UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the quarterly period ended: March 31, 2005

OR

For the transition period from                      to                     

Commission file number:     1-13759

REDWOOD TRUST, INC.

(415) 389-7373
(Registrant’s telephone number, including area code)

     Indicate by check mark whether the Registrant (1) has filed all documents and reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

     Indicate the number of shares outstanding of each of the issuer’s classes of stock, as of the last practicable date.

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REDWOOD TRUST, INC.
FORM 10-Q

INDEX

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PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except share data)

The accompanying notes are an integral part of these consolidated financial statements

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(In thousands, except share data)
(Unaudited)

For the Three Months Ended March 31, 2005:

For the Three Months Ended March 31, 2004:

The accompanying notes are an integral part of these consolidated financial statements

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)

The accompanying notes are an integral part of these consolidated financial statements.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS
March 31, 2005
(Unaudited)

NOTE 1. REDWOOD TRUST

Redwood Trust, Inc., together with its subsidiaries (Redwood), invests in, credit-enhances, and securitizes residential and commercial real estate loans and securities. Our primary business is credit-enhancing high-quality jumbo residential real estate loans nationwide. We also invest in securities that represent interests in pools of diverse types of real estate loans, including commercial real estate loans, home equity line of credit loans (HELOCs), real estate collateralized debt obligations (CDOs), and other mortgage assets.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation
The accompanying consolidated financial statements are unaudited. The unaudited interim consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and, in our opinion, reflect all adjustments (which include only normal recurring adjustments) necessary for a fair statement of our financial position, results of operations, and cash flows. These consolidated financial statements and notes thereto should be read in conjunction with our audited consolidated financial statements included in the Redwood’s Annual Report on Form 10-K for the year ended December 31, 2004. The results for the three months ended March 31, 2005 are not necessarily indicative of the expected results for the year ended December 31, 2005. Certain amounts for prior periods have been reclassified to conform to the March 31, 2005 presentation.

The March 31, 2005 and December 31, 2004 consolidated financial statements include the accounts of Redwood and its wholly-owned subsidiaries, Sequoia Mortgage Funding Corporation, Acacia CDO 1, LTD, Acacia CDO 2, LTD, Acacia CDO 3, LTD, Acacia CDO 4, LTD, Acacia CDO 5, LTD, Acacia CDO 6, LTD, Acacia CDO 7, LTD, and RWT Holdings, Inc. (Holdings), and Holdings’ wholly-owned subsidiaries, including Sequoia Residential Funding, Inc. For financial reporting purposes, references to Sequoia mean Sequoia Mortgage Funding Corporation and Sequoia Residential Funding, Inc. References to Acacia mean all of the aforementioned Acacia CDO entities. References to the Real Estate Investment Trust (REIT) mean Redwood exclusive of its taxable subsidiaries. The taxable subsidiaries of Redwood are Holdings and Holdings’ wholly owned subsidiaries. All significant inter-company balances and transactions have been eliminated.

Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (GAAP) requires us to make estimates and assumptions that affect the reported amounts of certain assets and liabilities and disclosure of contingent assets and liabilities as of the date of the consolidated financial statements and the reported amounts of certain revenues and expenses during the reported period. Our estimates are inherently subjective in nature and actual results could differ from those estimates.

Securitizations
Redwood acquires residential credit-enhancement securities (CES) either from its Sequoia securitizations or from securitizations sponsored by others. Under GAAP, the accounting treatment differs based on the acquisition method and is discussed below. CES are the non-rated, B-rated, and BB-rated securities in a real estate loan securitization.

Sequoia Residential Securitizations
We acquire residential real estate loans from third party originators for our Sequoia residential loan securitization programs. We then sell these loans to Sequoia entities that finance their purchases through

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the issuance of asset-backed securities (ABS). Redwood typically acquires as an investment the CES and a portion of the interest-only securities from these Sequoia entities. Redwood may also acquire other ABS securities issued by Sequoia for our Acacia CDO securitization program that Redwood sponsors (see below). All other Sequoia ABS are sold to third parties. Redwood’s investment in these securitizations is relatively small relative to the size of each Sequoia entity and Redwood’s maximum loss is limited to that investment.

