7.46% in the fourth quarter of 2000 to 4.00% in the fourth quarter of
2001.
TABLE 6
RESIDENTIAL MORTGAGE LOANS -- INTEREST INCOME AND YIELDS
(ALL DOLLARS IN THOUSANDS)
ANNUAL
AVERAGE MORTGAGE NET
AVERAGE NET AVERAGE PREPAY PREMIUM CREDIT TOTAL
PRINCIPAL PREMIUM CREDIT RATE INTEREST AMORTIZATION PROVISION INTEREST
BALANCE BALANCE RESERVE (CPR) INCOME EXPENSE EXPENSE INCOME YIELD
---------- ------- -------- --------- -------- ------------ --------- -------- -----
Q1: 2000 $1,337,428 $16,061 $(4,187) 14% $24,378 $ (640) $ (119) $23,619 7.00%
Q2: 2000 1,276,340 15,372 (4,290) 16% 23,648 (515) (128) 23,005 7.15%
Q3: 2000 1,202,056 14,760 (4,454) 22% 23,118 (829) (240) 22,049 7.27%
Q4: 2000 1,141,624 14,141 (4,696) 16% 22,316 (611) (244) 21,461 7.46%
Q1: 2001 1,083,943 13,519 (4,895) 21% 20,371 (485) (184) 19,702 7.21%
Q2: 2001 1,007,227 12,747 (5,051) 24% 17,492 (1,065) (164) 16,263 6.41%
Q3: 2001 1,087,593 12,138 (4,950) 25% 16,583 (1,180) (151) 15,252 5.57%
Q4: 2001 1,372,552 12,023 (5,065) 19% 18,053 (3,990) (268) 13,795 4.00%
1999 $1,115,874 $13,895 $(3,505) 25% $77,065 $(3,915) $(1,346) $71,804 6.38%
2000 1,238,993 15,080 (4,408) 17% 93,460 (2,595) (731) 90,134 7.21%
2001 1,138,482 12,646 (4,991) 22% 72,499 (6,720) (767) 65,012 5.67%
Credit results remain excellent for our residential mortgage loan portfolio.
Credit losses were $29,000 in the fourth quarter of 2001. Credit losses for 2001
were $382,000, largely as the result of a loss on a single loan. All credit
losses were charged against our credit reserve that we have established for this
portfolio. At December 31,
37
2001, our residential mortgage loan credit reserve was $5.2 million, equal to
0.35% of the current balance of this portfolio.
During 2001, our residential loan delinquencies declined from $5.7 million to
$5.1 million. Delinquencies include loans delinquent more than 90 days, in
bankruptcy, in foreclosure, and real estate owned. As a percentage of our loan
portfolio, delinquencies declined from 0.50% to 0.34% during 2001. Delinquencies
and credit losses may rise during 2002 as a result of the weak economy.
TABLE 7
RESIDENTIAL MORTGAGE LOANS -- CREDIT RESULTS
(AT PERIOD END, ALL DOLLARS IN THOUSANDS)
LOSS SEVERITY REALIZED ANNUALIZED ENDING
ENDING DELINQUENT DELINQUENT ON LIQUIDATED CREDIT CREDIT LOSSES CREDIT
BALANCE LOANS LOAN % LOANS LOSSES AS % OF LOANS RESERVE
---------- ---------- ---------- ------------- -------- ------------- -------
Q1: 2000 $1,330,674 $5,338 0.40% 0% $ 0 0.00% $4,244
Q2: 2000 1,267,780 4,968 0.39% 9% (42) 0.01% 4,330
Q3: 2000 1,186,799 4,330 0.36% 0% 0 0.00% 4,573
Q4: 2000 1,130,997 5,667 0.50% 0% 0 0.00% 4,814
Q1: 2001 1,071,819 6,371 0.59% 13% (30) 0.01% 4,968
Q2: 2001 1,060,470 4,913 0.46% 14% (12) 0.00% 5,120
Q3: 2001 1,354,606 4,823 0.36% 60% (311) 0.09% 4,960
Q4: 2001 1,474,862 5,069 0.34% 39% (29) 0.01% 5,199
1999 $1,385,589 $4,635 0.33% 4% $ (5) 0.00% $4,125
2000 1,130,997 5,667 0.50% 9% (42) 0.00% 4,814
2001 1,474,862 5,069 0.34% 42% (382) 0.03% 5,199
The characteristics of our loans continue to show the high-quality nature of our
residential mortgage loan portfolio. At December 31, 2001, we owned 4,177
residential loans with a total value of $1.5 billion. These were all "A" quality
loans at origination. All these loans are adjustable rate loans. Our average
loan size was $353,100. Northern California loans were 10% of the total and
Southern California loans were 12% of the total. Loans originated in 1999 or
earlier were 55% of the total. On average, our residential mortgage loans have
30 months of seasoning. Loans where the original loan balance exceeded 80%
loan-to-value (LTV) made up 28% of loan balances; we benefit from mortgage
insurance or additional pledged collateral on 99% of these loans, serving to
substantially lower the effective LTV on these loans. The average effective LTV
at origination for our mortgage loans (including the effect of mortgage
insurance, pledged collateral, and other credit enhancements) was 68%. Given
housing appreciation and loan amortization, we estimate the current effective
LTV of our residential mortgage loans is roughly 58%.
38
TABLE 8
RESIDENTIAL MORTGAGE LOANS -- LOAN CHARACTERISTICS
(ALL DOLLARS IN THOUSANDS)
DEC. 2001 SEP. 2001 JUN. 2001 MAR. 2001 DEC. 2000
--------- --------- --------- --------- ---------
PRINCIPAL VALUE (FACE VALUE) $1,470,467 $1,346,346 $1,053,158 $1,063,633 $1,122,170
INTERNAL CREDIT RESERVES (5,199) (4,960) (5,120) (4,968) (4,814)
PREMIUM(DISCOUNT) TO BE AMORTIZED 9,594 13,220 12,432 13,154 13,641
--------- --------- --------- --------- ---------
RETAINED RESIDENTIAL LOANS $1,474,862 $1,354,606 $1,060,470 $1,071,819 $1,130,997
NUMBER OF LOANS 4,177 3,909 3,306 3,433 3,633
AVERAGE LOAN SIZE $353 $347 $321 $312 $311
ADJUSTABLE % 100% 81% 73% 71% 71%
HYBRID % 0% 19% 27% 29% 29%
FIXED % 0% 0% 0% 0% 0%
NORTHERN CALIFORNIA 10% 10% 13% 13% 13%
SOUTHERN CALIFORNIA 12% 12% 10% 11% 12%
FLORIDA 11% 11% 9% 9% 9%
NEW YORK 8% 8% 9% 8% 8%
GEORGIA 8% 7% 4% 5% 5%
NEW JERSEY 5% 5% 6% 5% 5%
TEXAS 4% 5% 5% 5% 5%
OTHER STATES 42% 42% 44% 44% 43%
YEAR 2001 ORIGINATION 45% 34% 7% 0% 0%
YEAR 2000 ORIGINATION 0% 0% 0% 0% 0%
YEAR 1999 ORIGINATION 11% 12% 17% 18% 19%
YEAR 1998 ORIGINATION OR EARLIER 44% 54% 76% 82% 81%
% BALANCE IN LOANS > $1MM PER LOAN 15% 14% 11% 11% 11%
We fund most of our mortgage loans through the issuance of long-term debt
through our special purpose subsidiary, Sequoia Mortgage Funding Corporation
(Sequoia). This type of financing is non-recourse to Redwood Trust. Our exposure
to our $1.3 billion of long-term financed loans is limited to our investment in
Sequoia, which at December 31, 2001 was $33.0 million or 2.5% of the Sequoia
loan balances. Short-term funded residential mortgage loans at December 31, 2001
were $153 million. We intend to permanently fund all of our residential loans
with the non-recourse long-term Sequoia debt that we issue from time to time.
RESIDENTIAL CREDIT-ENHANCEMENT SECURITIES
At year-end 2001, we owned $191 million of residential credit-enhancement
securities. These securities have below-investment-grade credit ratings and
represent subordinated interests in pools of high-quality jumbo residential
mortgage loans. Our investment in these securities more than doubled from the
$81 million we owned at the end of 2000. We increased our capacity to evaluate
and acquire these assets, and deepened our relationships with the sellers of
these assets. At the same time, the volume of newly originated and seasoned
loans undergoing securitization and available for purchase increased. We expect
to continue to acquire residential credit-enhancement securities in 2002. We
have already made substantial acquisitions of these securities in the first
quarter of 2002.
39
TABLE 9
RESIDENTIAL CREDIT-ENHANCEMENT SECURITIES -- ACTIVITY
(ALL DOLLARS IN THOUSANDS)
DEC. 2001 SEP. 2001 JUN. 2001 MAR. 2001 DEC. 2000
--------- --------- --------- --------- ---------
START OF PERIOD BALANCES $188,283 $158,704 $100,849 $ 80,764 $65,118
ACQUISITIONS 17,132 27,172 61,195 20,695 14,885
SALES (7,786) 0 (1,780) 0 (2,897)
PRINCIPAL PAYMENTS (3,857) (1,895) (1,952) (1,022) (715)
AMORTIZATION (92) 86 161 126 346
MARK-TO-MARKET (BALANCE SHEET) (3,258) 4,216 223 2,654 3,876
MARK-TO-MARKET (INCOME STATEMENT) 391 0 8 (2,368) 151
--------- --------- --------- --------- ---------
END OF PERIOD BALANCES $190,813 $188,283 $158,704 $100,849 $80,764
========= ========= ========= ========= =========
Our residential credit-enhancement securities are "first-loss", "second-loss",
or "third loss" interests. First loss interests are generally allocated actual
credit losses on the entire underlying pool of loans up to a maximum of the
principal amount of first loss interest. Our ownership of first loss interests
provides credit-enhancement principal protection from the initial losses in the
underlying pool for the second loss, third loss, and more senior interests. Any
first loss interests that are owned by others and that are junior to our second
and third loss interests provide our interests with some principal protection
from losses (they serve as external credit-enhancement).
At December 31, 2001, we owned $353.4 million principal (face) value of
residential credit-enhancement securities at a cost basis of $187.2 million.
After mark-to-market adjustments, our net investment in these assets, as
reflected on our balance sheet, was $190.8 million. Over the life of the
underlying mortgage loans, we expect to receive principal payments from these
securities of $353.4 million less credit losses (credit losses were $764,000 in
2001). We receive interest payments each month on the outstanding principal
amount. Of the $162.6 million difference between principal value and reported
value, $140.4 million is designated as an internal credit reserve (reflecting
our estimate of future credit losses over the life of the underlying mortgages),
$25.9 million is designated as purchase discount to be amortized into income
over time, and $3.7 million represented balance sheet market valuation
adjustments.
TABLE 10
RESIDENTIAL CREDIT-ENHANCEMENT SECURITIES -- NET BOOK VALUE
(ALL DOLLARS IN THOUSANDS)
DEC. 2001 SEP. 2001 JUN. 2001 MAR. 2001 DEC. 2000
--------- --------- --------- --------- ---------
TOTAL PRINCIPAL VALUE (FACE VALUE) $ 353,435 $ 323,870 $266,004 $155,233 $124,878
INTERNAL CREDIT RESERVES (140,411) (112,133) (78,170) (35,722) (27,052)
DISCOUNT TO BE AMORTIZED (25,863) (30,365) (31,824) (21,137) (16,883)
--------- --------- -------- -------- --------
NET INVESTMENT 187,161 181,372 156,010 98,374 80,943
MARKET VALUATION ADJUSTMENTS 3,652 6,911 2,694 2,475 (179)
--------- --------- -------- -------- --------
NET BOOK VALUE $ 190,813 $ 188,283 $158,704 $100,849 $ 80,764
FIRST LOSS POSITION, PRINCIPAL VALUE $ 129,019 $ 105,830 $76,386 $41,156 $34,959
SECOND LOSS POSITION, PRINCIPAL VALUE 96,567 84,876 67,700 37,197 30,703
THIRD LOSS POSITION, PRINCIPAL VALUE 127,849 133,164 121,918 76,880 59,216
--------- --------- -------- -------- --------
TOTAL PRINCIPAL VALUE $ 353,435 $ 323,870 $266,004 $155,233 $124,878
FIRST LOSS POSITION, NET BOOK VALUE $ 29,648 $ 25,886 $18,956 $13,191 $ 12,080
SECOND LOSS POSITION, NET BOOK VALUE 60,074 53,925 43,733 25,106 21,109
THIRD LOSS POSITION, NET BOOK VALUE 101,091 108,472 96,015 62,552 47,575
--------- --------- -------- -------- --------
TOTAL NET BOOK VALUE $ 190,813 $ 188,283 $158,704 $100,849 $ 80,764
========= ========= ======== ======== ========
Total interest income from our residential credit-enhancement securities
increased to $5.4 million in the fourth quarter of 2001 from $5.2 million in the
third quarter of 2001 and $2.5 million in the fourth quarter of 2000. An
increase in our net investment in these securities was the principal reason for
increasing interest income. Income from these securities was $16.7 million in
2001, $8.5 million in 2000, and $4.2 million in 1999.
40
Our credit-enhancement portfolio yield was 12.01% during the fourth quarter of
2001, a decline from 12.44% in the third quarter 2001 and 13.06% in the fourth
quarter of 2000. Yields for this portfolio fell to 12.15% during 2001, a
decrease from 14.49% during 2000, and 23.00% during 1999. Yields have been
decreasing over the past several years due to the acquisition of an increased
proportion of third loss interests. Third loss interests have lower yields than
first or second loss interests due to their lower risk levels.
Credit losses lower than (or later than) anticipated by our designated credit
reserve and/or faster than anticipated long-term prepayment rates could result
in increasing yields being recognized from our current portfolio under the
effective yield method. Credit losses higher than (or earlier than) anticipated
by our designated credit reserve and/or slower than anticipated long-term
prepayment rates could result in lower yields being recognized under the
effective yield method and/or market value adjustments through our income
statement under EITF 99-20.
TABLE 11
RESIDENTIAL CREDIT-ENHANCEMENT SECURITIES -- INTEREST INCOME AND YIELDS
(ALL DOLLARS IN THOUSANDS)
AVERAGE NET
AVERAGE AVERAGE NET DISCOUNT TOTAL
PRINCIPAL CREDIT DISCOUNT AVERAGE COUPON AMORTIZATION INTEREST
VALUE RESERVE BALANCE BASIS INCOME INCOME INCOME YIELD
--------- --------- -------- -------- ------- ------------ -------- ------
Q1: 2000 $ 56,439 $ (11,567) $ (6,758) $ 38,114 $ 1,048 $ 567 $ 1,615 16.95%
Q2: 2000 77,173 (16,361) (7,654) 53,158 1,412 723 2,135 16.07%
Q3: 2000 100,857 (21,484) (11,956) 67,417 1,928 356 2,284 13.55%
Q4: 2000 113,370 (24,596) (12,514) 76,260 2,144 346 2,490 13.06%
Q1: 2001 135,471 (31,415) (18,260) 85,796 2,516 126 2,642 12.32%
Q2: 2001 184,472 (48,845) (21,920) 113,707 3,242 161 3,403 11.97%
Q3: 2001 296,417 (96,364) (31,378) 168,675 5,160 86 5,246 12.44%
Q4: 2001 328,652 (121,183) (27,914) 179,555 5,484 (92) 5,392 12.01%
1999 $ 27,976 $ (6,816) $ (2,891) $ 18,269 $ 1,900 $2,302 $ 4,202 23.00%
2000 87,070 (18,527) (9,734) 58,809 6,532 1,992 8,524 14.49%
2001 236,947 (74,763) (24,907) 137,276 16,402 281 16,683 12.15%
Credit losses for the $52 billion portfolio that we credit enhanced at December
31, 2001 totaled $3.1 million in 2001. The annualized rate of credit loss was
less than 1 basis point (0.01%) of the portfolio. Of this loss, $2.3 million was
borne by the external credit enhancements to our positions and $0.8 million was
incurred by us and charged against our internal reserves.
Delinquencies (over 90 days, foreclosure, bankruptcy, and REO) in our
credit-enhancement portfolio increased from 0.22% of the current balances at the
end of the third quarter of 2001 to 0.24% at the end of the fourth quarter of
2001. Delinquencies of the underlying loan pools at the end of 2000 were 0.23%.
We expect delinquency and loss rates for our existing residential
credit-enhancement securities to increase from their current modest levels,
given the weaker economy and the natural seasoning pattern of these loans.
41
TABLE 12
RESIDENTIAL CREDIT-ENHANCEMENT SECURITIES -- CREDIT RESULTS
(AT PERIOD END, ALL DOLLARS IN THOUSANDS)
REDWOOD'S LOSSES TO TOTAL CREDIT
UNDERLYING DELINQUENCIES SHARE OF EXTERNAL TOTAL LOSSES AS
MORTGAGE ------------------ CREDIT CREDIT CREDIT % OF LOANS
LOANS $ % LOSSES ENHANCEMENT LOSSES (ANNUALIZED)
----------- ------- ----- --------- ----------- ------ ------------
Q1: 2000 $ 8,539,491 $ 49,731 0.58% $ (270) $ (543) $ (813) 0.04%
Q2: 2000 20,925,931 45,999 0.22% (187) (1,350) (1,537) 0.03%
Q3: 2000 21,609,785 58,102 0.27% (245) (345) (590) 0.01%
Q4: 2000 22,633,860 51,709 0.23% (56) (1,512) (1,568) 0.03%
Q1: 2001 27,081,361 63,893 0.24% (55) (550) (605) 0.01%
Q2: 2001 38,278,631 98,287 0.26% (196) (824) (1,020) 0.01%
Q3: 2001 49,977,641 107,821 0.22% (192) (407) (599) 0.01%
Q4: 2001 51,720,856 124,812 0.24% (321) (571) (892) 0.01%
1999 $ 6,376,571 $ 45,451 0.71% $(1,146) $(1,995) $(3,141) 0.05%
2000 22,633,860 51,709 0.23% (758) (3,750) (4,508) 0.02%
2001 51,720,856 124,812 0.24% (764) (2,352) (3,116) 0.01%
At year-end 2001, we had $90 million of external credit enhancements and $141
million of internal credit reserves for this portfolio. External credit reserves
serve to protect us from credit losses on a specific asset basis and represent
the principal value of interests that are junior to us and are owned by others.
Total reserves of $231 million represented 45 basis points (0.45%) of our
credit-enhancement portfolio of $52 billion. Reserves, credit protection, and
risks are specific to each credit-enhancement interest.
TABLE 13
RESIDENTIAL CREDIT-ENHANCEMENT SECURITIES -- CREDIT PROTECTION
(AT PERIOD END, ALL DOLLARS IN THOUSANDS)
DEC. 2001 SEP. 2001 JUN. 2001 MAR. 2001 DEC. 2000
--------- --------- --------- --------- ---------
INTERNAL CREDIT RESERVES $140,411 $112,133 $ 78,170 $ 35,722 $ 27,052
EXTERNAL CREDIT ENHANCEMENT 90,224 94,745 91,004 86,600 86,840
--------- --------- --------- --------- ---------
TOTAL CREDIT PROTECTION $230,635 $206,878 $169,174 $122,322 $113,892
AS % OF TOTAL PORTFOLIO 0.45% 0.41% 0.44% 0.45% 0.50%
The characteristics of the loans that we credit-enhance continue to show their
high-quality nature. At December 31, 2001, we credit enhanced 133,634 loans
(with a principal value of $52 billion) in our total credit-enhancement
portfolio. Of the $52 billion loan balances, 68% were fixed-rate loans, 17% were
hybrid loans (loans that become adjustable 3 to 10 years after origination), and
15% were adjustable-rate loans. The average size of the loans that we
credit-enhanced was $387,033. We credit-enhanced 1,601 loans with principal
balances in excess of $1 million; these loans had an average size of $1.4
million and a total loan balance of $2.2 billion. Loans over $1 million were 1%
of the total number of loans and 4% of the total balance of loans that we
credit-enhanced at year-end.
A FICO credit score was obtained at origination and is available for 84% of the
loans in our portfolio. For these loans, the average FICO score was 726.
Borrowers with FICO scores over 720 comprised 58% of the portfolio, those with
scores between 680 and 720 comprised 24%, those with scores between 620 and 680
comprised 16%, and those with scores below 620 comprised 2% of our residential
credit-enhancement securities. In general, loans with lower FICO scores have
strong compensating factors.
Many of the loans that we credit enhance are seasoned. On average, our
credit-enhanced loans have 28 months of seasoning. Generally, the credit risk
for these loans is reduced as property values have appreciated and the loan
balances have amortized. In effect, the current LTV ratio for seasoned loans is
often much reduced from the LTV ratio at origination.
42
Loans with LTV's at origination in excess of 80% made up 7% of loan balances. We
benefit from mortgage insurance or additional pledged collateral on 99% of these
loans, serving to substantially reduce the effective LTV on these loans. The
average effective LTV at origination for all the loans we credit enhance
(including the effect of mortgage insurance, pledged collateral, and other
credit enhancements) was 71%. Given housing appreciation and loan amortization,
we estimate the average current effective LTV for these loans is roughly 55%.
TABLE 14
RESIDENTIAL CREDIT-ENHANCEMENT SECURITIES -- UNDERLYING COLLATERAL
CHARACTERISTICS
(ALL DOLLARS IN THOUSANDS)
DEC. 2001 SEP. 2001 JUN. 2001 MAR. 2001 DEC. 2000
----------- ----------- ----------- ----------- -----------
CREDIT-ENHANCEMENT SECURITIES $51,720,856 $49,977,641 $38,278,631 $27,081,361 $22,633,860
NUMBER OF CREDIT-ENHANCED LOANS 133,634 132,555 105,721 77,011 63,675
AVERAGE LOAN SIZE $387 $377 $362 $352 $356
ADJUSTABLE % 15% 11% 19% 28% 35%
HYBRID % 17% 19% 20% 11% 7%
FIXED % 68% 70% 61% 61% 58%
NORTHERN CALIFORNIA 27% 25% 26% 23% 25%
SOUTHERN CALIFORNIA 26% 26% 28% 24% 25%
NEW YORK 5% 5% 5% 6% 6%
TEXAS 4% 4% 3% 4% 3%
NEW JERSEY 3% 3% 3% 4% 4%
VIRGINIA 3% 3% 3% 3% 3%
OTHER STATES 32% 34% 32% 36% 34%
YEAR 2001 ORIGINATION 43% 32% 21% 7% 0%
YEAR 2000 ORIGINATION 10% 14% 14% 21% 19%
YEAR 1999 ORIGINATION 22% 31% 36% 29% 35%
YEAR 1998 OR EARLIER ORIGINATION 25% 23% 29% 43% 46%
% BALANCE IN LOANS > $1MM PER LOAN 4% 3% 4% 6% 6%
The geographic dispersion of our credit-enhancement portfolio generally mirrors
that of the jumbo residential market as a whole, with approximately half of our
loans concentrated in California.
For the loans that we credit enhance where the home is located in Northern
California (27% of the total portfolio), at December 31, 2001 the average loan
balance was $411,500, the average FICO score was 725, and the average LTV at
origination was 69%. On average, these Northern California loans have 26 months
of seasoning, with 46% originated in year 2001, 7% in year 2000, and 47% in
years 1999 or earlier. At December 31, 2001, 543 of these loans had principal
balances in excess of $1 million; these larger loans had an average size of $1.4
million and a total loan balance of $735 million. They represented 2% of the
total number of Northern California loans and 5% of the total balance of
Northern California loans. Delinquencies in our Northern California residential
credit-enhancement portfolio at December 31, 2001 were 0.14% of current loan
balances.
For the 26% of our loans where the home is located in Southern California, the
average loan balance at December 31, 2001 was $401,500, the average FICO score
was 716, and the average LTV at origination was 72%. These Southern California
loans have 36 months of seasoning, on average, with 33% originated in year 2001,
6% in year 2000, and 61% in years 1999 or earlier. At December 31, 2001, 567 of
these loans had principal balances in excess of $1 million; these loans had an
average size of $1.4 million and a total loan balance of $796 million. They
represented 2% of the total number of Southern California loans and 6% of the
total balance of Southern California loans. Delinquencies in our Southern
California residential credit-enhancement portfolio at December 31, 2001 were
0.28% of current loan balance.
43
COMBINED RESIDENTIAL LOAN PORTFOLIOS
The tables below summarize the credit protection of our residential mortgage
loans and our residential credit-enhancement securities on a combined basis.
TABLE 15
RESIDENTIAL PORTFOLIOS -- CREDIT PROTECTION
(ALL DOLLARS IN THOUSANDS)
TOTAL
REDWOOD'S CREDIT
TOTAL RESIDENTIAL EXTERNAL TOTAL PROTECTION
RESIDENTIAL CREDIT CREDIT CREDIT AS % OF
LOANS RESERVE ENHANCEMENT PROTECTION LOANS
----------- ----------- ----------- ---------- ----------
Q1: 2000 $ 9,870,165 $ 16,137 $34,310 $ 50,447 0.51%
Q2: 2000 22,193,711 25,159 79,403 104,562 0.47%
Q3: 2000 22,796,584 26,709 78,564 105,273 0.46%
Q4: 2000 23,764,857 31,866 86,840 118,706 0.50%
Q1: 2001 28,153,180 40,690 86,600 127,290 0.45%
Q2: 2001 39,339,101 83,290 91,004 174,294 0.44%
Q3: 2001 51,332,246 117,093 94,745 211,838 0.41%
Q4: 2001 53,195,718 145,610 90,224 235,834 0.44%
1999 $ 7,762,160 $ 15,366 $26,111 $ 41,477 0.53%
2000 23,764,857 31,866 86,840 118,706 0.50%
2001 53,195,718 145,610 90,224 235,834 0.44%
The table below summarizes the credit performance of our residential mortgage
loans and our residential credit-enhancement securities on a combined basis.
TABLE 16
RESIDENTIAL PORTFOLIOS -- CREDIT PERFORMANCE
(ALL DOLLARS IN THOUSANDS)
DELINQUENCIES LOSSES TOTAL
AS % OF REDWOOD'S TO CREDIT
TOTAL SHARE OF EXTERNAL TOTAL LOSSES AS
RESIDENTIAL CREDIT CREDIT CREDIT % OF LOANS
DELINQUENCIES LOANS LOSSES ENHANCEMENT LOSSES (ANNUALIZED)
------------- ------------- --------- ----------- -------- ------------
Q1: 2000 $ 55,069 0.56% $ (270) $ (543) $ (813) 0.03%
Q2: 2000 50,967 0.23% (229) (1,350) (1,579) 0.03%
Q3: 2000 62,432 0.27% (245) (345) (590) 0.01%
Q4: 2000 57,376 0.24% (56) (1,512) (1,568) 0.03%
Q1: 2001 70,264 0.25% (85) (550) (635) 0.01%
Q2: 2001 103,200 0.26% (208) (824) (1,032) 0.01%
Q3: 2001 112,644 0.22% (503) (407) (910) 0.01%
Q4: 2001 129,881 0.24% (352) (571) (923) 0.01%
1999 $ 50,086 0.65% $(1,151) $(1,995) $(3,146) 0.04%
2000 57,376 0.24% (799) (3,751) (4,550) 0.02%
2001 129,881 0.24% (1,148) (2,352) (3,500) 0.01%
44
COMMERCIAL MORTGAGE LOANS
Our commercial real estate loan portfolio decreased from $76 million to $51
million during 2001 due to loan payoffs and sales. We intend to acquire
commercial loans and commercial loan participations in 2002.
TABLE 17
COMMERCIAL MORTGAGE LOANS -- ACTIVITY
(ALL DOLLARS IN THOUSANDS)
DEC. 2001 SEP. 2001 JUN. 2001 MAR. 2001 DEC. 2000*
--------- --------- --------- --------- ----------
START OF PERIOD BALANCES $ 64,362 $67,043 $70,077 $76,082 $ 64,641
ACQUISITIONS 210 0 1,500 0 25,267
SALES 0 (2,645) (3,573) (1,513) 0
PRINCIPAL PAYMENTS (13,403) (44) (897) (4,572) (13,865)
AMORTIZATION 29 15 104 76 39
MARK-TO-MARKET (BALANCE SHEET) 0 0 0 0 0
MARK-TO-MARKET (INCOME STATEMENT) (114) (7) (168) 4 0
-------- ------- ------- ------- --------
END OF PERIOD BALANCES $ 51,084 $64,362 $67,043 $70,077 $ 76,082
======== ======= ======= ======= ========
*Includes loans held at RWT Holdings, Inc., which was consolidated with our
financials as of January 1, 2001.
The yield on our commercial mortgage loans increased in the fourth quarter of
2001, due to earlier than expected payoffs, allowing us to accelerate the
recognition of deferred origination fees, prepayment penalty, and exit fees. All
loans in our portfolio have interest rate floors, so the decline in short-term
interest rates in 2001 did not have a material impact on the yields on these
loans. Total interest income and average yields rose in 2000 from 1999 levels
due to rising interest rates and loans added to our portfolio during 2000 with
generally higher yields.
TABLE 18
COMMERCIAL MORTGAGE LOANS -- INTEREST INCOME AND YIELDS
(ALL DOLLARS IN THOUSANDS)
AVERAGE
AVERAGE NET DISCOUNT CREDIT TOTAL
PRINCIPAL DISCOUNT COUPON AMORTIZATION PROVISION INTEREST
VALUE BALANCE INCOME INCOME EXPENSE INCOME YIELD
--------- -------- ------ ------------ --------- -------- ------
Q1: 2000* $31,924 $ (681) $ 711 $151 $0 $ 862 11.04%
Q2: 2000* 40,355 (744) 1,029 52 0 1,081 10.92%
Q3: 2000* 62,169 (1,423) 1,399 465 0 1,864 12.27%
Q4: 2000* 77,910 (1,611) 2,121 154 0 2,275 11.93%
Q1: 2001 73,836 (1,208) 1,857 76 0 1,933 10.65%
Q2: 2001 70,279 (878) 1,857 104 0 1,961 11.30%
Q3: 2001 66,024 (724) 1,680 15 0 1,695 10.38%
Q4: 2001 64,851 (601) 1,862 29 0 1,891 11.77%
1999* $26,651 $ (266) $2,636 $ 73 $0 $2,709 10.26%
2000* 53,127 (1,116) 5,260 822 0 6,082 11.69%
2001 68,715 (851) 7,256 224 0 7,480 11.02%
*Includes loans held at RWT Holdings, Inc., which was consolidated with our
financials as of January 1, 2001.
To date, we have not experienced delinquencies or credit losses in our
commercial mortgage loans. Nor have we established a credit reserve for our
commercial loans. A slowing economy, and factors particular to each loan, could
cause credit concerns and issues in the future. If this occurs, we may need to
provide for future losses or reduce the reported market value for commercial
mortgage loans held for sale. Other factors may also affect the market value of
these loans.
45
TABLE 19
COMMERCIAL MORTGAGE LOANS -- CHARACTERISTICS
(ALL DOLLARS IN THOUSANDS)
DEC. 2001 SEP. 2001 JUN. 2001 MAR. 2001 DEC. 2000*
--------- --------- --------- --------- ----------
COMMERCIAL MORTGAGE LOANS $51,084 $64,362 $67,043 $70,077 $76,082
NUMBER OF LOANS 8 14 16 18 20
AVERAGE LOAN SIZE $ 6,386 $ 4,597 $ 4,190 $ 3,893 $ 3,804
SERIOUS DELINQUENCY $ $0 $0 $0 $0 $0
REALIZED CREDIT LOSSES $0 $0 $0 $0 $0
CALIFORNIA % 59% 67% 68% 71% 73%
*Includes loans held at RWT Holdings, Inc., which was consolidated with our
financials as of January 1, 2001.
Our goal is to secure long-term, non-recourse debt for our commercial mortgage
loans. We accomplished this by obtaining $17 million of long-term debt in the
form of senior loan participations to fund $21 million of our existing portfolio
of commercial mortgage loans in 2001. In March 2002, we issued another $8
million of long-term debt collateralized by our commercial real estate loans.
Our remaining short-funded loans are financed with a combination of equity and
short- and medium-term credit facilities.
SECURITIES PORTFOLIO
Our securities portfolio consists of all the securities we own with the
exception of residential credit-enhancement securities that are discussed
separately. Our securities portfolio currently consists primarily of
investment-grade residential mortgage securities held to generate interest
income. We may acquire lower-rated and more diverse securities in 2002. During
2001, this portfolio decreased by 11% from $764 million to $683 million. As a
part of our long-term strategy, we plan to reduce short-term debt utilized to
fund our securities portfolio; we expect to either reduce the size of our
securities and/or to fund securities with long-term debt.
TABLE 20
SECURITIES PORTFOLIO -- ACTIVITY
(ALL DOLLARS IN THOUSANDS)
DEC. 2001 SEP. 2001 JUN. 2001 MAR. 2001 DEC. 2000
--------- --------- --------- --------- ---------
START OF PERIOD BALANCES $608,793 $ 739,187 $1,000,612 $ 764,775 $ 874,343
ACQUISITIONS 147,251 47,323 16,051 310,026 79,983
SALES (15,260) (106,297) (162,753) (11,000) (128,163)
PRINCIPAL PAYMENTS (53,400) (71,692) (113,165) (65,726) (61,421)
PREMIUM AMORTIZATION (799) (898) (1,086) (586) (591)
MARK-TO-MARKET (BALANCE SHEET) (2,034) 1,087 (94) (6) 35
MARK-TO-MARKET (INCOME STATEMENT) (1,069) 83 (378) 3,129 589
-------- --------- ---------- ---------- ---------
END OF PERIOD BALANCES $683,482 $ 608,793 $ 739,187 $1,000,612 $ 764,775
======== ========= ========== ========== =========
Total interest income from this portfolio was $9.9 million in the fourth quarter
of 2001, a decrease from $10.7 million in the third quarter of 2001 and from
$16.2 million in the fourth quarter of 2000. This decrease was the result of
lower average balances and lower yields. For similar reasons, our total interest
income for 2001 of $54.3 million was lower than the $67.2 million earned in 2000
and the $66.2 million earned in 1999.
The yields on this portfolio fell during the fourth quarter of 2001 due to
declining short-term interest rates, as the bulk of these securities represent
interests in pools of adjustable-rate residential mortgage loans. We expect
adjustable coupon rates to continue to decrease for the first several months of
2002, even if interest rates stabilize or rise. Mortgage prepayment rates have
been relatively high for the later part of 2001, further depressing yields due
to the faster amortization of purchase premiums.
46
TABLE 21
SECURITIES PORTFOLIO -- INTEREST INCOME AND YIELDS
(ALL DOLLARS IN THOUSANDS)
AVERAGE MORTGAGE NET
AVERAGE NET PREPAYMENT PREMIUM TOTAL
EARNING PREMIUM RATES INTEREST AMORTIZATION INTEREST
ASSETS BALANCE (CPR) INCOME EXPENSE INCOME YIELD
-------- ------- ---------- -------- ----------- -------- -----
Q1: 2000 $944,301 $ 8,118 19% $17,510 $ (450) $17,060 7.16%
Q2: 2000 902,265 7,225 20% 17,362 (163) 17,199 7.56%
Q3: 2000 868,159 8,946 20% 17,278 (572) 16,706 7.62%
Q4: 2000 822,452 9,595 19% 16,832 (591) 16,241 7.81%
Q1: 2001 874,307 10,164 19% 17,634 (586) 17,048 7.71%
Q2: 2001 910,793 14,013 31% 17,648 (1,086) 16,562 7.16%
Q3: 2001 626,246 12,332 32% 11,642 (898) 10,744 6.73%
Q4: 2001 628,193 11,838 31% 10,702 (799) 9,903 6.19%
1999 $999,972 $ 9,177 27% $69,769 $(3,550) $66,219 6.56%
2000 884,081 8,475 20% 68,982 (1,776) 67,206 7.53%
2001 758,844 12,092 28% 57,626 (3,369) 54,257 7.04%
The table below presents our securities portfolio by asset type.
TABLE 22
SECURITIES PORTFOLIO -- CHARACTERISTICS
(RESIDENTIAL MORTGAGE BACKED SECURITIES, UNLESS NOTED)
(ALL DOLLARS IN THOUSANDS)
CREDIT DEC. SEP. JUN. MAR. DEC.
RATING 2001 2001 2001 2001 2000
------ ---- ---- ---- ---- ----
FNMA & FHLMC - ADJUSTABLE "AAA" $353,523 $389,400 $434,732 $ 485,639 $509,802
FNMA & FHLMC - HYBRID "AAA" 20,223 0 2,828 3,096 11,402
JUMBO PRIME- ADJUSTABLE AAA or AA 144,813 138,261 243,078 451,950 185,018
JUMBO PRIME- HYBRID AAA or AA 137,926 43,775 0 0 7,964
JUMBO PRIME- FIXED AAA or AA 5,018 15,732 24,815 23,997 9,439
SUBPRIME - FLOATERS AAA or AA 14,600 14,600 14,600 19,277 23,015
SUBPRIME - FIXED AAA to BBB 600 1,050 13,026 13,062 17,044
INTEREST-ONLY - RESIDENTIAL AAA 13 53 60 71 113
INTEREST-ONLY - COMMERCIAL AAA 4,874 5,008 5,082 2,534 0
CBO EQUITY - MIXED REAL ESTATE B or NR 1,892 914 966 986 978
-------- -------- -------- ---------- --------
TOTAL SECURITIES PORTFOLIO $683,482 $608,793 $739,187 $1,000,612 $764,775
REALIZED CREDIT LOSSES DURING QUARTER $0 $0 $0 $0 $0
We own fixed rate securities in our securities portfolio and our residential
credit-enhancement securities portfolio, but generally not in amounts that
materially exceed our equity capital base (see Table 31). We have generally
avoided funding fixed rate assets with floating rate liabilities.
INTEREST EXPENSE
Our cost of borrowed funds almost halved over the past twelve months, from 6.96%
in the fourth quarter of 2000 to 3.56% in the fourth quarter of 2001, as the
expense of our adjustable-rate debt declined in conjunction with falling
short-term interest rates. Our average debt levels rose slightly from $1.9
billion in the fourth quarter of 2000 to $2.0 billion the fourth quarter of
2001. Due to the decline in borrowing costs, our interest expenses declined from
$34 million in the fourth quarter of 2000 to $18 million in the fourth quarter
of 2001.
47
TABLE 23
INTEREST EXPENSE
(ALL DOLLARS IN THOUSANDS)
LONG LONG SHORT SHORT
AVERAGE TERM TERM AVERAGE TERM TERM TOTAL
LONG DEBT DEBT SHORT DEBT DEBT TOTAL COST
TERM INTEREST COST OF TERM INTEREST COST OF INTEREST OF
DEBT EXPENSE FUNDS DEBT EXPENSE FUNDS EXPENSE FUNDS
---------- -------- ------- ---------- -------- ------- -------- -----
Q1: 2000 $ 972,338 $15,359 6.32% $1,225,562 $19,572 6.39% $ 34,931 6.36%
Q2: 2000 1,258,859 20,927 6.65% 865,068 14,206 6.57% 35,133 6.62%
Q3: 2000 1,191,730 20,449 6.86% 827,114 14,245 6.89% 34,694 6.87%
Q4: 2000 1,125,898 19,559 6.95% 819,160 14,286 6.98% 33,845 6.96%
Q1: 2001 1,072,172 17,838 6.65% 910,515 13,575 5.96% 31,413 6.34%
Q2: 2001 1,018,646 15,167 5.96% 964,543 11,843 4.91% 27,010 5.45%
Q3: 2001 933,340 12,714 5.45% 852,341 8,841 4.15% 21,555 4.83%
Q4: 2001 1,193,050 11,949 4.01% 839,879 6,142 2.93% 18,091 3.56%
1999 $1,090,242 $65,785 6.03% $ 955,890 $53,442 5.59% $119,227 5.83%
2000 1,137,324 76,294 6.71% 933,619 62,309 6.67% 138,603 6.69%
2001 1,054,135 57,668 5.47% 891,251 40,401 4.53% 98,069 5.04%
The table below lists our long-term debt issuance.