Even though these securitizations are a legal sale and a sale for tax purposes, Redwood treats these securitizations as financings under the provisions of Financial Accounting Statement No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (FAS 140), as we have retained effective control over these loans. Control is maintained through our active management of the assets in the securitization entity, our retained asset transfer discretion, our ability to direct certain servicing decisions, or a combination of the foregoing. Accordingly, the underlying loans owned by the Sequoia entities and the Sequoia ABS issued to third parties are shown on our Consolidated Balance Sheets under residential real estate loans and ABS issued. In our Consolidated Statements of Income, we record interest income on the loans and interest expense on the ABS issued. Sequoia ABS securities (CES, investment grade, or interest-only) acquired by Redwood for its own portfolio from these Sequoia entities are eliminated in consolidation and thus are not shown on our GAAP balance sheets.

Residential and Commercial Securitizations Sponsored by Others
In contrast to the accounting treatment for Sequoia transactions, residential CES acquired from securitizations sponsored by others are reported as an asset on our Consolidated Balance Sheets under “residential loan credit-enhancement securities” and the assets owned by and ABS issued by the securitization entity are not consolidated on our GAAP balance sheet. Similarly, commercial CES acquired from securitizations sponsored by others are reported as an asset on our Consolidated Balance Sheets under “securities portfolio” and the assets owned by and ABS issued by the securitization entity are not consolidated on our GAAP balance sheets.

Acacia Securitizations
We acquire various investment grade and non-investment grade residential and commercial real estate securities from third parties and Sequoia for our Acacia CDO securitization programs. We sell these securities to Acacia securitization entities. The Acacia entities finance their purchases by re-securitizing these securities via the issuance of ABS. Redwood typically acquires for its own a portfolio the securities issued from Acacia entities that bear the first-loss and second-loss credit risk of the Acacia assets. Similar to the Sequoia transactions, Redwood’s investment in these securitizations is relatively small relative to the size of each Acacia entity and Redwood’s maximum loss is limited to that investment. Even though these securitizations are a sale for tax purposes, Redwood treats these securitizations as financings under the provisions of FAS 140, as we retain effective control over these entities. Accordingly, assets owned by the Acacia entities are shown on our Consolidated Balance Sheets. Residential securities rated BBB and above are included in our securities portfolio, while lower-rated residential securities are included in residential loan credit-enhancement securities. In our Consolidated Statements of Income, we record interest income on Acacia’s securities and interest expense on the ABS issued by Acacia. Acacia ABS acquired by Redwood for its own portfolio are eliminated in consolidation and thus are not shown on Redwood’s GAAP balance sheets.

Earning Assets
Earning assets (as consolidated for GAAP purposes) consist primarily of residential and commercial real estate loans and securities. Coupon interest is recognized as revenue when earned according to the terms of the loans and securities and when, in our opinion, it is collectible. Purchase discounts and premiums related to earning assets are amortized into interest income over their estimated lives considering the actual and future estimated prepayments of the earning assets using the interest method (i.e., in determining an effective yield). Gains or losses on the sale of earning assets are based on the specific identification method.

Residential Real Estate Loans: Held-for-Investment
Real estate loans 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. The majority of consolidated residential real estate loans are classified as held-for-investment because the consolidated securitization entities that own these assets have the ability and intent to hold these loans to maturity.

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While we generally do not sell real estate loans to third parties as part of our normal business operations, consolidated real estate loans may be sold from time to time, especially subsequent to our election to call ABS previously issued by a securitization entity sponsored by us.

Pursuant to Financial Accounting Statement No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Cost of Leases (FAS 91), we use the interest method to determine an effective yield and amortize the premium on loans. For loans acquired prior to July 1, 2004, we use coupon interest rates as they change over time and anticipated principal prepayments. For loans acquired after July 1, 2004, we calculate an interest method or effective yield to amortize the premium using the initial coupon interest rate of the loans (without regard to future changes in the underlying indices) and anticipated prepayments.

Commercial Real Estate Loans: Held-for-Investment
Commercial real estate loans for which we have the ability and intent to hold to maturity are classified as held-for-investment and are carried at their unpaid balance adjustments for unamortized discount and net of any allowance for credit losses.

Residential and Commercial Real Estate Loans: Held-for-Sale
Residential and commercial real estate loans that we are marketing for sale are classified as real estate loans held-for-sale. These are carried at the lower of original cost or market value on a loan-by-loan basis. Any lower of cost or market adjustments on these loans are recognized in net recognized gains and valuation adjustments in our Consolidated Statements of Income.