TABLE 24
LONG-TERM DEBT CHARACTERISTICS
(ALL DOLLARS IN THOUSANDS)
PRINCIPAL INTEREST
ORIGINAL ESTIMATED OUTSTANDING RATE AT
LONG TERM DEBT DEBT ISSUE ISSUE STATED CALLABLE AT DEC. 31, DEC. 31,
ISSUE RATING DATE AMOUNT INDEX MATURITY DATE 2001 2001
- ----- ------ -------- ---------- -------------- -------- --------- ----------- ----
SEQUOIA 1 A1 AAA 7/29/97 $ 334,347 1m LIBOR 2/15/28 Called 0 n/a
SEQUOIA 1 A2 AAA 7/29/97 200,000 Fed Funds 2/15/28 Called 0 n/a
SEQUOIA 2 A1 AAA 11/6/97 592,560 1y Treasury 3/30/29 2003 222,554 4.90%
SEQUOIA 2 A2 AAA 11/6/97 156,600 1m LIBOR 3/30/29 2003 58,816 2.27%
SEQUOIA 3 A1 AAA 6/26/98 225,459 Fixed to 12/02 5/31/28 Retired 0 n/a
SEQUOIA 3 A2 AAA 6/26/98 95,000 Fixed to 12/02 5/31/28 Retired 0 n/a
SEQUOIA 3 A3 AAA 6/26/98 164,200 Fixed to 12/02 5/31/28 2002 56,928 6.35%
SEQUOIA 3 A4 AAA 6/26/98 121,923 Fixed to 12/02 5/31/28 2002 121,923 6.25%
SEQUOIA 3 M1 AA/AAA 6/26/98 16,127 Fixed to 12/02 5/31/28 2002 16,127 6.79%
SEQUOIA 3 M2 A/AA 6/26/98 7,741 Fixed to 12/02 5/31/28 2002 7,741 6.79%
SEQUOIA 3 M3 BBB/A 6/26/98 4,838 Fixed to 12/02 5/31/28 2002 4,838 6.79%
SEQUOIA 1A A1 AAA 5/4/99 157,266 1m LIBOR 2/15/28 2002 55,921 2.52%
SEQUOIA 4 A AAA 3/21/00 377,119 1m LIBOR 8/31/24 2005 248,304 2.29%
COMMERCIAL 1 N/A 3/30/01 8,891 1m LIBOR 11/1/02 N/A 8,891 5.09%
COMMERCIAL 2 N/A 3/30/01 8,320 1m LIBOR 10/1/03 N/A 8,320 5.09%
SEQUOIA 5 A AAA 10/29/01 496,667 1m LIBOR 10/29/26 2006 491,426 2.27%
SEQUOIA 5 B1 AA 10/29/01 5,918 1m LIBOR 10/29/26 2006 5,918 2.72%
SEQUOIA 5 B2 A 10/29/01 5,146 1m LIBOR 10/29/26 2006 5,146 2.72%
SEQUOIA 5 B3 BBB 10/29/01 2,316 1m LIBOR 10/29/26 2006 2,316 2.72%
---------- ---------- -----
TOTAL LONG-TERM DEBT $2,980,438 $1,315,169 3.42%
========== ========== =====
In 2001, Fitch Ratings, a credit rating agency, upgraded the credit ratings on
three of our debt issues (Sequoia 3 M1 to M3).
48
OPERATING EXPENSES
Our ratio of operating expenses to equity dropped to 3.60% and our efficiency
ratio (operating expenses divided by net interest income after credit expenses)
dropped to 21% in the fourth quarter of 2001. Operating expenses grew by 18% in
2001 while the scale of our business (as measured by our equity capital base)
grew by 43%. We expect that our operating expense ratios may continue to improve
in 2002 if we continue to grow. As we increase the scale of our business, we
expect to continue to benefit from operating leverage as we expect growth in our
operating expenses will be restrained relative to growth in equity and net
interest income.
TABLE 25
OPERATING EXPENSES
(ALL DOLLARS IN THOUSANDS)
EFFICIENCY
OPERATING OPERATING RATIO:
EXPENSES EXPENSES OPERATING OPERATING
REPORTED UNCONSOLIDATED OF CLOSED FROM EXPENSES/ EXPENSES/
OPERATING HOLDINGS BUSINESS ONGOING AVERAGE NET INTEREST
EXPENSES EXPENSES UNITS OPERATIONS EQUITY INCOME
--------- -------------- --------- ---------- -------- ------------
Q1: 2000 $ 2,147 $ 865 $ (210) $ 2,802 5.24% 36%
Q2: 2000 2,239 590 (6) 2,823 5.30% 36%
Q3: 2000 2,066 536 (5) 2,597 4.87% 37%
Q4: 2000 1,398 400 0 1,798 3.34% 23%
Q1: 2001 2,980 0 0 2,980 5.49% 30%
Q2: 2001 3,378 0 0 3,378 6.13% 30%
Q3: 2001 2,748 0 0 2,748 4.32% 24%
Q4: 2001 2,730 0 0 2,730 3.60% 21%
1999 $ 3,835 $22,267 $(17,616) $ 8,486 3.57% 32%
2000 7,850 2,391 (221) 10,020 4.68% 33%
2001 11,836 0 0 11,836 4.75% 26%
OTHER INCOME (EXPENSE) AND EQUITY IN LOSSES IN HOLDINGS
In 2001, other income and expense primarily consists of variable stock option
expense associated with certain stock options. This expense, a type of
mark-to-market expense, occurs as our stock price rises above the underlying
strike price on a small portion of our outstanding options.
We now report Holdings on a consolidated basis. In years prior to 2001, we
accounted for our interest in Holdings as an equity investment; our losses from
Holding for these years are reported as "other income and expense." The costs of
business units that were closed are the primary expenses associated with
Holdings in 1999.
MARK-TO-MARKET ADJUSTMENTS
Changes in the market value of certain of our mortgage assets and interest rate
agreements affect our GAAP earnings each quarter. For the full year of 2001,
income statement mark-to-market adjustments totaled negative $0.8 million; these
adjustments were due, in part, to the cumulative mark-to-market effect realized
upon the adoption of EITF 99-20 and marking assets to bid-side values upon
acquisition. We also mark-to-market certain assets through our balance sheet;
these adjustments affect our reported book value but not our earnings. Net
balance sheet and income statement mark-to-market adjustments were negative $6.1
million in the fourth quarter of 2001 but were positive $2.0 million for the
year 2001.
SHAREHOLDER WEALTH
In the 7.5 years since the commencement of Redwood's operations, cumulative
shareholder wealth has grown at a compound rate of 18% per year. We define
shareholder wealth as growth in tangible book value per share, plus dividends
paid, plus reinvestment of dividends. In calculating shareholder wealth, we
assume that dividends are
49
reinvested through the purchase of additional shares at the prevailing book
value per share. With this assumption, the shareholder wealth we have created
can be compared to book value per share growth at a non-REIT company that has
retained its earnings and compounds book value within the company. This is a
measure of management value-added, not a measure of actual shareholder returns.
Book value per share was $11.67 in September 1994 when we commenced operations.
We increased book value to $22.21 per share at December 31, 2001 through the
retention of cash by keeping dividends lower than cash flow, changes in market
values of assets, issuance of stock at prices above book value, and repurchases
of stock below book value. Since we mark-to-market many of our assets through
our balance sheet, reported book value is a good approximation of tangible value
in the company. Cumulative dividends paid during this period were $9.87 per
share, and reinvestment earnings on those dividends were $6.03 per share. Thus,
cumulatively, shareholder wealth has increased from $11.67 per share to $38.11
per share during this 7.5 year period. A company that earned an 18% after-tax
return on equity and retained all its earnings would have shown a similar amount
of shareholder wealth growth during this period.
TABLE 26
SHAREHOLDER WEALTH
(DOLLARS PER SHARE)
BOOK CUMULATIVE
VALUE REINVESTMENT CUMULATIVE
PER CUMULATIVE EARNINGS ON SHAREHOLDER
SHARE DIVIDENDS DIVIDENDS DIVIDENDS WEALTH
----- --------- ---------- ------------ -----------
SEP. 1994 $11.67 $0.00 $0.00 $0.00 $11.67
DEC. 1994 10.82 0.25 0.25 0.00 11.07
DEC. 1995 12.38 0.96 1.21 0.09 13.68
DEC. 1996 16.50 1.67 2.88 1.07 20.45
DEC. 1997 21.55 2.15 5.03 3.07 29.65
DEC. 1998 20.27 0.28 5.31 2.67 28.25
DEC. 1999 20.88 0.40 5.71 3.07 29.66
DEC. 2000 21.47 1.61 7.32 4.11 32.90
DEC. 2001 22.21 2.55 9.87 6.03 38.11
TAXABLE INCOME AND DIVIDENDS
We generally intend to distribute over time as preferred and common stock
dividends 100% of our REIT taxable income earned at our parent company, Redwood
Trust, which has elected REIT status (but not the earnings generated in our
taxable subsidiaries). Our REIT taxable income may differ materially from our
core earnings or reported GAAP income. The table below summarizes the
differences between our GAAP earnings and taxable income in each of the past
three years. The taxable income results presented for 2001 represents our
current best estimate; actual taxable income we report on our tax return to be
filed later this year may end up being different from these estimates for a
variety of reasons.
50
TABLE 27
DIFFERENCES BETWEEN GAAP EARNINGS AND REIT TAXABLE INCOME
(DOLLARS PER SHARE)
2001 2000 1999
---------- --------- ---------
GAAP INCOME BEFORE PREFERRED DIVIDENDS $32,887 $18,934 $ 1,728
(EARNINGS)/LOSSES FROM TAXABLE SUBSIDIARIES (1,023) 1,676 21,633
AMORTIZATION EXPENSES (4,765) (5,858) (12,559)
CREDIT EXPENSES 21 462 995
OPERATING EXPENSES 3,261 461 (375)
MARK-TO-MARKET ADJUSTMENTS 1,577 2,348 (3,610)
---------- --------- ---------
REIT TAXABLE INCOME BEFORE DIVIDENDS $31,958 $18,023 $ 7,812
REIT TAXABLE INCOME SPILLOVER FROM PRIOR YEAR $ 2,002 $871 $0
REIT TAXABLE INCOME AVAILABLE FOR DISTRIBUTION 33,960 18,894 7,812
---------- --------- ---------
TOTAL DIVIDENDS (COMMON AND PREFERRED) $29,753 $16,892 $ 6,941
PERCENTAGE OF YEAR'S REIT TAXABLE INCOME
DISTRIBUTED 87% 89% 89%
REIT TAXABLE INCOME SPILLOVER INTO NEXT YEAR $ 4,207 $ 2,002 $871
SHARES OUTSTANDING AT YEAR-END 12,611,749 8,809,500 8,783,341
PER SHARE REIT TAXABLE INCOME SPILLOVER $0.33 $0.23 $0.10
Our common stock dividend policy and distributions are set by our Board of
Directors. Generally, distributions depend on our REIT taxable income, GAAP
earnings, cash flows, overall financial condition, maintenance of REIT status,
and such other factors as the Board of Directors deems relevant. The Board of
Directors may reduce our regular dividend rate (but not below the minimum
dividend distribution requirements) when it believes it may be in the long-term
interest of Redwood Trust and its shareholders to do so. No dividends will be
paid or set apart for payment on shares of our common stock unless full
cumulative dividends have been paid on our Class B 9.74% Cumulative Convertible
Preferred Stock. As of December 31, 2001, full cumulative dividends have been
paid on the Class B Preferred Stock.
Under current policy, the Board sets our regular dividend at a rate that it
believes is more likely than not to be sustainable, given current expectations
for cash flow generation and other factors. In years when our dividend
distribution requirements exceed what we believe to be our sustainable dividend
rate, the Board may declare one or more special quarterly cash dividends.
Distributions to our shareholders will generally be subject to tax as ordinary
income, although a portion of such distributions may be designated by us as
capital gain or may constitute a tax-free return of capital. All dividends
declared and paid in the last three years have been ordinary income. Our Board
of Directors may elect to maintain a steady dividend rate during periods of
fluctuating REIT taxable income. In such event, the Board may choose to declare
dividends that include a return of capital. We will generally attempt to avoid
acquiring assets or structuring financings or sales at the REIT corporate level
that may generate unrelated business taxable income (UBTI) or excess inclusion
income for our shareholders but there can be no assurance that we will be
successful in doing so. We annually furnish to each shareholder a statement
setting forth distributions paid during the preceding year and their
characterization as ordinary income, capital gains or return of capital. For a
discussion of the Federal income tax treatment of our distributions, see
"Federal Income Tax Considerations - Taxation of Holders of Redwood Trust's
Common Stock" elsewhere in this Form 10-K.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in conformity with GAAP requires us to
make estimates and assumptions that affect the reported amounts of certain
assets and liabilities at the date of the financial statements and the reported
amounts of certain revenues and expenses during the reported period. Actual
results could differ from those estimates. The critical accounting policies, and
how changes in estimates might affect our financial results and statements, are
discussed below.
51
We estimate the fair value of our assets and hedges using available
market information and other appropriate valuation methodologies. We
believe the estimates we use accurately reflect the values we may be
able to receive should we choose to sell them. Our estimates are
inherently subjective in nature and involve matters of uncertainty and
judgment to interpret relevant market and other data. Many factors are
necessary to estimate market values, including, but not limited to
interest rates, prepayment rates, and amount and timing of credit
losses.
In addition to our valuation processes, we are active acquirers, and
occasional sellers, of the assets we own and we are active users of
hedges. Thus, we have the ability to understand and determine changes
in assumptions that are taking place in the market place, and make
appropriate changes in our assumptions for valuing assets in our
portfolio. In addition, we use third party sources to assist in
developing our estimates. Furthermore, for many of the assets we pledge
to obtain collateralized short-term borrowings, we obtain market
valuations from our counterparties on our assets in order to establish
the maximum amount of borrowings.
Changes in the perceptions regarding future events can have a material
impact on the value of such assets. Should such changes, or other
factors, result in significant changes in the market values, our income
and/or book value could be adversely affected.
We recognize revenue on most of our assets using the effective yield
method. The use of this method requires us to project the cash flow
over the remaining life of each asset. Such projections include
assumptions about interest rates, prepayment rates, timing and amount
of credit losses, when certain tests will be met that may allow for
changes in payments made under the structure of securities, and other
factors. There can be no assurance that our assumptions used to
generate future cash flows, or the current period's yield for each
asset, will prove to be accurate. Our current period earnings may be
not accurately reflect the yield to be earned on that asset for the
remaining life.
We review our cash flow projections on an ongoing basis. We monitor the
critical performance factors for each loan and security. Our
expectations of future asset cash flow performance are shaped by input
and analysis received from external sources, internal models, and our
own judgment and experience.
One assumption used in projecting cash flows, and thus our current
yield, is the level and timing of credit losses that we expect to incur
over the lives of our earning assets. We establish this level of future
estimated credit losses as a credit reserve. The reserve is based upon
our assessment of various factors affecting our assets, including
current and projected economic conditions, delinquency status, and
external credit protection. Our actual credit losses, and the timing of
these losses, may differ from those estimates used to establish the
reserve. Such differences will result in different yields over the life
of the asset than we may be currently reporting under GAAP. If such
differences are adverse, and the market value of our assets has
declined below our carrying value, we may need to take current period
mark-to-market charges through our income statement.
We continually review and update, if appropriate, all of our
assumptions. Despite this continual review, there can be no assurance
that our assumptions used to estimate cash flows, fair values, and
effective yields will prove to be correct as interest rates, economic
conditions, real estate conditions, and the market's perception of the
future constantly change.
FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES
CASH FLOW
Cash flow from operations equals earnings adjusted for non-cash items,
such as depreciation, amortization, provisions, and mark-to-market
adjustments. Free cash flow equals cash flow from operations less
capital expenditures and increases in working capital. Generally, free
cash flow (together with principal receipts from assets) is available
to pay dividends, pay down debt, repurchase stock, or acquire new
portfolio assets. Funds retained to support a net increase in portfolio
investment generally equals free cash flow less dividends plus any net
issuance of stock. The presentation of free cash flow and funds
available for portfolio investing is intended to supplement the
presentation of cash provided by operating activities in accordance
with GAAP. Since all companies do not calculate these alternative
measures of cash flow in the same fashion, free cash flow and funds
retained for portfolio investing may not be comparable to similarly
titled measures reported by other companies.
52
Over the past several quarters, our cash flow from operations has exceeded our
earnings and our dividend distributions. In the fourth quarter of 2001, cash
flow from operations was $15.5 million, consisting of earnings of $9.0 million
plus non-cash depreciation, amortization, compensation, and mark-to-market
adjustments of $6.5 million. Our free cash flow, which is our cash flow from
operations plus changes in working capital, property, plant, equipment, and
other non-earning assets, was $16.0 million. In addition, we issued $33.7
million in new common stock during the quarter through a common stock offering
and our direct stock purchase and dividend reinvestment plan. We used the
available cash from these sources to fund our common stock dividend of $8.3
million and to increase our investment in our portfolio activities by $41.4
million.
For the year 2001, cash flow from operations was $43.4 million, an increase from
the $25.1 million we generated in 2000. Our cash flow from operations in 2001
was the result of earnings of $30.2 million, plus non-cash expenses and
adjustments of $13.2 million. The non-cash expenses are primarily our net
premium amortization expense. Working capital decreases net of capital
expenditures totaled $4.3 million during the year, resulting in free cash flow
of $47.7 million generated during 2001. This free cash flow was used to pay out
$23.3 million in common dividends. Our three equity offerings in 2001, plus our
dividend reinvestment program provided an additional $85.8 million in capital.
Our funds available for incremental investment in our portfolio in 2001 totaled
$110.2 million
TABLE 28
CASH FLOW
(ALL DOLLARS IN THOUSANDS)
CHANGES IN NET
WORKING FUNDS
CASH CAPITAL AVAILABLE
NON- FLOW AND FREE COMMON (PURCHASE)/ FOR
GAAP CASH FROM OTHER CASH DIVIDENDS SALE PORTFOLIO
EARNINGS ITEMS OPERATIONS ASSETS FLOW PAID OF STOCK INVESTING
-------- ----- ---------- ------ ---- --------- ----------- ---------
Q1: 2000 $ 3,283 $ 3,042 $ 6,325 $ 5,070 $11,395 $ (2,196) $ 45 $ 9,244
Q2: 2000 3,086 2,476 5,562 4,584 10,145 (3,076) 0 7,069
Q3: 2000 4,878 1,079 5,957 (2,345) 3,612 (3,516) 381 477
Q4: 2000 4,963 2,276 7,239 (4,941) 2,299 (3,700) 2 (1,399)
Q1: 2001 6,680 1,345 8,025 4,536 12,561 (3,876) 986 9,671
Q2: 2001 6,463 3,004 9,467 (1,096) 8,371 (4,448) 548 4,471
Q3: 2001 8,065 2,386 10,451 366 10,817 (6,715) 50,586 54,688
Q4: 2001 8,955 6,496 15,451 541 15,992 (8,268) 33,665 41,389
1999 $(1,013) $29,468 $28,455 $ 5,254 $33,709 $ (1,323) $(37,334) $ (4,948)
2000 16,210 8,873 25,083 2,368 27,451 (12,488) 428 15,391
2001 30,163 13,231 43,394 4,347 47,741 (23,307) 85,785 110,219
Our ability to retain significant amounts of the free cash flow that we generate
may be diminished in the future should our minimum dividend distribution
requirements increase relative to our free cash flow (see the discussion on
"Taxable Income and Dividends" above).
SHORT-TERM BORROWINGS AND LIQUIDITY
The substantial majority of our short-term borrowings have maturities of one
year or earlier and have interest rates that change monthly to a margin over or
under the one month LIBOR interest rate.
Some of our short-term borrowing facilities are committed, for which we pay
fees, but most are uncommitted. Our facilities are generally for a term of up to
one year, although certain assets maybe funded for periods up to three years.