Residential Loan Credit-Enhancement and Securities Portfolio Securities: Available-for-Sale
These securities are classified as available-for-sale (AFS) and are carried at their estimated fair value. Cumulative unrealized gains and losses are reported as a component of accumulated other comprehensive income in our Consolidated Statements of Stockholders’ Equity.

When recognizing revenue on AFS securities, we employ the interest method and determine an account for purchase premiums, discounts, and other net capitalized fees or costs associated with these securities. For securities rated AAA or AA, we use the interest method as prescribed under FAS 91, while for securities rated A or lower we use the interest method as prescribed under the Emerging Issues Task Force of the Financial Accounting Standards Board 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (EITF 99-20). The use of these methods requires us to project cash flows over the remaining life of each asset. These projections include assumptions about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. We review and make adjustments to our cash flow projections on an ongoing basis and monitor these projections based on input and analyses received from external sources, internal models, and our own judgment and experience. 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.

Redwood monitors its available-for-sale securities for other-than-temporary impairment. We use the guidelines prescribed under EITF 99-20, Financial Accounting Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (FAS 115), and/or Staff Accounting Bulletin No. 5(m), Other-Than-Temporary Impairment for Certain Investments in Debt and Equity Securities (SAB 5(m)). Any impairments resulting in other-than-temporary market valuations below our cost basis are reported under net recognized gains and losses and valuation adjustments in our Consolidated Statements of Income.

Credit Reserves
For consolidated residential loans, HELOC loans, and commercial real estate loans held-for-investment, we establish and maintain credit reserves based on estimates of credit losses inherent in these loan portfolios as of the balance sheet date. To calculate the credit reserve, we assess inherent losses by determining loss factors (default, the timing of defaults, and the loss severity upon default) that can be specifically applied to each of our loan pools. We follow the guidelines of Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation (SAB 102), and Financial Accounting Statement No. 5, Accounting for Contingencies (FAS 5), in setting credit reserves for our consolidated loans.

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The following factors are considered and applied in such determination:

	•	On-going analysis of the pool of loans — including, but not limited to, the age of our loans, underwriting standards, business climate, economic conditions, geographical considerations, past performance of similar loans, and other observable data
	•	Historical loss rates
	•	Relevant environmental factors
	•	Relevant market research and publicly available third-party reference loss rates
	•	Trends in delinquencies and charge-offs
	•	Effects in changes in credit concentrations
	•	Prepayment assumptions

Once we determine applicable default amounts, the timing of the defaults, and severity of loss upon the default, we estimate the expected losses of each pool of loans over their expected lives. We then estimate the timing of these losses and the losses probable to occur over an effective loss confirmation period. This period is defined as the range of time between the probable occurrence of a credit loss (such as the initial deterioration of the borrower’s financial condition) and the confirmation of that loss (the actual impairment or charge-off of the loan). The losses expected to occur within the effective loss confirmation period are the basis of our credit reserves because we believe those losses exist as of the reported date of the financial statements. We re-evaluate the level of our credit reserves on at least a quarterly basis and record provision, charge-offs, and recoveries monthly.

Additionally, if a loan becomes real estate owned (REO) or is reclassified as held-for-sale, valuations specific to that loan also include analysis of the underlying collateral.

The credit reserve for credit losses for the commercial real estate loan portfolio includes a detailed analysis of each loan and the underlying property. The following factors are considered and applied in such determination.

	•	On-going analysis of each individual loan
	•	On-going evaluation of fair values of collateral using current appraisals and other valuations
	•	Discounted cash flow analysis
	•	Security perfection
	•	Borrowers ability to meet obligations

Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less.

Other Assets
Restricted Cash
Restricted cash includes principal and interest payments from real estate loans and securities owned by consolidated securitization entities that is collateral for or payable to ABS issued by those entities, cash pledged as collateral on interest rate agreements, and cash held back from borrowers until certain loan agreement requirements are been met. Corresponding liabilities for cash held back from borrowers are included in accrued expenses and other liabilities on our Consolidated Balance Sheets.

Deferred Tax Assets
Net deferred tax assets represent the net benefit of net operating loss carry forwards, real estate asset basis differences, and recognized tax gains on whole loan securitizations that will be recognized under GAAP through the financial statements in future periods.