These facilities have restrictions on pledged asset types and debt covenant
tests; we continue to meet these requirements.
At December 31, 2001, we have over a dozen uncommitted facilities for short-term
collateralized debt, with credit approval for $4 billion of borrowings. We have
had no difficulty securing short-term borrowings on favorable
53
terms. Outstanding borrowings under these agreements were $568 million
at December 31, 2001, a decrease from $690 million at year-end 2000 due
to a reduction in our securities portfolio.
We also had two short-term facilities available to fund our residential
mortgage loan portfolio at December 31, 2001. These facilities totaled
over $1 billion; we had $146 million outstanding borrowings at December
31, 2001, and $6 million outstanding borrowings at December 31, 2000.
We anticipate using these facilities, and possibly enter into new
facilities, as we acquire whole loans in anticipation of a
securitization.
We had three borrowing facilities for residential credit-enhancement
securities totaling $140 million and two borrowing facilities for
commercial mortgage loans totaling $58 million at December 31, 2001.
Outstanding borrowings under these agreements were $83 million at
December 31, 2001, and $61 million at December 31, 2000.
At this time we see no material negative trends that we believe would
affect our access to short-term borrowings or bank credit lines
sufficient to maintain safe operations, that would suggest that our
liquidity reserves would be called upon, or that would likely cause us
to be in danger of a covenant default. However, many factors, including
ones external to us, may affect our liquidity in the future.
In the first quarter of 2002, we added borrowing facilities for our
residential credit-enhancement securities and our residential mortgage
loans. There can be no assurance that we will be able to find or retain
sufficient borrowing agreements to fund all our potential acquisition
opportunities.
Under our internal risk-adjusted capital system, we maintain liquidity
reserves in the form of cash and unpledged liquid assets. These
liquidity reserves may be needed in the event of a decline in the
market value, or a change in the acceptability to lenders of the
collateral we pledge to secure short-term borrowings, or for other
liquidity needs. We maintained liquidity reserves at or in excess of
our policy levels during 2001. At December 31, 2001, we had $74 million
of unrestricted cash and highly liquid (unpledged) assets available to
meet potential liquidity needs. Total available liquidity equaled 9% of
our short-term debt balances. At December 31, 2000, we had $54 million
of liquid assets, equaling 7% of our short-term debt balances.
LONG-TERM DEBT
The $1.3 billion of long-term debt on our December 31, 2001
consolidated balance sheet is non-recourse debt. Substantially all this
debt was issued through our special purpose financing subsidiary,
Sequoia, and is collateralized by residential mortgage loans. The
remaining $17 million of this debt is backed by commercial loans and
was created through the sale of senior participations. The holders of
our long-term debt can look only to the cash flow from the mortgages
specifically collateralizing the debt for repayment. By using this
source of financing, our liquidity risks are limited. Our special
purpose financing subsidiaries that issue debt have no call on
Redwood's general liquidity reserves, and there is no debt rollover
risk as the loans are financed to maturity. The market for AAA-rated
long-term debt of the type that we issue to fund residential loans
through Sequoia is a large, global market that has been relatively
stable for many years. At this time, we believe we could issue more of
this debt on reasonable terms if we should choose to do so. During
2001, we sold two commercial loan participations of $17 million. In
March 2002, we sold an additional senior participation for $8 million.
The market for senior participations on commercial loans of the types
in our portfolio is limited and there can be no assurance that we will
be able to sell future participations.
EQUITY CAPITAL AND RISK-ADJUSTED CAPITAL GUIDELINES
Excluding short- and long-term collateralized debt, we are capitalized
entirely by common and preferred equity capital. Our equity base
increased from $216 million to $308 million in 2001 as a result of
three equity offerings totaling $80 million, $3 million in asset
appreciation, $3 million in retention of cash flow, and $6 million in
stock issuance through our direct stock purchase and dividend
reinvestment program. We raised another $40 million of new capital
through an equity offering in February 2002 and have raised $6 million
of capital through our direct stock purchase and dividend reinvestment
program in the first three months of 2002. We will seek to raise
additional equity capital in the future when opportunities to expand
our business are attractive and when such issuance is likely to benefit
long-term earnings and dividends per share.
54
The amount of portfolio assets that can be supported with a given capital base
is limited by our internal risk-adjusted capital policies. Our risk-adjusted
capital policy guideline amounts are expressed in terms of an equity-to-assets
ratio and vary with market conditions and asset characteristics. Our
risk-adjusted capital guideline is further discussed under "Capital Risks". At
December 31, 2001, our minimum capital amounts were: 73% of residential
credit-enhancement portfolio interests; 100% of net retained interests in
residential loan portfolio after long-term debt issuance (Sequoia equity); 8% of
short-term debt funded residential whole loans; 11% of securities portfolio; and
37% of commercial mortgage loan portfolio.
Our total risk-adjusted capital guideline amount for assets on our balance sheet
was $279 million (11% of asset balances) at December 31, 2001. Capital required
for outstanding commitments at December 31, 2001 for asset purchases settling
later in 2002 was $3 million. Thus, at December 31, 2001, our total capital
committed at quarter end was $282 million, our total capital available was $308
million, and our excess capital to support growth in the first quarter of 2002
was $26 million.
BALANCE SHEET LEVERAGE
As reported on Redwood's balance sheet of December 31, 2001, our
equity-to-assets ratio was 13% and our debt-to-equity ratio was 6.9 times. We
believe Redwood's balance sheet is generally less leveraged than many banks,
savings and loans, and other financial institutions such as Fannie Mae and
Freddie Mac that are in similar businesses to ours.
A majority of Redwood Trust's debt is non-recourse debt. Holders of non-recourse
debt can look only to the pledged assets - and not to Redwood - for repayment.
Therefore, another useful measure of the leverage Redwood employs is to compute
ratios comparing Redwood's equity base to its recourse debt levels and Redwood's
"at-risk" assets (our assets excluding those assets pledged to non-recourse
debt). These adjustments generally conform Redwood's balance sheet to what would
be reported if Redwood accounted for its securitizations as sales rather than
financings. Total reported assets at December 31, 2001 were $2.4 billion; of
these, $1.3 billion were pledged to non-recourse debt and $1.1 billion were
"at-risk". Total reported liabilities at December 31, 2001 were $2.1 billion;
non-recourse debt was $1.2 billion and recourse debt was $0.8 billion. At
year-end, our ratio of equity-to-at-risk-assets was 28% and our ratio of
recourse-debt-to-equity was 2.6 times.
Our long-term plan is reduce short-term recourse debt levels, in part by
replacing this debt with long-term non-recourse debt. If we are successful in
this funding strategy, and we continue to grow, our reported leverage levels may
increase at the same time that our recourse leverage levels will decrease.
TABLE 29
LEVERAGE RATIOS
(ALL DOLLARS IN THOUSANDS)
RECOURSE EQUITY RECOURSE EQUITY REPORTED
AT DEBT TO DEBT AND TO DEBT
RISK AND OTHER AT-RISK LIABILITIES REPORTED TO
ASSETS LIABILITIES EQUITY ASSETS TO EQUITY ASSETS EQUITY
---------- ----------- -------- ------- ----------- -------- --------
Q1: 2000 $1,141,241 $ 931,541 $209,700 18% 4.4 9% 10.6
Q2: 2000 1,026,281 817,897 208,384 20% 3.9 9% 9.8
Q3: 2000 1,043,554 832,890 210,664 20% 4.0 10% 9.4
Q4: 2000 983,097 767,433 215,664 22% 3.6 10% 8.7
Q1: 2001 1,226,951 1,005,280 221,671 18% 4.5 10% 9.3
Q2: 2001 1,099,885 875,871 224,014 20% 3.9 11% 8.3
Q3: 2001 1,387,409 1,107,557 279,852 20% 4.0 12% 7.1
Q4: 2001 1,120,061 812,288 307,773 28% 2.6 13% 6.9
1999 $1,471,570 $1,261,635 $209,935 14% 6.0 9% 10.5
2000 983,097 767,433 215,664 22% 3.6 10% 8.7
2001 1,120,061 812,288 307,773 28% 2.6 13% 6.9
55
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We seek to manage the risks inherent in all financial institutions -
including credit risk, liquidity risk, interest rate risk, prepayment
risk, market value risks, and capital risks -- in a prudent manner
designed to insure our company's longevity. At the same time, we
endeavor to provide our shareholders an opportunity to realize a high,
steady, and rising dividend and an attractive total rate of return
through stock ownership in our company. In general, we seek, to the
best of our ability, to assume risks that can be quantified from
historical experience, to actively manage such risks, to earn
sufficient compensation to justify the taking of such risks, and to
maintain capital levels consistent with the risks we do take.
CREDIT RISK
The majority of our potential credit risk comes from high-quality
residential mortgage loans. This includes residential mortgage loans we
own and loans we effectively "guarantee" or "insure" through
acquisitions of credit-enhancement securities. We also are exposed to
potential credit risks in our commercial mortgage loan portfolio. A
small amount of our securities portfolio is currently exposed to credit
risk; the bulk of this portfolio has very high credit ratings and would
not normally be expected to incur credit losses. We also have credit
risk with counter-parties with whom we do business.
It should be noted that the establishment of a credit reserve for GAAP
or a designated credit reserve under the effective yield method does
not reduce our taxable income or our dividend payment obligations as a
REIT. For taxable income, many of our credit expenses will be
recognized only as incurred. Thus, the timing and recognition amount of
credit losses for GAAP and tax, and for our earnings and our dividends,
may differ. A material increase in actual credit losses may not affect
our GAAP income due to our reserves but could materially reduce our
dividend payment obligations.
The method that we use to account for future credit losses depends upon
the type of asset that we own. For our credit-enhancement securities,
we establish a credit reserve upon the acquisition of such assets under
the effective yield method of accounting. In addition, first loss and
other credit-enhancement interests that are junior to our positions
that we do not own act as a form of external credit reserve for us on a
specific asset basis; these interests junior to ours will absorb credit
losses in the pool of underlying mortgage loans before the principal of
our interest will be affected. For our residential and commercial
mortgage loans, we establish a credit reserve based on anticipation of
losses by taking credit provisions through our income statement. Most
of the assets in our securities portfolio do not have material credit
risk, and, thus, no credit reserves are established. When we acquire
assets for this portfolio where credit risk exists, we will establish
the appropriate reserve as necessary.
LIQUIDITY RISK
Our primary form of financing is the issuance of long-term,
non-recourse securitized debt that very closely matches the interest
rate, prepayment rate, and maturities of our assets that we pledge to
secure this debt. Once we issue this debt, our recourse exposure to the
underlying assets is limited to our net investment after debt issuance.
We believe this is a secure and robust form of financing that
effectively eliminates liquidity risk for this portion of our balance
sheet and eliminates a variety of other potential risks as well.
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. Trends in the liquidity of the capital markets in general may
affect our ability to rollover short-term debt. At December 31, 2001,
we had $797 million of short-term debt collateralized by assets. Of
this debt, $568 million was collateralized by investment-grade
securities, $66 million by residential credit-enhancement securities,
$17 million by commercial mortgage loans, and $146 million by
high-quality residential mortgage loans under accumulation for a future
securitization. If our short term debt was called, or we could not
renew lines, we may need to sell assets in an unfavorable environment.
There can be no assurance that such sales would satisfy our
liabilities. The events of September 11, 2001 did not impact our
liquidity. We have and continue to develop business continuity plans
which may help preserve access to liquidity and help mitigate the
effect of any disruptions to our operations in the event of a disaster.
As a part of our long-term planning, we generally intend to reduce our
short-term debt levels, especially short-term debt used to fund long
maturity assets that we intend to retain. We expect, under our current
plan, that our primary use of short-term debt will be to fund assets
under accumulation for securitization.
56
The table below presents our contractual obligations as of December 31, 2001.
The debt appears on our balance sheet. The operating leases are commitments
which are expensed as paid per terms of the contracts. Additional information on
these obligations are presented in our Notes to Consolidated Financial
Statements.
TABLE 30
CONTRACTUAL OBLIGATIONS
(ALL DOLLARS IN THOUSANDS)
STATED
TOTAL MATURITIES COMMENTS
---------- ----------- ---------------------------------------------------------------
SHORT-TERM DEBT $ 796,811 2002 Weighted average maturity is 82 days
LONG-TERM DEBT, RESIDENTIAL $1,296,504 2017 - 2029 Non-recourse debt amortizes as residential collateral pays down
LONG-TERM DEBT, COMMERCIAL $ 17,211 2002 - 2003 Non-recourse debt amortizes as commercial collateral pays down
ASSET PURCHASE COMMITMENTS $ 17,400 2002 Most acquisitions were completed in first quarter 2002
OPERATING LEASES $ 2,600 2002-2005 Office rent and software licenses
INTEREST RATE RISK
Our strategy is to maintain an asset/liability posture that is effectively
match-funded so that the achievement of our long-term goals is unlikely to be
affected by changes in interest rates, yield curves, or mortgage prepayment
rates.
At year-end 2001, the interest rate characteristics of our debt closely matched
the interest rate characteristics of our assets that were funded with debt. We
had $2.1 billion of adjustable-rate debt matched with $2.1 billion of
adjustable-rate assets. We had $308 million of equity invested primarily in
fixed rate assets and working capital.
As a part of our current asset/liability strategy, we have been maintaining a
slight mismatch between the interest rate adjustment periods of our
adjustable-rate debt and our adjustable-rate assets. In effect, we own six-month
LIBOR assets (and, to a lesser degree, one-year Treasury index assets) funded
with one month LIBOR debt. The interest rate on this debt adjusts each month to
the current one month LIBOR rate plus a margin. The interest rate on the
six-month LIBOR assets adjusts more slowly to market conditions; each month, the
coupon rate on approximately one-sixth of these assets adjusts to the current
six-month LIBOR rate plus a margin. Any single change in short-term interest
rates could thus have some short-term effect on our earnings (generally, for the
next two quarters). We would expect that the spread between our asset yields and
our cost of borrowed funds would be more favorable in a falling short-term
interest rate environment than in a rising short-term interest rate environment.
This trend may be partially or fully offset over time by the equity-funded
portion of our balance sheet, which would generally have increasing net interest
earnings (and perhaps better credit results) in a rising rate environment.
In 2001, short-term interest rates fell throughout the year, and our earnings
benefited from this pricing adjustment mismatch. We would expect our spread to
narrow over the next few quarters assuming interest rates stabilize or rise.
We have achieved our desired asset/liability mix on-balance sheet. As the table
below shows our variable-rate asses are generally funded with variable-rate debt
and our fixed-rate assets are generally funded with equity. As a result, we have
generally ceased our hedging activities. We intend to use interest rate
agreements as part of our asset/liability strategy in the future when necessary
to achieve our asset/liability management goals.
57
TABLE 31
ASSET / LIABILITY MATCHING AS OF DECEMBER 31, 2001
(ALL DOLLARS IN THOUSANDS)
ONE MONTH ONE YEAR NON-INTEREST TOTAL
ASSET ASSET LIBOR TREASURY HYBRID BEARING LIABILITIES
TYPE AMOUNT LIABILITIES LIABILITIES LIABILITIES LIABILITIES EQUITY AND EQUITY
---- ------ ----------- ----------- ----------- ----------- ------ ----------
CASH (UNRESTRICTED) $ 9,030 $ 9,030 $ 0 $0 $ 0 $ 0 $ 9,030
ONE MONTH LIBOR 479,309 479,309 0 0 0 0 479,309
SIX MONTH LIBOR 965,359 965,359 0 0 0 0 965,359
COFI/OTHER ARM 71,586 71,586 0 0 0 0 71,586
ONE YEAR TREASURY 545,015 321,668 223,347 0 0 0 545,015
FIXED / HYBRID < 1 YR * 38,219 38,219 0 0 0 0 23,581
HYBRID 196,633 2,008 0 0 0 194,625 211,271
FIXED 104,120 0 0 0 0 104,120 104,120
NON-EARNING ASSETS 26,373 0 0 0 17,345 9,028 26,373
---------- ---------- -------- -- ------- -------- ----------
TOTAL $2,435,644 $1,887,179 $223,347 $0 $17,345 $307,773 $2,435,644
========== ========== ======= == ======= ======== ==========
*Projected principal receipts on fixed-rate and hybrid assets over the next
twelve months.
Changes in interest rates can have many affects on our business aside from those
discussed in this section, including affecting our liquidity, market values, and
mortgage prepayment rates.
PREPAYMENT RISK
We seek to maintain an asset/liability posture that mitigates the effects that
mortgage prepayment trends may have on our ability to achieve our long-term
objectives. For the development of our business, there are positive and negative
aspects to both slow prepayment rate environments and fast prepayment rate
environments. In general, it would be difficult to say which scenario would be
preferred over the longer term.
Prepayments affect short-term GAAP earnings primarily through amortization of
purchase premium and discount. Although we have roughly equal amounts of premium
and discount, variations in a specific asset's current and long-term estimated
prepayment rates and differing accounting methods for various types of assets
can cause earnings fluctuations as individual asset prepayment rates change.
TABLE 32
UNAMORTIZED PREMIUM AND DISCOUNT BALANCES
(ALL DOLLARS IN THOUSANDS)
NET NET
GROSS GROSS PREMIUM/ AMORTIZATION
PREMIUM DISCOUNT (DISCOUNT) (EXPENSE)
------- --------- ---------- ------------
Q1: 2000 $31,948 $(14,273) $17,675 $ (522)
Q2: 2000 29,068 (17,602) 11,466 45
Q3: 2000 29,202 (20,223) 8,979 (1,040)
Q4: 2000 25,437 (21,400) 4,037 (818)
Q1: 2001 29,598 (25,809) 3,789 (869)
Q2: 2001 29,046 (36,230) (7,184) (1,885)
Q3: 2001 27,921 (34,308) (6,387) (1,977)
Q4: 2001 26,518 (30,562) (4,044) (4,852)
1999 $30,449 $(24,191) $ 6,258 $(5,162)
2000 25,437 (21,400) 4,037 (2,335)
2001 26,518 (30,562) (4,044) (9,583)
We could have material net premium amortization expenses even if we do not have
a high net premium balance. This could occur because our premium mortgage assets
generally prepay at a faster rate than do our discount mortgage assets, and
because the yields of our premium assets are generally more sensitive to changes
in
58
prepayment rates than are the yields of our discount assets. Yields for
most of our assets are affected both by estimated future long-term
prepayment rates and by current prepayment rates.
MARKET VALUE RISK
At December 31, 2001, we owned mortgage securities and loans totaling
$691 million that we account for on a mark-to-market basis (in the case
of mortgage loans, on a lower-of-cost-or-market basis) for purposes of
determining reported earnings. Of these assets, 100% had
adjustable-rate coupons. Market value fluctuations for our assets not
only affect our reported earnings, but also can affect our liquidity,
especially to the extent these assets are funded with short-term
borrowings. We currently do not have a significant number of interest
rate agreements; such agreements are reported at market value, with any
periodic changes reported either through the income statement or our
balance sheet. Furthermore, under SFAS 133, certain assets whose market
value changes are not currently reported through the income statement
may have such changes reported through the income statement if such
assets are hedged.
At December 31, 2001, we owned $367 million of assets that were
marked-to-market through our balance sheet but not our income
statement. Market value fluctuations of these assets can affect the
reported value of our stockholders' equity base.
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
our short-term borrowings declines or the market for short-term
borrowings changes in an adverse manner.
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 securities
rated below AA, residential credit-enhancement interests, retained
interests from our Sequoia securitizations of our residential retained
portfolio assets, commercial mortgage whole loans, and retained
commercial mortgage junior participants are generally higher than for
higher-rated securities and residential whole loans. Capital
requirements for 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 most of our retained interests in Sequoia
generally equal our net investment. The sum of the capital adequacy
amounts for all of our mortgage assets is our aggregate capital
adequacy guideline amount.
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 assets would increase, at least on a
temporary basis, due to periodic and life caps and slowing prepayment
rates for mortgage assets. We measure all of our 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 and as the market values of our assets, net of
mark-to-market gains on hedges, decrease. (Such market value declines
may be temporary, 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 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 may authorize management to
acquire assets in a limited amount beyond the usual constraints of our
risk-adjusted capital policy.
59
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, as a
REIT, our dividends must equal at least 90% of our net REIT income as
calculated for tax purposes. In each case, our activities and balance
sheet are measured with reference to historical cost or fair market
value without considering inflation.
QUANTITATIVE INFORMATION ABOUT MARKET RISK
The table below incorporates information that may be useful in
analyzing certain market-value risks on our balance sheet. One scenario
regarding potential future principal repayments and interest rates of
our assets and liabilities is presented in the table. There are many
assumptions used to generate this information and there can be no
assurance that assumed events will occur as anticipated. Future sales,
principal repayments, acquisitions, calls, and restructurings could
materially change our interest rate risk profile. As discussed
throughout this Form 10-K, many factors will affect our earnings.
For our interest-rate sensitive assets, the table presents principal
cash flows and related average interest rates by year of maturity. The
forward curve (future interest rates as implied by the yield structure
of debt markets) as of December 31, 2001 was used to project the
average coupon rates for each year presented, based on the existing
characteristics of the portfolio. The timing of principal cash flows
includes assumptions on the prepayment speeds of these assets based on
their recent prepayment performance and future prepayment performance
consistent with this scenario; actual prepayments speeds could vary
significantly from these assumptions. Furthermore, this table does not
include anticipated credit losses and assumes all of the principal we
are entitled to receive will be received. The actual amount and timing
of credit losses will affect the principal payments and effective rates
during all periods.
60
QUANTITATIVE INFORMATION ON MARKET RISK
PRINCIPAL AMOUNTS MATURING
AND EFFECTIVE RATES DURING PERIOD AT DECEMBER 31, 2001
-------------------------------------------------- ------------------------------------
(ALL DOLLARS IN THOUSANDS) THERE- PRINCIPAL REPORTED EST. MARKET
INTEREST RATE SENSITIVE ASSETS 2002 2003 2004 2005 2006 AFTER VALUE VALUE VALUE
- ------------------------------------ ------ ------- ------- ------- ------ ------- --------- --------- ------------
RESIDENTIAL MORTGAGE LOANS
ADJUSTABLE RATE Principal Value 466,173 299,785 193,444 137,671 99,588 273,807 1,470,468 1,474,862 1,471,468
Interest Rate 4.77% 5.87% 6.90% 7.30% 7.57% 7.92% 100.30% 100.07%
RESIDENTIAL CREDIT ENHANCEMENT INTERESTS
ADJUSTABLE RATE Principal 9,595 2,038 1,421 810 6,093 33,465 53,422 31,069 31,069
Interest Rate 5.22% 6.55% 7.76% 8.20% 8.50% 9.28% 58.16% 58.16%
HYBRID Principal 6,059 11,744 10,768 13,335 17,106 61,804 120,816 65,015 65,015
Interest Rate 6.58% 6.58% 6.58% 6.95% 8.27% 8.61% 53.81% 53.81%
FIXED RATE AND Principal 2,276 2,433 5,605 16,768 28,781 123,334 179,197 94,730 94,730
INTEREST ONLY Interest Rate 6.72% 6.72% 6.72% 6.72% 6.72% 6.72% 52.86% 52.86%
SECURITIES
COMMERCIAL MORTGAGE LOANS
ADJUSTABLE RATE Principal Value 633 35,526 6,125 0 0 0 42,284 41,789 41,813
Interest Rate 10.20% 10.20% 4.96% n/a n/a n/a 98.83% 98.87%
HYBRID Principal Value 116 128 168 179 178 8,738 9,507 9,295 9,295
Interest Rate 11.00% 11.00% 9.50% 9.59% 10.44% 10.63% 97.78% 97.78%
SECURITIES PORTFOLIO
ADJUSTABLE RATE Principal Value 167,789 111,287 74,451 49,962 33,664 70,800 507,953 513,548 513,548
Interest Rate 5.69% 5.90% 7.17% 7.68% 7.98% 8.32% 101.10% 101.10%
HYBRID Principal Value 29,651 19,412 46,008 22,740 40,276 0 158,087 158,149 158,149
Interest Rate 6.31% 6.31% 6.41% 6.51% 6.51% n/a 100.04% 100.04%
FIXED RATE AND
INTEREST ONLY
SECURITIES Principal Value 117 804 1,227 945 729 3,093 6,915 11,784 11,784
Interest Rate 8.07% 8.07% 8.07% 8.07% 8.07% 8.07% n/m n/m
PRINCIPAL AMOUNTS MATURING
AND EFFECTIVE RATES DURING PERIOD
--------------------------------------------------
INTEREST RATE THERE- PRINCIPAL REPORTED EST. MARKET
SENSITIVE LIABILITIES 2002 2003 2004 2005 2006 AFTER VALUE VALUE VALUE
- ------------------------------------ ------ ------- ------- ------- ------ ------- --------- --------- ------------
SHORT-TERM DEBT
REVERSE REPURCHASE
AGREEMENTS
AND BANK WAREHOUSE Principal 780,024 3,138 13,649 0 0 0 796,811 796,811 796,811
FACILITIES Interest Rate 2.20% 6.30% 7.39% n/a n/a n/a 100.00% 100.00%
LONG-TERM DEBT
VARIABLE RATE Principal 415,824 280,301 165,574 115,591 85,239 254,640 1,315,169 1,313,715 1,295,323
Interest Rate 4.14% 5.12% 5.87% 6.25% 6.51% 6.77% 99.89% 99.49%
NOTIONAL AMOUNTS MATURING
AND EFFECTIVE RATES DURING PERIOD
--------------------------------------------------
DETAIL OF INTEREST THERE- NOTIONAL REPORTED EST. MARKET
RATE AGREEMENTS* 2002 2003 2004 2005 2006 AFTER VALUE VALUE VALUE
- ------------------------------------ ------ ------- ------- ------- ------ ------- --------- --------- ------------
Caps with Strike
Rates < 7% Notional 8,000 0 0 0 0 0 8,000 0 0
Strike Rate 6.72% n/a n/a n/a n/a n/a 0.00% 0.00%
Caps with Strike Rates
of 7% to 10% Notional 5,000 0 0 0 0 0 5,000 0 0
Strike Rate 8.60% n/a n/a n/a n/a n/a 0.00% 0.00%
Caps with Strike
Rates > 10% Notional 300,000 0 0 0 0 0 300,000 0 0
Strike Rate 10.40% n/a n/a n/a n/a n/a 0.00% 0.00%
*Interest Rate Agreements which represent mirroring transactions are not
included in this table.)
61
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements of the Company and Holdings and
the related Notes, together with the Reports of Independent Accountants
thereon, are set forth on pages F-1 through F-23 of this Form 10-K and
incorporated herein by reference.
ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 as to directors and executive
officers of the Company is incorporated herein by reference to the
definitive Proxy Statement to be filed pursuant to Regulation 14A under
the headings "Election of Directors" and "Management of the Company."
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference
to the definitive Proxy Statement to be filed pursuant to Regulation
14A under the heading "Executive Compensation."
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated herein by reference
to the definitive Proxy Statement to be filed pursuant to Regulation
14A under the heading "Security Ownership of Certain Beneficial Owners
and Management."
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated herein by reference
to the definitive Proxy Statement to be filed pursuant to Regulation
14A under the heading "Executive Compensation - Certain Relationships
and Related Transactions."
PART IV
ITEM 14. EXHIBITS, CONSOLIDATED FINANCIAL STATEMENTS SCHEDULES AND REPORTS
ON FORM 8-K
(a) Documents filed as part of this report:
(1) Consolidated Financial Statements
(2) Schedules to Consolidated Financial Statements: All
Consolidated Financial Statements schedules not included
have been omitted because they are either inapplicable or
the information required is provided in the Company's
Consolidated Financial Statements and Notes thereto,
included in Part II, Item 8, of this Annual Report on
Form 10-K.
62
(3) Exhibits:
Exhibit
Number Exhibit
- ------- -------
3.1 Articles of Amendment and Restatement of the Registrant (a)
3.1.1 Certified Certificate of Amendment of the Charter of Registrant (k)
3.2 Articles Supplementary of the Registrant (a)
3.3 Amended and Restated Bylaws of the Registrant (b)
3.3.1 Amended and Restated Bylaws, amended December 13, 1996 (g)
3.3.2 Amended and Restated Bylaws, amended March 15, 2001 (p)
3.3.3 Amended and Restated Bylaws, amended January 24, 2002
3.4 Articles Supplementary of the Registrant, dated August 14, 1995 (d)
3.4.1 Articles Supplementary of the Registrant relating to the Class B 9.74%
Cumulative Convertible Preferred Stock, filed August 9, 1996 (f)
4.2 Specimen Common Stock Certificate (a)
4.3 Specimen Class B 9.74% Cumulative Convertible Preferred Stock
Certificate (f)
4.4 In May 1999, the Bonds issued pursuant to the Indenture, dated as of
June 1, 1997, between Sequoia Mortgage Trust 1 and First Union National
Bank, as Trustee, were redeemed, restructured, and contributed to
Sequoia Mortgage Trust 1A, interests in which were then privately
placed with investors (i)
4.4.1 Indenture dated as of October 1, 1997 between Sequoia Mortgage Trust 2
(a wholly-owned, consolidated subsidiary of the Registrant) and Norwest
Bank Minnesota, N.A., as Trustee (j)
4.4.2 Sequoia Mortgage Trust 1A Trust Agreement, dated as of May 4, 1999
between Sequoia Mortgage Trust 1 and First Union National Bank (l)
4.4.3 Indenture dated as of October 1, 2001 between Sequoia Mortgage Trust 5
(a wholly-owned consolidated subsidiary of the Registrant) and Bankers
Trust Company of California, N.A., as Trustee (q)
9.1 Voting Agreement, dated March 10, 2000 (p)
10.1 [Reserved]
10.2 [Reserved]
10.3 [Reserved]
10.4 Founders Rights Agreement, dated August 19, 1994, between the
Registrant and the original holders of Common Stock of the Registrant
(a)
10.5 Form of Reverse Repurchase Agreement for use with Agency Certificates,
Privately-Issued Certificates and Privately-Issued CMOs (a)
10.5.1 Form of Reverse Repurchase Agreement for use with Mortgage Loans (d)
10.6.1 [Reserved]
10.7 [Reserved]
10.8 Forms of Interest Rate Cap Agreements (a)
10.9 [Reserved]
10.9.2 [Reserved]
10.9.3 Custodian Agreement (U.S. Custody), dated December 1, 2000, between the
Registrant and Bankers Trust Company (p)
10.10 Employment Agreement, dated August 19, 1994, between the Registrant and
George E. Bull (a)
10.11 Employment Agreement, dated August 19, 1994, between the Registrant and
Douglas B. Hansen (a)
10.12 [Reserved]
10.13 [Reserved]
10.13.1 Employment Agreement, dated March 13, 2000, between the Registrant and
Harold F. Zagunis (n)
10.13.2 Employment Agreement, dated March 23, 2001, between the Registrant and
Andrew I. Sirkis (p)
10.13.3 Employment Agreement, dated April 20, 2000, between the Registrant and
Brett D. Nicholas (p)
10.14 1994 Amended and Restated Executive and Non-Employee Director Stock
Option Plan (c)
63
10.14.1 1994 Amended and Restated Executive and Non-Employee Director Stock
Option Plan, amended March 6, 1996 (d)
10.14.2 Amended and Restated 1994 Executive and Non-Employee Director Stock
Option Plan, amended December 13, 1996 (h)
10.14.3 Amended and Restated Executive and Non-Employee Director Stock Option
Plan, amended March 4, 1999 (o)
10.14.4 Amended and Restated Executive and Non-Employee Director Stock Option
Plan, amended January 18, 2001 (p)
10.27 [Reserved]
10.29 [Reserved]
10.29.1 Form of Dividend Reinvestment and Stock Purchase Plan (g)
10.30 [Reserved]
10.30.1 [Reserved]
10.31 RWT Holdings, Inc. Series A Preferred Stock Purchase Agreement, dated
March 1, 1998 (m)
10.32 Administrative Personnel and Facilities Agreement dated as of April 1,
1998, between Redwood Trust, Inc. and RWT Holdings, Inc. (m)
10.32.1 First Amendment to Administrative Personnel and Facilities Agreement
dated as of April 1, 1998, between Redwood Trust, Inc. and RWT
Holdings, Inc. (m)
10.33 Lending and Credit Support Agreement dated as of April 1, 1998, between
RWT Holdings, Inc., Redwood Residential Funding, Inc., Redwood
Commercial Funding, Inc., and Redwood Financial Services, Inc., and
Redwood Trust, Inc. (m)
10.34 Form of Master Forward Commitment Agreements for RWT Holdings, Inc.,
Residential Redwood Funding, Inc., Redwood Commercial Funding, Inc. and
Redwood Financial Services, Inc. (m)
11.1 Statement re: Computation of Per Share Earnings
21 List of Subsidiaries
23 Consent of Accountants
- --------------------
(a) Incorporated by reference to the correspondingly numbered
exhibit to the Registration Statement on Form S-11 (33-92272)
filed by the Registrant with the Securities and Exchange
Commission on May 19, 1995.
(b) Incorporated by reference to the correspondingly numbered
exhibit to the Registration Statement on Form S-11 (33-97946)
filed by the Registrant with the Securities and Exchange
Commission on October 10, 1995.
(c) Incorporated by reference to the correspondingly numbered
exhibit to the Registration Statement on Form S-11 (33-94160)
filed by the Registrant with the Securities and Exchange
Commission on June 30, 1995.
(d) Incorporated by reference to the correspondingly numbered
exhibit to the Registration Statement on Form S-11 (333-02962)
filed by the Registrant with the Securities and Exchange
Commission on March 26, 1996.
(e) [Reserved]
(f) Incorporated by reference to the correspondingly numbered
exhibit to the Registration Statement on Form S-11 (333-08363)
filed by the Registrant with the Securities and Exchange
Commission on July 18, 1996.
(g) Incorporated by reference to the Registration Statement on Form
S-3 (333-18061) filed by the Registrant with the Securities and
Exchange Commission on January 2, 1997.
64
(h) Incorporated by reference to the correspondingly numbered
exhibit to Form 8-K (26436) filed by the Registrant with the
Securities and Exchange Commission on January 7, 1997.
(i) Incorporated by reference to the Form 8-K filed by Sequoia
Mortgage Funding Corporation with the Securities and Exchange
Commission on August 12, 1997.
(j) Incorporated by reference to the Form 8-K filed by Sequoia
Mortgage Funding Corporation with the Securities and Exchange
Commission on November 18, 1997.
(k) Incorporated by reference to the Form 8-K (1-13759) filed by the
Registrant with the Securities and Exchange Commission on July
20, 1998.
(l) Incorporated by reference to the Form 10-Q (0-26436) filed by
the Registrant with the Securities and Exchange Commission for
the fiscal quarter ended June 30, 1999.
(m) Incorporated by reference to the Form 10-K (1-13759) filed by
the Registrant with the Securities and Exchange Commission for
the fiscal year ended December 31, 1998.
(n) Incorporated by reference to the Form 10-Q (1-13759) filed by
the Registrant with the Securities and Exchange Commission for
the fiscal quarter ended March 31, 2000.
(o) Incorporated by reference to the Form 10-K (1-13759) filed by
the Registrant with the Securities and Exchange Commission for
the fiscal year ended December 31, 1999.
(p) Incorporated by reference to the Form 10-K (1-13759) filed by
the Registrant with the Securities and Exchange Commission for
the fiscal year ended December 31, 2000.
(q) Incorporated by reference to the Form 8-K (1-13759) filed by
Sequoia Mortgage Funding Corporation with the Securities and
Exchange Commission on November 15, 2001.
(b) Reports on Form 8-K:
None.
65
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) the Securities Exchange Act
of 1934, the Registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
REDWOOD TRUST, INC.
Dated: March 21, 2002 By: /s/ George E. Bull
----------------------------------------
George E. Bull
Chairman and Chief Executive Officer
Pursuant to the requirements the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Registrant and
in the capacities and on the dates indicated.
Signature Title Date
- --------- ----- ----
/s/ George E. Bull George E. Bull March 21, 2002
- --------------------------- Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
/s/ Douglas B. Hansen Douglas B. Hansen March 21, 2002
- --------------------------- Director, President
/s/ Harold F. Zagunis Harold F. Zagunis March 21, 2002
- --------------------------- Chief Financial Officer, Secretary,
Treasurer and Controller
(Principal Financial and Accounting Officer)
/s/ Richard D. Baum Richard D. Baum March 21, 2002
- --------------------------- Director
/s/ Thomas C. Brown Thomas C. Brown March 21, 2002
- --------------------------- Director
/s/ Mariann Byerwalter Mariann Byerwalter March 21, 2002
- --------------------------- Director
/s/ Thomas F. Farb Thomas F. Farb March 21, 2002
- --------------------------- Director
/s/ Charles J. Toeniskoetter Charles J. Toeniskoetter March 21, 2002
- ---------------------------- Director
/s/ David L. Tyler David L. Tyler March 21, 2002
- ---------------------------- Director
66
REDWOOD TRUST, INC.
CONSOLIDATED FINANCIAL STATEMENTS AND
REPORT OF INDEPENDENT ACCOUNTANTS
FOR INCLUSION IN FORM 10-K
ANNUAL REPORT FILED WITH
SECURITIES AND EXCHANGE COMMISSION
DECEMBER 31, 2001
F-1
REDWOOD TRUST, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Consolidated Financial Statements - Redwood Trust, Inc.:
Consolidated Balance Sheets at December 31, 2001 and 2000 ............... F-3
Consolidated Statements of Operations for the years ended
December 31, 2001, 2000 and 1999....................................... F-4
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 2001, 2000 and 1999....................................... F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 2001, 2000 and 1999....................................... F-6
Notes to Consolidated Financial Statements............................... F-7
Report of Independent Accountants.......................................... F-23
F-2
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
December 31, December 31,
2001 2000
------------ ------------
ASSETS
Residential mortgage loans $1,474,862 $1,130,997
Residential credit-enhancement securities 190,813 80,764
Commercial mortgage loans 51,084 57,169
Securities portfolio 683,482 764,775
Cash and cash equivalents 9,030 15,483
---------- ----------
Total Earning Assets 2,409,271 2,049,188
Restricted cash 3,399 5,240
Accrued interest receivable 13,729 16,084
Principal receivable 7,823 7,986
Other assets 1,422 3,617
---------- ----------
TOTAL ASSETS $2,435,644 $2,082,115
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term debt $ 796,811 $ 756,222
Long-term debt, net 1,313,715 1,095,835
Accrued interest payable 2,569 5,657
Accrued expenses and other liabilities 6,498 4,180
Dividends payable 8,278 4,557
---------- ----------
Total Liabilities 2,127,871 1,866,451
---------- ----------
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; 12,661,749 and
8,809,500 issued and outstanding 127 88
Additional paid-in capital 328,668 242,522
Accumulated other comprehensive income 2,701 (89)
Cumulative earnings 59,961 27,074
Cumulative distributions to stockholders (110,201) (80,448)
---------- ----------
Total Stockholders' Equity 307,773 215,664
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $2,435,644 $2,082,115
========== ==========
The accompanying notes are an integral part of these
consolidated financial statements.