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Deferred Asset-Backed Security Issuance Costs
Deferred ABS issuance costs are costs associated with the issuance of ABS from the securitization entities we sponsor. These costs typically include underwriting, rating agency, legal, accounting, and other fees. Deferred ABS issuance costs are reported on our Consolidated Balance Sheets as deferred charges and are amortized as an adjustment to consolidated interest expense using the interest method based on the actual and estimated repayment schedule of the related ABS issued.

Other Assets
Other assets on our Consolidated Balance Sheets include REO, fixed assets, prepaid interest, and other prepaid expenses. REO is reported at the lower of cost or market.

Interest Rate Agreements
We maintain an overall interest rate risk management strategy that incorporates the use of derivative interest rate agreements for a variety of reasons, including minimizing significant fluctuations in earnings or market values on certain assets or liabilities that may be caused by interest rate volatility. The interest rate agreements we use as part of our interest rate risk management strategy may include interest rate options, swaps, options on swaps, futures contracts, options on futures contracts, and options on forward purchases (collectively referred to as interest rate agreements). On the date an interest rate agreement is entered into, we designate 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 instrument). See Note 5 for a further discussion on interest rate agreements.

Risks and Uncertainties
We take certain risks inherent in financial institutions, including, but not limited to, credit risk, liquidity risk, interest rate risk, prepayment risk, market value risk, reinvestment risk, and capital risk. In addition, there are several other risks and uncertainties specific to our business. We seek to actively manage these risks and uncertainties while also providing our stockholders with an appropriate rate of return in light of these risks and uncertainties. There can be no assurances that risks and uncertainties are adequately provided for in our financial statements.

Debt and Asset-Backed Securities Issued
Redwood debt is short-term debt collateralized by loans and securities. We carry this debt on our balance sheet at its unpaid principal balance. Redwood currently does not have any long-term debt.

The majority of our consolidated liabilities reported on our Consolidated Balance Sheets represent ABS issued by bankruptcy-remote securitization entities. These ABS issued are carried at their unpaid principal balances net of any unamortized discount or premium. Our exposure to loss from consolidated securitization entities (such as Sequoia and Acacia) is limited (except, in some circumstances, for limited loan repurchase obligations) to our net investment in securities we have acquired from these entities. As required by the governing documents related to each series of ABS, Sequoia and Acacia assets are held in the custody of trustees. Trustees collect principal and interest payments (less servicing and related fees) from the assets and make corresponding principal and interest payments to the issued ABS. ABS obligations are payable solely from the assets of these entities and are otherwise non-recourse to Redwood.

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Taxes
We have elected to be taxed as a REIT under the Internal Revenue Code and the corresponding provisions of state law. In order to qualify as a REIT, we must distribute at least 90% of our annual REIT taxable income (this does not include taxable income retained in our taxable subsidiaries) to stockholders within the time frame set forth in the tax rules, and we must meet certain other requirements. If these requirements are met, we generally will not be subject to Federal or state income taxation at the corporate level with respect to the REIT taxable income we distribute to our stockholders. We may retain up to 10% of our REIT taxable income and pay corporate income taxes on this retained income while continuing to maintain our REIT status. See Note 8 for a further discussion on taxes.

The taxable income of Holdings and its subsidiaries is not included in REIT taxable income, and is subject to state and Federal income taxes at the applicable statutory rates. Deferred income taxes, to the extent they exist, reflect estimated future tax effects of temporary differences between the amounts of taxes recorded for financial reporting purposes and amounts actually payable currently as measured by tax laws and regulations. Holdings provides for deferred income taxes to reflect estimated future tax effects.

We have recorded a provision for income taxes in our Consolidated Statements of Income based upon our estimated liability for Federal and state income tax purposes. These tax liabilities arise from estimated taxable earnings in taxable subsidiaries and from the planned retention of a portion of our estimated REIT taxable income. See Note 8 for further discussion on income taxes.

Net Income Per Share
Basic net income per share is computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted average number of common shares and potential common shares outstanding during the period. Potential common shares outstanding are calculated using the treasury stock method, which assumes that all dilutive common stock equivalents are exercised and the funds generated by the exercise are used to buy back outstanding common stock at the average market price of the common stock during the reporting period.

Pursuant to EITF 03-6, Participating Securities and the Two-Class Method under FASB No. 128 (EITF 03-6), it was determined that there was no allocation of income for our outstanding stock options as they were antidilutive during the three months ended March 31, 2004 and 2005, and there were no other participating securities during these periods.

The following table provides reconciliation of denominators of the basic and diluted net income per share computations.

For the three months ended March 31, 2005 and 2004, the number of potential common shares that were anti-dilutive totaled 166,878, and 5,729, respectively.

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Comprehensive Income
Current period net unrealized gains and losses on residential loan CES, securities portfolio available-for-sale, and interest rate agreements classified as cash flow hedges are reported as a component of comprehensive income on our Consolidated Statements of Comprehensive Income, with cumulative unrealized gains and losses classified as accumulated other comprehensive income in our Consolidated Statements of Stockholders’ Equity. See Note 10 for further discussion of accumulated other comprehensive income.

Stock-Based Compensation
As of March 31, 2005 and December 31, 2004, we had one stock-based employee compensation plan and one employee stock purchase plan, which are described more fully in Note 10. In accordance with the guidance of Financial Accounting Statement No. 148, Accounting for Stock Based Compensation – Transition and Disclosure, an amendment for FASB Statement No. 123, (FAS 148) we elected to prospectively apply the fair value method of accounting for stock-based awards issued subsequent to December 31, 2002.

We continue to account for all stock-based compensation awards issued prior to 2003 under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), and related interpretations. Under these provisions, when we granted stock-based compensation awards we did not include any stock-based employee compensation cost in net income, as all awards granted under the plan had an exercise price equal to the market value of the underlying common stock on the date of grant.

Had Redwood applied Financial Accounting Statement No. 123, Accounting for Stock Based Compensation (FAS 123), to options granted prior to 2003, net income and net income per share would have been the pro-forma amounts indicated below:

The Black-Scholes option-pricing model was used in determining fair values of option grants accounted for under FAS 123. The model requires the use of assumptions like strike price, expected life, risk free rate of return, and stock price volatility. These options are generally granted over the course of the calendar year. The options granted in the first three months of 2005 and 2004 had dividend equivalent rights, and accordingly, the assumed dividend yield is zero. See Note 10 for a description of options granted during prior periods. The following table describes the weighted averages used for calculating the value of options granted in the three months ended March 31, 2005 and 2004.

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Recent Accounting Pronouncements
The EITF released EITF 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03-1). For investments that meet the scope of this pronouncement, EITF 03-1 provides application guidance to determine when an investment is considered other-than-temporary impaired, whether that impairment is other-than-temporary, and the measurement of impairment. The guidance also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. In general, EITF 03-1 states that if the fair value of an applicable investment is lower than its book value, it is considered impaired. This impairment is considered other-than-temporary unless the investor has the ability and intent to hold the investment for a reasonable period of time sufficient for a forecasted recovery of the value of the asset. Certain disclosure requirements of this pronouncement are currently in effect and are presented in Note 3. The recognition and measurement guidance of this pronouncement will become effective at a later date to be determined. Accordingly, we continue to evaluate other than temporary impairments as prescribed under EITF 99-20, FAS 115, and/or SAB 5(m).

In 2003, the Accounting Standards Executive Committee issued a Statement of Position No. 3, Accounting for Certain Loans or Debt Securities Acquired in a Transfer (SOP 03-3). This SOP addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or acquired in a transfer if those differences are attributable, at least in part, to credit quality. Among other things, the SOP requires that the excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) not be recognized as an adjustment of yield, loss accrual, or valuation allowance. In addition, the SOP requires certain footnote disclosures and prohibits investors from displaying accretable yield and nonaccretable difference on the face of the balance sheet. SOP 03-3 becomes effective for loans or debt securities acquired in fiscal years beginning after December 15, 2004. We believe this principle will not have a material impact on us given that the loans or debt securities we acquire will generally not be subject to its provisions.