F-3
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share data)
Years Ended December 31,
2001 2000 1999
----------- ---------- ----------
INTEREST INCOME
Residential mortgage loans $ 65,012 $ 90,134 $ 71,804
Residential credit-enhancement securities 16,683 8,524 4,202
Commercial mortgage loans 7,480 2,002 1,081
Securities portfolio 54,257 67,206 66,219
Cash and cash equivalents 1,107 1,395 2,658
----------- ---------- ----------
Total interest income 144,539 169,261 145,964
INTEREST EXPENSE
Short-term debt (40,401) (62,309) (53,442)
Long-term debt (57,668) (76,294) (65,785)
----------- ---------- ----------
Total interest expense (98,069) (138,603) (119,227)
NET INTEREST INCOME 46,470 30,658 26,737
Operating expenses (11,836) (7,850) (3,835)
Equity in losses of RWT Holdings, Inc. -- (1,676) (21,633)
Other income (expense) (911) 98 175
Net unrealized and realized market value gains (losses) 1,532 (2,296) 284
----------- ---------- ----------
Net income before preferred dividend and change in accounting principle 35,255 18,934 1,728
Dividends on Class B preferred stock (2,724) (2,724) (2,741)
----------- ---------- ----------
Net income before change in accounting principle 32,531 16,210 (1,013)
Cumulative effect of adopting EITF 99-20 (See Note 2) (2,368) -- --
----------- ---------- ----------
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS $ 30,163 $ 16,210 $ (1,013)
=========== ========== ==========
EARNINGS PER SHARE:
Basic Earnings Per Share:
Net income before change in accounting principle $ 3.20 $ 1.84 $ (0.10)
Cumulative effect of adopting EITF 99-20 $ (0.23) $ -- $ --
Net income $ 2.97 $ 1.84 $ (0.10)
Diluted Earnings Per Share:
Net income before change in accounting principle $ 3.11 $ 1.82 $ (0.10)
Cumulative effect of adopting EITF 99-20 $ (0.23) $ -- $ --
Net income $ 2.88 $ 1.82 $ (0.10)
Weighted average shares of common stock and common stock equivalents:
Basic 10,163,581 8,793,487 9,768,345
Diluted 10,474,764 8,902,069 9,768,345
The accompanying notes are an integral part of these
consolidated financial statements.
F-4
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(In thousands, except share data)
Accumulated
Class B other Cumulative
Preferred stock Common stock Additional compre- distri-
-------------------------------------- paid-in hensive Cumulative butions to
Shares Amount Shares Amount capital income earnings stockholders Total
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1998 909,518 $26,736 11,251,556 $113 $279,201 $ (370) $ 6,412 $ (57,302) $254,790
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income before
preferred dividend -- -- -- -- -- -- 1,728 -- 1,728
Net unrealized loss on assets
available-for-sale -- -- -- -- -- (2,978) -- -- (2,978)
--------
Total comprehensive loss -- -- -- -- -- -- -- -- (1,250)
Repurchase of preferred stock (7,450) (219) -- -- -- -- -- -- (219)
Issuance of common stock -- -- 15,285 -- 22 -- -- -- 22
Repurchase of common stock -- -- (2,483,500) (25) (37,129) -- -- -- (37,154)
Dividends declared:
Preferred -- -- -- -- -- -- -- (2,741) (2,741)
Common -- -- -- -- -- -- -- (3,513) (3,513)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1999 902,068 $26,517 8,783,341 $ 88 $242,094 $(3,348) $ 8,140 $ (63,556) $209,935
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income before
preferred dividend -- -- -- -- -- -- 18,934 -- 18,934
Net unrealized income on assets
available-for-sale -- -- -- -- -- 3,259 -- -- 3,259
--------
Total comprehensive income -- -- -- -- -- -- -- -- 22,193
Issuance of common stock -- -- 26,159 -- 428 -- -- -- 428
Dividends declared:
Preferred -- -- -- -- -- -- -- (2,724) (2,724)
Common -- -- -- -- -- -- -- (14,168) (14,168)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2000 902,068 $26,517 8,809,500 $ 88 $242,522 $ (89) $27,074 $ (80,448) $215,664
- ------------------------------------------------------------------------------------------------------------------------------------
Comprehensive income:
Net income before
preferred dividend -- -- -- -- -- -- 32,887 -- 32,887
Reclassification adjustment due
to adoption of EITF 99-20 -- -- -- -- -- 2,368 -- -- 2,368
Net unrealized income on assets
available-for-sale -- -- -- -- -- 422 -- -- 422
--------
Total comprehensive income -- -- -- -- -- -- -- -- 35,677
Issuance of common stock -- -- 3,852,249 39 86,146 -- -- -- 86,185
Dividends declared:
Preferred -- -- -- -- -- -- -- (2,724) (2,724)
Common -- -- -- -- -- -- -- (27,029) (27,029)
- ------------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 2001 902,068 $26,517 12,661,749 $127 $328,668 $ 2,701 $59,961 $(110,201) $307,773
====================================================================================================================================
The accompanying notes are an integral part of these
consolidated financial statements.
F-5
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Years Ended December 31,
-----------------------------------
2001 2000 1999
--------- --------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income available to common stockholders before
preferred dividend $ 32,887 $ 18,934 1,728
Adjustments to reconcile net income to net cash
(used in) provided by operating activities:
Depreciation and amortization 11,226 4,170 6,773
Provision for credit losses 768 731 1,346
Non-cash stock compensation 401 --
Equity in losses of RWT Holdings, Inc. -- 1,676 21,633
Net unrealized and realized market value (gains) losses (1,532) 2,296 (284)
Cumulative effect of adopting EITF 99-20 2,368 -- --
Net purchases of mortgage loans held-for-sale (672,192) 362,857 (363,105)
Principal payments on mortgage loans held-for-sale 11,384 20,598 59,782
Net (purchases) sales of mortgage securities trading (61,294) (97,113) (118,380)
Principal payments on mortgage securities trading 302,176 278,170 460,508
Net (purchases) sales of interest rate agreements (664) (2,810) 276
Net change in:
Accrued interest receivable 2,068 (2,266) 5,238
Principal receivable 163 (3,387) 7,836
Other assets 1,045 (651) 195
Accrued interest payable (3,088) 195 (5,358)
Accrued expenses and other liabilities 2,318 1,361 (203)
--------- --------- ---------
Net cash (used in) provided by operating activities (371,966) 584,761 77,985
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of mortgage loans held-for-investment -- (407,203) --
Proceeds from sales of mortgage loans held-for-investment 4,313 -- --
Principal payments on mortgage loans held-for-investment 330,178 226,179 310,892
Purchases of mortgage securities available-for-sale (313,757) (58,306) (17,691)
Proceeds from sales of mortgage securities available-for-sale 33,070 2,897 --
Principal payments on mortgage securities available-for-sale 10,534 1,875 442
Net decrease in restricted cash 1,841 144 7,473
Investment in RWT Holdings, Inc. -- -- (9,900)
Loans to RWT Holdings, Inc., net of repayments -- 6,500 --
Increase in receivable from RWT Holdings, Inc. -- 472 (27)
--------- --------- ---------
Net cash provided by (used in) provided by investing activities 66,179 (227,442) 291,189
--------- --------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings (repayments) on short-term debt 22,389 (497,343) (4,005)
Proceeds from issuance of long-term debt 525,190 375,844 (337)
Repayments on long-term debt (307,999) (225,434) (359,180)
Net proceeds from issuance of common stock 85,785 428 22
Repurchases of preferred stock -- -- (202)
Repurchases of common stock -- -- (37,154)
Dividends paid (26,031) (15,212) (4,064)
--------- --------- ---------
Net cash provided by (used in) financing activities 299,334 (361,717) (404,920)
--------- --------- ---------
Net (decrease) increase in cash and cash equivalents (6,453) (4,398) (35,746)
Cash and cash equivalents at beginning of period 15,483 19,881 55,627
--------- --------- ---------
Cash and cash equivalents at end of period $ 9,030 $ 15,483 $ 19,881
========= ========= =========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid for interest $ 100,919 $ 137,454 $ 122,520
========= ========= =========
The accompanying notes are an integral part of these
consolidated financial statements.
F-6
REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2001
NOTE 1. THE COMPANY
Redwood Trust, Inc. ("Redwood Trust") together with its subsidiaries, is a real
estate finance company. Our primary business is owning, financing, and credit
enhancing high-quality jumbo residential mortgage loans nationwide. Redwood
Trust also finances real estate through its securities portfolio and its
commercial loan portfolio. Redwood Trust's primary source of revenue is monthly
payments made by homeowners on their mortgages, and its primary expense is the
cost of borrowed funds. Redwood Trust is structured as a Real Estate Investment
Trust ("REIT") and, therefore, the majority of net earnings are distributed to
shareholders as dividends.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The December 31, 2001 consolidated financial statements include the accounts of
Redwood Trust and its wholly-owned subsidiaries, Sequoia Mortgage Funding
Corporation ("Sequoia") and RWT Holdings, Inc. ("Holdings"). The December 31,
2000 and 1999 consolidated financial statements include the accounts of Redwood
Trust and Sequoia, and Redwood Trust's equity interest in Holdings. For
financial reporting purposes, references to the "Company" mean Redwood Trust,
Sequoia, and Holdings.
Substantially all of the assets of Sequoia, consisting primarily of residential
whole loans shown as part of Residential Mortgage Loans, are 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 which are collateral for
Long-Term Debt is limited to its net equity investment in Sequoia and its net
equity investment in two commercial mortgage loans, as the Long-Term Debt is
non-recourse to the Company. All significant intercompany balances and
transactions with Sequoia and Holdings have been eliminated in the consolidation
of the Company at December 31, 2001. Certain amounts for prior periods have been
reclassified to conform to the December 31, 2001 presentation.
During March 1998, the Company acquired an equity interest in Holdings. Prior to
January 1, 2001, the Company owned all of the preferred stock and had a
non-voting, 99% economic interest in Holdings. The Company accounted for its
investment in Holdings under the equity method. Under this method, original
equity investments in Holdings were recorded at cost and adjusted by the
Company's share of earnings or losses and decreased by dividends received. On
January 1, 2001, the Company acquired 100% of the voting common stock of
Holdings for $300,000 in cash consideration from two officers of Holdings, and
Holdings became a wholly-owned consolidated subsidiary of the Company. This
transaction did not have a material effect on the consolidated financial
statements of the Company.
USE OF ESTIMATES
The preparation of financial statements in conformity with Generally Accepted
Accounting Principles requires management to make estimates and assumptions that
affect the reported amounts of certain assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of certain revenues and expenses during the reported
period. Actual results could differ from those estimates. The primary estimates
inherent in the accompanying consolidated financial statements are discussed
below.
Fair Value. Management estimates the fair value of its financial instruments
using available market information and other appropriate valuation
methodologies. The fair value of a financial instrument, as defined by Statement
of Financial Accounting Standards ("SFAS") No. 107, Disclosures about Fair Value
of Financial Instruments, is the amount at which the instrument could be
exchanged in a current transaction between willing parties, other than in a
forced liquidation sale. Management's estimates are inherently subjective in
nature and involve matters of
F-7
uncertainty and judgment to interpret relevant market and other data.
Accordingly, amounts realized in actual sales may differ from the fair valueS
presented in Notes 3, 5 and 9.
Reserve for Credit Losses. A reserve for credit losses is maintained at a level
deemed appropriate by management to provide for known credit losses, as well as
losses inherent in Redwood's earning assets. The reserve is based upon
management's assessment of various factors affecting its assets, including
current and projected economic conditions, delinquency status, and credit
protection. 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. 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.
Individual mortgage loans are considered impaired when, based on current
information and events, it is probable that a creditor will be unable to collect
all amounts due according to the contractual terms of the loan agreement. When a
loan is impaired, impairment is measured based upon the present value of the
expected future cash flows discounted at the loan's effective interest rate, the
loan's observable market price, or the fair value of the underlying collateral.
At December 31, 2001 and December 31, 2000, the Company had no impaired mortgage
loans.
RISKS AND UNCERTAINTIES
The Company takes certain risks inherent in financial institutions, including,
but not limited to, credit risk, liquidity risk, interest rate risk, prepayment
risk, market value risk, and capital risk. In addition, there are several risks
and uncertainties specific to Redwood Trust. The Company seeks to actively
manage such risks while also providing stockholders an appropriate rate of
return for risks taken. There can be no assurances that such risks and
uncertainties are adequately provided for in the Company's financial statements,
although management has prepared these financial statements in an effort to
properly present the risks taken.
EITF 99-20
During 1999, the Emerging Issues Task Force ("EITF") issued EITF 99-20,
Recognition of Interest Income and Impairment on Purchased and Retained
Beneficial Interests in Securitized Financial Assets. EITF 99-20 establishes new
income and impairment recognition standards for interests in certain securitized
assets. Under the provisions of EITF 99-20, the holder of beneficial interests
should recognize the excess of all estimated cash flows attributable to the
beneficial interest estimated at the acquisition date over the initial
investment (the accretable yield) as interest income over the life of the
beneficial interest using the effective yield method. If the estimated cash
flows change, then the holder of the beneficial interest should recalculate the
accretable yield and adjust the periodic accretion recognized as income
prospectively. If the fair value of a beneficial interest has declined below its
carrying amount, an other-than-temporary decline is considered to exist if there
has been a decline in estimated future cash flows. The difference between the
carrying value and fair value of the beneficial interest is recorded as a
mark-to-market impairment loss through the income statement. Any impairment
adjustments under the provisions of EITF 99-20 are recognized as mark-to-market
adjustments under "Net Unrealized and Realized Market Value Gains (Losses)" on
the Consolidated Statement of Operations.
The Company adopted the provisions of EITF 99-20 effective January 1, 2001. At
that date, the Company held certain beneficial interests in which the fair value
had declined below the carrying value and current projections of cash flows were
less than cash flows anticipated at acquisition. Accordingly, the Company
recorded a $2.4 million charge through the Statement of Operations during the
quarter ended March 31, 2001 as a cumulative effect of a change in accounting
principle for certain mark-to-market adjustments on these beneficial interests
that had previously been recorded as unrealized losses through Accumulative
Other Comprehensive Income as a component of Stockholders' Equity. Since this
was a reclassification of declines in market values that had already been
recognized in the Company's balance sheet and stockholders' equity accounts,
there was no change in net carrying value upon adoption.
F-8
EARNING ASSETS
The Company's earning assets consist primarily of residential and commercial
real estate mortgage loans and mortgage securities ("Earning Assets"). Mortgage
loans and securities pledged as collateral under borrowing arrangements in which
the secured party has the right by contract or custom to sell or repledge the
collateral have been classified as "pledged" as discussed in Note 3. 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. Purchase
discounts and premiums relating to Earning Assets are amortized into interest
income over the lives of the Earning Assets using the effective yield method
based on projected cash flows over the life of the security. Gains or losses on
the sale of Earning Assets are based on the specific identification method.
Mortgage Loans: 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 any allowance for credit losses. All of the Sequoia loans that are pledged or
subordinated to support the Long-Term Debt are classified as
held-for-investment. Commercial loans that the Company has secured financing
through the term of the loan or otherwise has the intent and the ability to hold
to maturity, are classified as held-for-investment.
Mortgage Loans: Held-for-Sale
Mortgage Loans held-for-sale (residential and commercial) are carried at the
lower of original cost or aggregate market value ("LOCOM"). Realized and
unrealized gains and losses on these loans are recognized in Net Unrealized and
Realized Market Value Gains (Losses) on the Consolidated Statements of
Operations. Real estate owned ("REO") assets of the Company are included in
Mortgage Loans held-for-sale.
Mortgage Securities: Trading
Mortgage securities classified as trading 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.
Mortgage Securities: Available-for-Sale
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.
Interest income on loans and securities is calculated using the effective yield
method based on projected cash flows over the life of the asset. Yields on each
asset vary as a function of credit results, prepayment rates, and interest
rates. For Residential Credit-Enhancement Securities purchased at a discount, a
portion of the discount for each security is designated as a credit reserve,
with the remaining portion of the discount designated to be amortized into
income over the life of the security using the effective yield method. If future
credit losses exceed the Company's original expectations, or credit losses occur
more quickly than expected, or prepayment rates occur more slowly than expected,
the yield over the remaining life of the security may be adjusted downwards or
the Company may take a mark-to-market earnings charge to write down the basis in
the security to current market value. If future credit losses are less than the
Company's original estimate, or credit losses occur later than expected, or
prepayment rates are faster than expected, the yield over the remaining life of
the security may be adjusted upwards.
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 may include principal and interest payments on
mortgage loans held as collateral for the Company's Long-Term Debt, cash pledged
as collateral on certain interest rate agreements, and cash held back from
borrowers until certain loan agreement requirements have been met. Any
corresponding liability for cash held back from borrowers is included in Accrued
Expenses and Other Liabilities on the Consolidated Balance Sheets.
F-9
OTHER ASSETS
Included in Other Assets on the Consolidated Balance Sheets are fixed assets,
prepaid expenses, and at December 31, 2000, the Company's equity interest in
Holdings.
INTEREST RATE AGREEMENTS
The Company maintains an overall interest-rate risk-management strategy that may
incorporate the use of derivative interest rate agreements for a variety of
reasons, including minimizing significant fluctuations in earnings that may be
caused by interest-rate volatility. Interest rate agreements the Company may use
as part of its interest-rate risk management strategy include interest rate
options, swaps, options on swaps, futures contracts, options on futures
contracts, and options on forward purchases (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).
The Company adopted SFAS No. 133 in 1998 and has elected not to seek hedge
accounting for its Interest Rate Agreements through 2001. Accordingly, such
instruments are designated as trading and 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. The Company may elect to seek hedge
accounting based on the provisions of SFAS No. 133 in the future.
Net premiums on interest rate agreements are amortized as a component of net
interest income over the effective period of the interest rate agreement using
the effective interest method. The income or expense related to interest rate
agreements is recognized on an accrual basis and is included in interest expense
on short-term debt in the consolidated statements of operations.
DEBT
Short-Term Debt and Long-Term Debt are carried at their unpaid principal
balances, net of any unamortized discount or premium and any unamortized
deferred bond issuance costs. The amortization of any discount or premium is
recognized as an adjustment to interest expense using the effective interest
method based on the maturity schedule of the related borrowings. Bond issuance
costs incurred in connection with the issuance of Long-Term Debt are deferred
and amortized over the estimated lives of the Long-Term Debt using the interest
method adjusted for the effects of estimated principal paydown rates.
INCOME TAXES
The Company has elected to be taxed as a REIT under the Internal Revenue Code
("Code") and the corresponding provisions of state law. In order to qualify as a
REIT, the Company must annually distribute at least 90% 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 year, 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 the fourth quarter 2001, which were paid in
January 2002, are considered taxable income to stockholders in 2001, the year
declared. All 2001 dividends were ordinary income to the Company's preferred and
common stockholders.
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
F-10
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.
NET INCOME 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 (loss) per share computations.
(IN THOUSANDS, EXCEPT SHARE DATA) YEARS ENDED DECEMBER 31,
-------------------------------------------------------
2001 2000 1999
----------------- ----------------- ------------------
NUMERATOR:
Numerator for basic and diluted earnings per share--
Net income (loss) before preferred dividend and
change in accounting principle $ 35,255 $ 18,934 $ 1,728
Cash dividends on Class B preferred stock (2,724) (2,724) (2,741)
----------------- ----------------- ------------------
Net income (loss) before change in accounting principle 32,531 16,210 (1,013)
Cumulative effect of adopting EITF 99-20 (2,368) -- --
----------------- ----------------- ------------------
Basic and Diluted EPS - Net income (loss)
available to common stockholders $30,163 $16,210 $(1,013)
================= ================= ==================
DENOMINATOR:
Denominator for basic earnings (loss) per share--
Weighted average number of common shares
outstanding during the period 10,163,581 8,793,487 9,768,345
Net effect of dilutive stock options 311,183 108,582 --
----------------- ----------------- ------------------
Denominator for diluted earnings (loss) per share-- 10,474,764 8,902,069 9,768,345
================= ================= ==================
BASIC EARNINGS (LOSS) PER SHARE:
Net income (loss) before change in accounting principle $3.20 $1.84 $(0.10)
Cumulative effect of adopting EITF 99-20 (.23) -- --
----------------- ----------------- ------------------
Net income (loss) per share $2.97 $1.84 $(0.10)
================= ================= ==================
DILUTED EARNINGS (LOSS) PER SHARE:
Net income (loss) before change in accounting principle $3.11 $1.82 $(0.10)
Cumulative effect of adopting EITF 99-20 (.23) -- --
----------------- ----------------- ------------------
Net income (loss) per share $2.88 $1.82 $(0.10)
================= ================= ==================
At December 31, 2001, the number of common equivalent shares issued by the
Company that were anti-dilutive totaled 400,560.
COMPREHENSIVE INCOME
Current period unrealized gains and losses on assets available-for-sale are
reported as a component of "Comprehensive Income" on the Consolidated Statements
of Stockholders' Equity with cumulative unrealized gains and losses classified
as "Accumulated Other Comprehensive Income" in Stockholders' Equity. At December
31, 2001 and 2000, the only component of Accumulated Other Comprehensive Income
was net unrealized gains and losses on assets available-for-sale.
F-11
RECENT ACCOUNTING PRONOUNCEMENTS
In July 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No.
141, Business Combinations and SFAS 142, Goodwill and Other Intangible Assets.
SFAS No. 141, among other things, eliminates the use of the pooling of interests
method of accounting for business combinations. Under the provisions of SFAS No.
142, goodwill will no longer be amortized, but will be subject to a periodic
test for impairment based upon fair values. SFAS No. 141 is effective for all
business combinations initiated after June 30, 2001. SFAS No. 142 is effective
beginning January 1, 2002.
The adoption of these statements is not expected to have a material effect on
the Company's financial statements.
NOTE 3. EARNING ASSETS
At December 31, 2001 and 2000, investments in Earning Assets generally consisted
of interests in adjustable-rate, hybrid, or fixed-rate real estate mortgage
loans on residential and commercial properties. Hybrid mortgages have an initial
fixed coupon rate for three to ten years followed by annual adjustments. The
original maturity of the majority of our residential mortgage assets is thirty
years. The actual amount of principal outstanding is subject to change based on
the prepayments of the underlying mortgage loans. The original maturity of the
majority of our commercial mortgage assets is three years.
At December 31, 2001 and 2000, the annualized effective yield after taking into
account the amortization expense due to prepayments on the Earning Assets was
5.28% and 8.01%, respectively, based on the reported carrying value of the
assets. For the years ended December 31, 2001 and 2000, the average balance of
Earning Assets was $2.1 billion and $2.2 billion, respectively.
At December 31, 2001 and 2000, Earning Assets consisted of the following:
RESIDENTIAL MORTGAGE LOANS
DECEMBER 31, 2001 DECEMBER 31, 2000
-------------------------------------- ---------------------------------------
HELD-FOR- HELD-FOR- HELD-FOR- HELD-FOR-
(IN THOUSANDS) SALE INVESTMENT TOTAL SALE INVESTMENT TOTAL
------------ ------------ ------------ ------------- ------------ ------------
Current Face $153,125 $1,317,343 $1,470,468 $6,784 $1,115,386 $1,122,170
Unamortized Discount (364) (132) (496) (126) -- (126)
Unamortized Premium 34 10,055 10,089 -- 13,767 13,767
------------ ------------ ------------ ------------- ------------ ------------
Amortized Cost 152,795 1,327,266 1,480,061 6,658 1,129,153 1,135,811
Reserve for Credit Losses -- (5,199) (5,199) -- (4,814) (4,814)
------------ ------------ ------------ ------------- ------------ ------------
Carrying Value $152,795 $1,322,067 $1,474,862 $6,658 $1,124,339 $1,130,997
============ ============ ============ ============= ============ ============
During 2001, $517.0 million of Residential Mortgage Loans held-for-sale were
transferred to Sequoia for securitization and are classified as part of Mortgage
Loans held-for-investment and are collateral for Long-Term Debt (see Note 7).
During the year ended December 31, 2000, the Company sold to Holdings
Residential Mortgage Loans held-for-sale for proceeds of $380.5 million,
resulting in no net gain or loss. These assets were subsequently transferred to
Sequoia for securitization during the year ended December 31, 2000, and are
classified as part of Mortgage Loans held-for-investment and are collateral for
Long-Term Debt (see Note 7).
At December 31, 2001 and 2000, residential mortgage loans with a net carrying
value of $148.2 million and $6.1 million were pledged as collateral under
short-term borrowing arrangements to third parties.
F-12
RESIDENTIAL CREDIT-ENHANCEMENT SECURITIES
DECEMBER 31, 2001 DECEMBER 31, 2000
(IN THOUSANDS) MORTGAGE SECURITIES MORTGAGE SECURITIES
AVAILABLE-FOR-SALE AVAILABLE-FOR-SALE
-------------------- -------------------
Current Face $353,435 $124,878
Unamortized Discount (25,863) (16,883)
Portion Of Discount Designated As A Credit Reserve (140,411) (27,052)
-------------------- -------------------
Amortized Cost 187,161 80,943
Gross Unrealized Gains 7,174 2,646
Gross Unrealized Losses (3,522) (2,825)
-------------------- -------------------
Carrying Value $190,813 $80,764
==================== ===================
The Company credit enhances pools of high-quality jumbo residential mortgage
loans by acquiring subordinated securities in third-party securitizations. The
subordinated interests in a securitization transaction bear the majority of the
potential credit risk for the securitized pool of mortgages, thus allowing the
more senior securitized interests to qualify for investment-grade ratings and to
be sold to the capital markets. The Company therefore commits capital that
effectively forms a "guarantee" or "insurance" on the securitized pool of
mortgages.
The Company's Residential Credit-Enhancement Securities are first-loss,
second-loss, and third-loss securities. First-loss securities are generally
allocated actual credit losses on the entire underlying pool of loans up to a
maximum of the principal amount of the first loss security. First-loss
securities provide credit-enhancement principal protection from the initial
losses in the underlying pool for the second loss, third loss, and more senior
securities. Any first loss securities that are owned by others and that are
junior to the Company's second and third loss securities provide the Company's
securities with some protection from losses, as they serve as external credit
enhancement. The Company provided some level of credit enhancement on $52
billion and $23 billion of loans securitized by third parties at December 31,
2001 and 2000, respectively.
As the Company purchases residential credit enhancement interests, a portion of
the discount for each security is designated as a credit reserve, with the
remaining portion of the discount designated to be amortized into income over
the life of the security using the effective yield method. If future credit
losses exceed the Company's original expectations, and the fair value of the
security is less than its carrying value, the Company will record a charge on
the Statement of Operations to write down the basis in the security. If future
credit losses exceed the Company's original expectations, and the fair value of
the security is greater than its carrying value, the Company will designate
additional discount as reserve, thus lowering the realized yield. If future
credit losses are less than the Company's original estimate, the yield over the
remaining life of the security may be adjusted upward. At December 31, 2001 and
2000, the Company designated $140.4 million and $27.1 million as a credit
reserve on its residential credit enhancement interests, respectively.
At December 31, 2001 and 2000, Residential Credit Enhancement Securities with a
net carrying value of $88.8 million and $32.3 million were pledged as collateral
under borrowing arrangements to third parties, respectively.
COMMERCIAL MORTGAGE LOANS
DECEMBER 31, 2001 DECEMBER 31, 2000
-------------------------------------- ---------------------------------------
HELD-FOR- HELD-FOR- HELD-FOR- HELD-FOR-
(IN THOUSANDS) SALE INVESTMENT TOTAL SALE INVESTMENT TOTAL
------------ ------------ ------------ ------------- ------------ ------------
Current Face $30,931 $20,860 $51,791 $34,275 $23,425 $57,700
Unamortized Discount (683) (24) (707) -- (531) (531)
------------ ------------ ------------ ------------- ------------ ------------
Carrying Value $30,248 $20,836 $51,084 $34,275 $22,894 $57,169
============ ============ ============ ============= ============ ============
At December 31, 2001 and 2000, commercial mortgage loans with a net carrying
value of $19.4 million and $37.7 million were pledged as collateral under
short-term borrowing arrangements to third parties, respectively. At
F-13
December 31, 2001, commercial mortgage loans held-for-investment with a net
carrying value of $20.8 million were pledged as collateral under long-term
borrowing arrangements to third parties. At December 31, 2000, there were no
long-term borrowings secured by commercial mortgage loans (see Note 7).
SECURITIES PORTFOLIO
DECEMBER 31, 2001 DECEMBER 31, 2000
--------------------------------------- ---------------------------------------
SECURITIES SECURITIES
(IN THOUSANDS) SECURITIES PORTFOLIO SECURITIES PORTFOLIO
PORTFOLIO AVAILABLE- PORTFOLIO AVAILABLE-
TRADING FOR-SALE TOTAL TRADING FOR SALE TOTAL
----------- ------------ ------------ ------------ ------------ ------------
Current Face $501,078 $171,877 $672,955 $751,449 $5,500 $756,949
Unamortized Discount (139) (1,320) (1,459) (388) (427) (815)
Unamortized Premium 6,634 6,303 12,937 8,551 -- 8,551
------------ ------------ ------------ ------------- ------------ ------------
Unamortized Cost 507,573 176,860 684,433 759,612 5,073 764,685
Gross Unrealized Gains -- 516 516 -- 105 105
Gross Unrealized Losses -- (1,467) (1,467) -- (15) (15)
------------ ------------ ------------ ------------- ------------ ------------
Carrying Value $507,573 $175,909 $683,482 $759,612 $5,163 $764,775
============ ============ ============ ============= ============ ============
Agency $353,523 $ 20,223 $373,746 $521,204 -- $521,204
Non-Agency 154,050 155,686 309,736 238,408 5,163 243,571
------------ ------------ ------------ ------------- ------------ ------------
Carrying Value $507,573 $175,909 $683,482 $759,612 $5,163 $764,775
============ ============ ============ ============= ============ ============
For the year ended December 31, 2001, the Company recognized net market value
gains of $1.6 million on its securities portfolio. For both of the years ended
December 31, 2000 and 1999, the Company recognized net market value gains of
$1.0 million and $1.2 million on its securities portfolio, respectively.
At December 31, 2001 and 2000, securities portfolio assets with a net carrying
value of $591.7 million and $702.2 million were pledged as collateral under
borrowing arrangements to third parties, respectively.
NOTE 4. RESERVE FOR CREDIT LOSSES
The Reserve for Credit Losses is reflected as a component of Earning Assets on
the Consolidated Balance Sheets. The following table summarizes the activity in
the Reserve for Credit Losses:
YEARS ENDED DECEMBER 31,
--------------------------------------
(IN THOUSANDS) 2001 2000 1999
------------- ----------- ------------
Balance at beginning of year $4,814 $4,125 $2,784
Provision for credit losses 767 731 1,346
Charge-offs (382) (42) (5)
------------- ----------- ------------
Balance at end of year $5,199 $4,814 $4,125
============= =========== ============
NOTE 5. INTEREST RATE AGREEMENTS
Through December 31, 2001, the Company reports its Interest Rate Agreements at
fair value, and has not elected to obtain hedge accounting treatment on any of
its Interest Rate Agreements. At December 31, 2001 and 2000, the fair value of
the Company's interest rate agreements was $0.0 and $0.1 million, respectively.
Interest Rate Agreements are included in Other Assets on the Consolidated
Balance Sheet.
During the years ended December 31, 2001, 2000, and 1999, the Company recognized
net market value losses of $0.4 million and $3.4 million, and net market value
gains of $2.0 million on Interest Rate Agreements, respectively. The market
value gains and losses are included in "Net Unrealized and Realized Market Value
Gains (Losses)" on the Consolidated Statements of Operations.
F-14
The Company generally attempts to structure its balance sheet to address many of
the interest rate risks inherent in financial institutions. The Company may
enter into certain interest rate agreements from time to time with the objective
of matching the interest rate characteristics of its assets and liabilities. At
December 31, 2001, the Company was not actively hedging its portfolio of Earning
Assets, but had few remaining interest rate caps with strike rates based on the
one and three month London Interbank Offered Rate ("LIBOR") ranging from 6.25%
to 11.00%, expiring in 2002, and two generally offsetting interest rate swaps
between Redwood Trust, Sequoia and a third party financial institution. At
December 31, 2001 and 2000, these generally offsetting interest rate swaps had
gross notional amounts of $445.1 million and $580.0 million, respectively. The
swap between Redwood and the third party financial institution required Redwood
to provide collateral in the form of agency securities totalling $6.6 million
and $2.8 million at December 31, 2001 and 2000, respectively. Sequoia did not
hold collateral of the third party financial institution for its swap at
December 31, 2001 or 2000.
In addition to the interest rate swap described above, at December 31, 2000, the
Company also had Interest Rate Agreements consisting of interest rate caps,
interest rate floors, interest rate futures, options on interest rate futures
and an additional interest rate swap. Substantially all of these Interest Rate
Agreements expired or were terminated and settled in cash during 2001.
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. The credit exposure reflects the fair market value of any
cash and collateral of the Company held by counterparties. The cash and
collateral held by counterparties are included in Restricted Cash and the
Securities Portfolio on the Consolidated Balance Sheets.
NOTIONAL AMOUNTS CREDIT EXPOSURE
------------------------------------- -------------------------------------
(IN THOUSANDS) DECEMBER 31, 2001 DECEMBER 31, 2000 DECEMBER 31, 2001 DECEMBER 31, 2000
------------------ ------------------ ------------------ ------------------
Interest Rate Options Purchased $313,000 $1,490,300 -- --
Interest Rate Swaps 445,107 584,992 $6,645 $2,814
Interest Rate Futures and Forwards -- 506,600 -- 948
------------------ ------------------ ------------------ ------------------
Total $758,107 $2,581,892 $6,645 $3,762
================== ================== ================== ==================
In general, the Company incurs 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 6. 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 of a portion of its Mortgage Assets. This Short-Term Debt is
collateralized by a portion of the Company's Earning Assets.
At December 31, 2001, the Company had $0.8 billion of Short-Term Debt
outstanding with a weighted-average borrowing rate of 2.19% and a
weighted-average remaining maturity of 82 days. This debt was collateralized
with $0.8 billion of Earning Assets. At December 31, 2000, the Company had $0.8
billion of Short-Term Debt outstanding with a weighted-average borrowing rate of
6.85% and a weighted-average remaining maturity of 122 days. This debt was
collateralized with $0.8 billion of Earning Assets.
At December 31, 2001 and 2000, the Short-Term Debt had the following remaining
maturities:
F-15
(IN THOUSANDS) DECEMBER 31, 2001 DECEMBER 31, 2000
------------------- -------------------
Within 30 days $ 270,855 $ 100,885
31 to 90 days 226,407 268,867
Over 90 days 299,549 386,470
------------------- -------------------
Total Short-Term Debt $796,811 $756,222
=================== ===================
For the years ended December 31, 2001, 2000 and 1999, the average balance of
Short-Term Debt was $0.9 billion, $0.9 billion, and $1.0 billion, with a
weighted-average interest cost of 4.53%, 6.57%, and 5.35%, respectively. The
maximum balance outstanding for each of the years ended December 31, 2001, 2000,
and 1999, was $1.3 billion. The Company continues to meet all of it debt
covenants for its short-term borrowing arrangements and credit facilities.
In addition to the facilities listed below, the Company has uncommitted
facilities with credit lines in excess of $4.0 billion at December 31, 2001. It
is the intention of the Company's management to renew committed and uncommitted
facilities as needed.
At December 31, 2001, the Company had short-term facilities with two Wall Street
Firms totaling $1.1 billion to fund Residential Mortgage Loans. At December 31,
2001, the Company had borrowings under these facilities of $145.7 million.
Borrowings under these facilities bear interest based on a specified margin over
the LIBOR. At December 31, 2001, the weighted average borrowing rate under these
facilities was 2.56%. These committed facilities expire in June and December
2002.
During 2001, the Company renegotiated one and entered into another committed
revolving mortgage warehousing credit facility for a total of $57.5 million.
These facilities are intended to finance commercial mortgage loans. At December
31, 2001, the Company had borrowings under these facilities of $17.0 million.
One of the facilities allows for loans to be financed to the maturity of the
loan, up to three years. Borrowings under these facilities bear interest based
on a specified margin over the LIBOR. At December 31, 2001, the weighted average
borrowing rate under these facilities was 3.87%. These committed facilities
expire in May and September 2002.
In September 2001, the Company renewed three master repurchase agreements with a
bank and two Wall Street Firms totaling $140.0 million. These facilities are
intended to finance residential mortgage-backed securities with lower than
investment grade ratings. At December 31, 2001, the Company had borrowings under
these facilities of $65.7 million. Borrowings under these facilities bear
interest based on a specified margin over LIBOR. At December 31, 2001, the
weighted average borrowing rate under these facilities was 2.92%. The Company
does not intend to renew a facility expiring in April 2002. Another facility
expires in September 2002, and a third facility has a six-month term that is
extended monthly. Unless notice is provided that the counterparty will not renew
the facility, the expiration on this third facility will remain at six months.
NOTE 7. LONG-TERM DEBT
Through securitization, the Company issues Residential Long-Term Debt in the
form of collateralized mortgage bonds secured by Residential Mortgage Loans
("Residential Bond Collateral"). The Residential Bond Collateral consists
primarily of adjustable-rate and hybrid, conventional, 30-year residential
mortgage loans secured by first liens on one- to four-family residential
properties. All Residential Bond Collateral is pledged to secure repayment of
the related Residential Long-Term Debt obligation. As required by the indentures
relating to the Residential Long-Term Debt, the Residential Bond Collateral is
held in the custody of trustees. The trustees collect principal and interest
payments (less servicing and related fees) on the Residential Bond Collateral
and make corresponding principal and interest payments on the Residential
Long-Term Debt. The obligations under the Residential Long-Term Debt are payable
solely from the Residential Bond Collateral and are otherwise non-recourse to
the Company.
Each series of Residential 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 Residential Bond
F-16
Collateral. Each series is also subject to redemption according to the specific
terms of the respective indentures. As a result, the actual maturity of any
class of a Residential Long-Term Debt series is likely to occur earlier than its
stated maturity.
The Commercial Long-Term Debt is secured by two adjustable-rate Commercial
Mortgage Loans with maturity dates in 2002 or 2003, which are secured by first
liens on the related commercial mortgage properties ("Commercial Loan
Collateral").
The Company's exposure to loss on the Residential Bond Collateral and the
Commercial Loan Collateral is limited to its net investment, as the Residential
and Commercial Long-Term Debt are non-recourse to the Company.
During the fourth quarter of 2001, the Company issued $510 million in face value
of Residential Long-Term Debt through Sequoia Mortgage Trust 5, a trust
established by Sequoia. As a result, the $517 million of Residential Bond
Collateral in the form of Residential Mortgage Loans held-for-sale was
reclassified to Residential Mortgage Loans held-for-investment.
The components of the collateral for the Company's Long-Term Debt are summarized
as follows:
(IN THOUSANDS) DECEMBER 31, 2001 DECEMBER 31, 2000
------------------- -------------------
Residential Mortgage Loans:
Residential Mortgage Loans held-for-sale $ 848 $ 315
Residential Mortgage Loans held-for-investment 1,322,067 1,124,339
Restricted cash 2,534 3,729
Accrued interest receivable 5,340 7,010
------------------- -------------------
Total Residential Collateral $ 1,330,789 $ 1,135,393
Commercial Mortgage Loans held-for-investment $ 20,836 $ --
------------------- -------------------
Total Long-Term Debt Collateral $ 1,351,625 $ 1,135,393
=================== ===================
The components of the Long-Term Debt at December 31, 2001 and 2000 along with
selected other information are summarized below:
(IN THOUSANDS) DECEMBER 31, 2001 DECEMBER 31, 2000
------------------- -------------------
Residential Long-Term Debt $1,297,958 $1,095,909
Commercial Long-Term Debt 17,211 --
Unamortized premium on Long-Term Debt 2,038 3,045
Deferred bond issuance costs (3,492) (3,119)
------------------- -------------------
Total Long-Term Debt $1,313,715 $1,095,835
=================== ===================
Range of weighted-average interest rates, by series - 2.28% to 6.35% 6.35% to 7.20%
residential
Stated residential maturities 2017 - 2029 2017 - 2029
Number of residential series 5 4
Weighted-average interest rates - commercial 5.09% --
Stated commercial maturities 2002 - 2003 --
Number of commercial series 2 --
For the years ended December 31, 2001, 2000, and 1999, the average effective
interest cost for Residential Long-Term Debt, as adjusted for the amortization
of bond premium, deferred bond issuance costs, and other related expenses, was
5.69%, 6.71%, and 6.03%, respectively. At December 31, 2001 and 2000, accrued
interest payable on Residential Long-Term Debt was $1.9 million and $3.1
million, respectively, and is reflected as a component of Accrued Interest
Payable on the Consolidated Balance Sheets. For the year ended December 31,
2001, the average
F-17
balance of Residential Long-Term Debt was $1.0 billion. For both of the years
ended December 31, 2000 and 1999, the average balance of Residential Long-Term
Debt was $1.1 billion.
At December 31, 2001, the weighted average interest rate for Commercial
Long-Term Debt was 5.09%, and the balance of Commercial Long-Term Debt was $17.2
million. At December 31, 2001, accrued interest payable on Commercial Long-Term
Debt was $0.1 million, and is reflected as a component of Accrued Interest
Payable on the Consolidated Balance Sheets.
NOTE 8. INCOME TAXES
As a REIT, Redwood Trust can exclude dividends for taxable income and thus,
effectively, may not be subject to income taxes. Holdings, the Company's taxable
REIT subsidiary, is subject to income taxes.
The current provision for income taxes for Holdings for each of the years ended
December 31, 2001, 2000, and 1999 was $3,200 and is a component of "Operating
Expenses" on the Consolidated Statement of Operations. These amounts represent
the minimum California franchise taxes. No additional tax provision has been
recorded for the years ended December 31, 2001, 2000, and 1999, as Holdings
reported a loss in years prior to 2001, and taxable income reported for 2001 was
offset by Federal and state net operating loss carryforwards from prior years.
In addition, due to the uncertainty of realization of net operating losses, no
deferred tax benefit has been recorded. A valuation allowance has been provided
to offset the deferred tax assets related to net operating loss carryforwards
and other future temporary deductions at December 31, 2001 and 2000. At December
30, 2001 and 2000, the deferred tax assets and associated valuation allowances
were approximately $9.3 million and $9.5 million, respectively. At December 31,
2001 and 2000, Holdings had net operating loss carryforwards of approximately
$24.4 million and $25.1 million for Federal tax purposes, and $10.4 million and
$10.8 million for state tax purposes, respectively. The Federal loss
carryforwards and a portion of the state loss carryforwards expire between 2018
and 2021, while the largest portion of the state loss carryforwards expire
between 2003 and 2006.
NOTE 9. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying values and estimated fair values of
the Company's financial instruments at December 31, 2001 and 2000.
(IN THOUSANDS) DECEMBER 31, 2001 DECEMBER 31, 2000
--------------------------------- -------------------------------
CARRYING VALUE FAIR VALUE CARRYING VALUE FAIR VALUE
----------------- --------------- --------------- ---------------
Assets
Mortgage Loans
Residential: held-for-sale $ 152,795 $ 152,795 $ 6,658 $ 6,658
Residential: held-for-investment 1,322,067 1,318,673 1,124,339 1,113,389
Commercial: held-for-sale 30,248 30,248 34,275 34,275
Commercial: held-for-investment 20,836 20,860 22,894 22,894
Mortgage Securities
Residential: trading 507,573 507,573 759,612 759,612
Residential: available-for-sale 366,722 366,722 85,927 85,927
Interest Rate Agreements -- -- 66 66
Investment in RWT Holdings, Inc. -- -- 1,899 1,989
Liabilities
Short-Term Debt 796,811 796,811 756,222 756,222
Long-Term Debt 1,313,715 1,295,323 1,095,835 1,085,368
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.
F-18
NOTE 10. STOCKHOLDERS' EQUITY
CLASS B 9.74% CUMULATIVE CONVERTIBLE PREFERRED STOCK
On August 8, 1996, the Company issued 1,006,250 shares of Class B Preferred
Stock ("Preferred Stock"). Each share of the Preferred Stock is convertible at
the option of the holder at any time into one share of Common Stock. Effective
October 1, 1999, the Company can either redeem or, under certain circumstances,
cause a conversion of the Preferred Stock. The Preferred Stock pays a dividend
equal to the greater of (i) $0.755 per share, per quarter or (ii) an amount
equal to the quarterly dividend declared on the number of shares of the Common
Stock into which the Preferred Stock is convertible. The Preferred Stock ranks
senior to the Company's Common Stock as to the payment of dividends and
liquidation rights. The liquidation preference entitles the holders of the
Preferred Stock to receive $31.00 per share plus any accrued dividends before
any distribution is made on the Common Stock. As of December 31, 2001 and 2000,
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. The Company did not repurchase
any shares of Preferred Stock during 2001 and 2000. Pursuant to the repurchase
program, the Company repurchased 7,450 shares of its Preferred Stock for $0.2
million during 1999. At December 31, 2001, there remained 142,550 shares
available under the authorization for repurchase.
STOCK OPTION PLAN
The Company has adopted a Stock Option Plan for executive officers, employees,
and non-employee directors (the "Plan"). The Plan authorizes the Board of
Directors (or a committee appointed by the Board of Directors) to grant
"incentive stock options" as defined under Section 422 of the Code ("ISOs"),
options not so qualified ("NQSOs"), deferred stock, restricted stock,
performance shares, stock appreciation rights, limited stock appreciation rights
("Awards"), and dividend equivalent rights ("DERs") to such eligible recipients
other than non-employee directors. Non-employee directors are automatically
provided annual grants of NQSOs with DERs pursuant to a formula under the Plan.
The number of shares of Common Stock available under the Plan for options and
Awards, subject to certain anti-dilution provisions, is 15% of the Company's
total outstanding shares of Common Stock. The total outstanding shares are
determined as the highest number of shares outstanding prior to any stock
repurchases. At December 31, 2001 and 2000, 299,064 and 476,854 shares of Common
Stock, respectively, were available for grant.
Of shares of Common Stock available for grant, no more than 500,000 shares of
Common Stock shall be cumulatively available for grant as ISOs. At December 31,
2001 and 2000, 346,379 and 328,152 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. At
December 31, 2001, 28,000 shares of restricted stock had been granted to two
officers of the Company. The restrictions on 7,000 of these shares expired on
January 1, 2002. The restrictions on 6.25% of the total restricted shares expire
on the first day of each calendar quarter starting April 1, 2002, and continuing
through January 1, 2005. No restricted stock had been granted prior to December
31, 2000.
The Company has granted stock options that accrue and pay stock and cash DERs.
This feature results in current expenses being incurred that relate to long-term
incentive grants made in the past. To the extent the Company increases its
common dividends or the market price of the Common Stock increases, stock and
cash DER expenses may increase. For the years ended December 31, 2001, 2000, and
1999, the Company accrued cash and stock DER expenses of $3.4 million, $2.1
million, and $0.5 million, respectively. Stock DERs represent shares of stock
which are issuable when the holders exercise the underlying stock options and
are considered to be variable stock awards under the provisions of Accounting
Principles Board ("APB") Opinion 25. For the year ended December 31, 2001, the
Company recognized variable stock option expense of $0.9 million, which is
included in Other Income (Expense) on the Consolidated Statement of Operations.
The number of stock DER shares accrued is based on the level of the Company's
common stock dividends and on the price of the common stock on the related
dividend payment date. At December 31, 2001 and 2000, there were 181,010 and
166,451 unexercised options with stock DERs under the Plan, respectively. Cash
DERs are accrued and paid based on the level of the Company's common stock
dividend. At
F-19
December 31, 2001 and 2000, there were 1,284,222 and 1,180,797 unexercised
options with cash DERs under the Plan, respectively. At December 31, 2001 and
2000, there were 153,269 and 147,550 outstanding stock options that did not have
DERs, respectively.
A summary of the status of the Company's Plan at year end and changes during the
years ending on that date is presented below.
DECEMBER 31, 2001 DECEMBER 31, 2000 DECEMBER 31, 1999
----------------------- ----------------------- ------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
(IN THOUSANDS, EXCEPT SHARE DATA) SHARES PRICE SHARES PRICE SHARES PRICE
------------ ---------- ------------ ---------- ------------- ----------
Outstanding options at January 1 1,494,798 $22.32 1,713,836 $21.97 1,739,787 $23.68
Options granted 143,319 $23.92 163,050 $16.90 371,950 $13.37
Options exercised (26,091) $14.00 (26,158) $12.26 (15,285) $0.68
Options canceled (12,126) $22.84 (372,070) $18.11 (387,990) $21.50
Dividend equivalent rights earned 18,601 -- 16,140 -- 5,374 --
------------ ------------ -------------
Outstanding options at December 31 1,618,501 $22.33 1,494,798 $22.32 1,713,836 $21.97
============ ============ =============
Options exercisable at year-end 921,075 $24.53 644,098 $25.47 401,697 $26.89
Weighted average fair value of options
granted during the year $1.01 $1.64 $1.33
The following table summarizes information about stock options outstanding at
December 31, 2001.
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
----------------------------------------------------- ------------------------------------
WEIGHTED-AVERAGE
RANGE OF NUMBER REMAINING WEIGHTED-AVERAGE NUMBER WEIGHTED-AVERAGE
EXERCISE PRICES OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
- -------------------- ---------------- ------------------ ----------------- ---------------- -------------------
$0 to $10 64,543 3.8 $ 0.28 64,543 $ 0.28
$10 to $20 690,697 7.1 $14.47 280,252 $14.95
$20 to $30 481,589 7.1 $22.93 254,370 $22.39
$30 to $40 283,200 5.0 $37.49 246,970 $37.58
$40 to $50 93,472 5.6 $45.03 69,940 $45.03
$50 to $53 5,000 5.5 $52.25 5,000 $52.25
---------------- ----------------
$0 to $53 1,618,501 6.5 $22.33 921,075 $24.53
================ ================
At December 31, 2001, the Company had one Stock Option Plan, which is described
above. The Company applies Accounting Principles Board ("APB") Opinion 25 and
related interpretations in accounting for this plan. Had compensation cost for
the Company's Plan been determined consistent with SFAS No. 123, Accounting for
Stock-Based Compensation, the Company's net income (loss) and earnings (loss)
per share would have been reduced to the pro forma amounts indicated below:
YEAR ENDED DECEMBER 31,
-------------------------------------
2001 2000 1999
------------ ------------ -----------
Net income (loss) As reported $30,163 $16,210 $(1,013)
(in thousands) Pro Forma $29,650 $15,611 $(1,687)
Basic net income (loss) As reported $2.97 $1.84 $(0.10)
per share Pro Forma $2.92 $1.78 $(0.17)
Diluted net income (loss) As reported $2.88 $1.82 $(0.10)
per share Pro Forma $2.83 $1.75 $(0.17)
F-20
For purposes of determining option values for use in the above tables, the
values are based on the Black-Scholes option pricing model as of the various
grant dates, using the following principal assumptions: expected stock price
volatility 22%, risk free rates of return based on the 5 year treasury rate at
the date of grant, and a dividend growth rate of 10%. The actual value, if any,
that the option recipient will realize from these options will depend solely on
the increase in the stock price over the option price when the options are
exercised.
COMMON STOCK REPURCHASES
The Company's Board of Directors approved the repurchase of 7,455,000 shares of
the Company's Common Stock in 1997. The Company did not repurchase any shares of
Common Stock during the years ended December 31, 2001 and 2000, and repurchased
2,483,500 shares for $37 million at an average price of $14.96 per share during
the year ended December 31, 1999. At December 31, 2001, there remained 1,000,000
shares available under the authorization for repurchase. The repurchased shares
have been returned to the Company's authorized but unissued shares of Common
Stock.
COMMON STOCK ISSUANCES
In July, August and October 2001, the Company completed three secondary
offerings of 1,092,500 shares, 1,150,000 shares, and 1,322,500 shares of common
stock for net proceeds of $23.9 million, $25.9 million, and $30.4 million,
respectively. In addition to the secondary offerings, the Company also issued
shares of common stock through its Dividend Reinvestment and Stock Purchase Plan
for net proceeds of $5.3 million during 2001.
NOTE 11. COMMITMENTS AND CONTINGENCIES
At December 31, 2001, the Company had entered into commitments to purchase $1.2
million of residential credit enhancement securities, and $12.4 million of other
securities for settlement during January 2002. At December 31, 2001, the Company
had committed to fund an additional $3.8 million on its commercial mortgage
loans to existing borrowers, provided the borrowers meet certain conditions.
At December 31, 2001, the Company is obligated under non-cancelable operating
leases with expiration dates through 2006. The total future minimum lease
payments under these non-cancelable leases are $2.6 million and are expected to
be recognized as follows: 2002 - $0.7 million; 2003 - $0.6 million; 2004 - $0.6
million; 2005 - $0.5 million; 2006 - $0.2 million.
NOTE 12. SUBSEQUENT EVENTS
In February 2002, the Company completed a secondary offering of 1,725,000 shares
of common stock for net proceeds of $40.3 million to fund the expansion of its
real estate finance business.
F-21
NOTE 13. QUARTERLY FINANCIAL DATA - UNAUDITED
Selected quarterly financial data follows:
(IN THOUSANDS, EXCEPT SHARE DATA) THREE MONTHS ENDED
----------------------------------------------------
DECEMBER 31 SEPTEMBER 30 JUNE 30 MARCH 31
------------- ------------- ----------- ------------
2001
Operating results:
Interest income $ 31,277 $ 33,172 $ 38,453 $ 41,637
Interest expense (18,091) (21,555) (27,010) (31,413)
Net interest income 13,186 11,617 11,443 10,224
Net income available to common stockholders 8,955 8,065 6,463 6,680
Per share data:
Net income - diluted $0.69 $0.75 $0.70 $0.74
Dividends declared per common share $0.60 $0.57 $0.55 $0.50
Special dividends declared per common share $0.15 $0.18 -- --
Dividends declared per preferred share $ 0.755 $ 0.755 $ 0.755 $ 0.755
2000
Operating results:
Interest income $ 41,755 $41,679 $43,008 $42,819
Interest expense (33,845) (34,694) (35,133) (34,931)
Net interest income 7,910 6,985 7,875 7,888
Net income available to common stockholders 4,963 4,878 3,086 3,283
Per share data:
Net income - diluted $ 0.55 $ 0.55 $ 0.35 $ 0.37
Dividends declared per common share $ 0.44 $ 0.42 $ 0.40 $ 0.35
Special dividends declared per common share -- -- -- --
Dividends declared per preferred share $ 0.755 $ 0.755 $ 0.755 $ 0.755
F-22
[PRICEWATERHOUSECOOPERS LOGO]
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Redwood Trust, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, stockholders' equity and cash flows
present fairly, in all material respects, the financial position of Redwood
Trust, Inc. (the Company) at December 31, 2001 and 2000 and the results of its
operations and its cash flows for each of the three years in the period ended
December 31, 2001, in conformity with accounting principles generally accepted
in the United States of America. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with auditing standards generally
accepted in the United States of America which require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In January 2001, the Company adopted the provisions of Emerging Issues Task
Force ("EITF") 99-20, Recognition of Interest Income and Impairment on Purchased
and Retained Beneficial Interests in Securitized Financial Assets. This change
is discussed in Note 2 of the Notes to Consolidated Financial Statements.
/s/ PricewaterhouseCoopers LLP
San Francisco, California
February 26, 2002
F-23
EXHIBIT INDEX
Exhibit
Number Exhibit
- ------- -------
3.1 Articles of Amendment and Restatement of the Registrant (a)
3.1.1 Certified Certificate of Amendment of the Charter of Registrant (k)
3.2 Articles Supplementary of the Registrant (a)
3.3 Amended and Restated Bylaws of the Registrant (b)
3.3.1 Amended and Restated Bylaws, amended December 13, 1996 (g)
3.3.2 Amended and Restated Bylaws, amended March 15, 2001 (p)
3.3.3 Amended and Restated Bylaws, amended January 24, 2002
3.4 Articles Supplementary of the Registrant, dated August 14, 1995 (d)
3.4.1 Articles Supplementary of the Registrant relating to the Class B 9.74%
Cumulative Convertible Preferred Stock, filed August 9, 1996 (f)
4.2 Specimen Common Stock Certificate (a)
4.3 Specimen Class B 9.74% Cumulative Convertible Preferred Stock
Certificate (f)
4.4 In May 1999, the Bonds issued pursuant to the Indenture, dated as of
June 1, 1997, between Sequoia Mortgage Trust 1 and First Union National
Bank, as Trustee, were redeemed, restructured, and contributed to
Sequoia Mortgage Trust 1A, interests in which were then privately
placed with investors (i)
4.4.1 Indenture dated as of October 1, 1997 between Sequoia Mortgage Trust 2
(a wholly-owned, consolidated subsidiary of the Registrant) and Norwest
Bank Minnesota, N.A., as Trustee (j)
4.4.2 Sequoia Mortgage Trust 1A Trust Agreement, dated as of May 4, 1999
between Sequoia Mortgage Trust 1 and First Union National Bank (l)
4.4.3 Indenture dated as of October 1, 2001 between Sequoia Mortgage Trust 5
(a wholly-owned consolidated subsidiary of the Registrant) and Bankers
Trust Company of California, N.A., as Trustee (q)
9.1 Voting Agreement, dated March 10, 2000 (p)
10.1 [Reserved]
10.2 [Reserved]
10.3 [Reserved]
10.4 Founders Rights Agreement, dated August 19, 1994, between the
Registrant and the original holders of Common Stock of the Registrant
(a)
10.5 Form of Reverse Repurchase Agreement for use with Agency Certificates,
Privately-Issued Certificates and Privately-Issued CMOs (a)
10.5.1 Form of Reverse Repurchase Agreement for use with Mortgage Loans (d)
10.6.1 [Reserved]
10.7 [Reserved]
10.8 Forms of Interest Rate Cap Agreements (a)
10.9 [Reserved]
10.9.2 [Reserved]
10.9.3 Custodian Agreement (U.S. Custody), dated December 1, 2000, between the
Registrant and Bankers Trust Company (p)
10.10 Employment Agreement, dated August 19, 1994, between the Registrant and
George E. Bull (a)
10.11 Employment Agreement, dated August 19, 1994, between the Registrant and
Douglas B. Hansen (a)
10.12 [Reserved]
10.13 [Reserved]
10.13.1 Employment Agreement, dated March 13, 2000, between the Registrant and
Harold F. Zagunis (n)
10.13.2 Employment Agreement, dated March 23, 2001, between the Registrant and
Andrew I. Sirkis (p)
10.13.3 Employment Agreement, dated April 20, 2000, between the Registrant and
Brett D. Nicholas (p)
10.14 1994 Amended and Restated Executive and Non-Employee Director Stock
Option Plan (c)
10.14.1 1994 Amended and Restated Executive and Non-Employee Director Stock
Option Plan, amended March 6, 1996 (d)
10.14.2 Amended and Restated 1994 Executive and Non-Employee Director Stock
Option Plan, amended December 13, 1996 (h)
10.14.3 Amended and Restated Executive and Non-Employee Director Stock Option
Plan, amended March 4, 1999 (o)
10.14.4 Amended and Restated Executive and Non-Employee Director Stock Option
Plan, amended January 18, 2001 (p)
10.27 [Reserved]
10.29 [Reserved]
10.29.1 Form of Dividend Reinvestment and Stock Purchase Plan (g)
10.30 [Reserved]
10.30.1 [Reserved]
10.31 RWT Holdings, Inc. Series A Preferred Stock Purchase Agreement, dated
March 1, 1998 (m)
10.32 Administrative Personnel and Facilities Agreement dated as of April 1,
1998, between Redwood Trust, Inc. and RWT Holdings, Inc. (m)
10.32.1 First Amendment to Administrative Personnel and Facilities Agreement
dated as of April 1, 1998, between Redwood Trust, Inc. and RWT
Holdings, Inc. (m)
10.33 Lending and Credit Support Agreement dated as of April 1, 1998, between
RWT Holdings, Inc., Redwood Residential Funding, Inc., Redwood
Commercial Funding, Inc., and Redwood Financial Services, Inc., and
Redwood Trust, Inc. (m)
10.34 Form of Master Forward Commitment Agreements for RWT Holdings, Inc.,
Residential Redwood Funding, Inc., Redwood Commercial Funding, Inc. and
Redwood Financial Services, Inc. (m)
11.1 Statement re: Computation of Per Share Earnings
21 List of Subsidiaries
23 Consent of Accountants