In December 2004, a revised version of the original FAS 123 was issued. Financial Accounting Statement No. 123R Share-Based Payment (FAS 123R), supersedes Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25). This Statement requires that the cost resulting from all share-based payment transactions be recognized in the financial statements. This Statement establishes fair value as the measurement objective in accounting for share-based payment arrangements and requires all transactions with employees, except for equity instruments held by employee stock ownership plans. Effective January 1, 2003 and in accordance with the transitional guidance of FAS 148 we elected to prospectively apply the fair value method of accounting for stock-based awards granted subsequent to December 31, 2002. In accordance with the implementation timeframe established by the Securities and Exchange Commission in April 2005, we plan to adopt FAS 123R as of January 1, 2006. The Company is still in the process of evaluating the impact of FAS 123R.

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NOTE 3. EARNING ASSETS

As of March 31, 2005 and December 31, 2004, our reported earning assets (owned by us or by consolidated securitization entities) consisted of investments in adjustable-rate, hybrid, and fixed-rate residential and commercial real estate loans and securities and home equity lines of credit. Hybrid loans have an initial fixed coupon rate for three to ten years followed by periodic (usually annual or semi-annual) adjustments. The original maturity of the majority of our residential real estate loans and residential real estate securities is usually twenty-five to thirty years. The original maturity of our commercial real estate loans and commercial real estate securities is generally up to ten years. The original maturity of our home equity lines of credit is ten years. The actual amount of principal outstanding is subject to change based on the prepayments of the underlying loans.

For the three months ended March 31, 2005 and 2004, the average consolidated balance of earning assets was $23.9 billion and $18.2 billion, respectively.

As of March 31, 2005 and December 31, 2004, earning assets consisted of the following:

Residential Real Estate Loans

We acquire residential real estate loans from third party originators for sale to securitization entities sponsored by us under our Sequoia program. We sell these loans to Sequoia securitization entities, which, in turn, issue ABS (shown as liabilities on our Consolidated Balance Sheets). The following table presents the carrying value of consolidated real estate loans as March 31, 2005 and December 31, 2004.

Loans held-for-investment are primarily residential real estate loans sold to securitization entities and are consolidated on our Consolidated Balance Sheets. Loans acquired for future sale to sponsored securitization entities are also classified as held-for-investment. Loans held-for-sale are those we anticipate selling to third parties and are reported at the lower of cost or market. The balance remained at $2 million from the prior quarter. The carrying value of these loans is reflective of their characteristics and anticipated sale proceeds.

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The following table provides detail of the activity of our residential real estate loan held-for-sale and held-for-investment portfolios for the three months ended March 31, 2005 and 2004.

We may exercise our right to call ABS issued by entities sponsored by us and subsequently sell the loans to third parties. If these transactions are not completed within a reporting period, we reclassify held-for-investment loans to held-for-sale loans once we determine which loans will be sold to third parties. To the extent these transactions are completed within a reporting period, the sale of loans is reported as a sale of loans held-for-investment in our Statements of Cash Flows.

Our goal is to sell all of the residential real estate loans we acquire to securitization entities that finance their purchases of loans from us through the issuance of ABS. During the period we accumulate loans for securitization, we fund these loans with equity and with short-term borrowings sourced through various whole loan-financing facilities available to us.

The table below presents information regarding residential real estate loans pledged under our borrowing agreements.

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Residential Home Equity Lines of Credit (HELOCs)

Beginning in 2004, we acquired residential HELOCs from third-party originators for sale to securitization entities under our Sequoia program. These loans are indexed to the prime rate and were sold to a securitization entity that, in turn, issued ABS. The table below represents the carrying value of consolidated HELOCs.

There was no HELOC purchase or sale activity for the three months ended March 31, 2005 or 2004.

Our goal is to sell the HELOCs we accumulate to securitization entities that raise the proceeds necessary to buy the loans from us through the issuance of ABS. As of March 31, 2005 and December 31, 2004, all consolidated HELOCs were owned by securitization entities.

Residential Loan Credit-Enhancement Securities

The residential loan credit-enhancement securities shown on our Consolidated Balance Sheets include non-rated, B-rated, and BB-rated securities acquired from securitizations sponsored by others. Our residential loan CES provided some level of credit enhancement on $130 billion and $126 billion of high-quality residential real estate loans securitized by third parties as of March 31, 2005 and December 31, 2004, respectively.

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As a result of the concentrated credit risk associated with CES, we are generally able to acquire these securities at a discount to their face (principal) value. A portion of this discount is designed as credit protection and the remainder is accreted into income over the remaining life of the security.

The amount of designated credit protection is determined based upon various factors affecting these assets, including economic conditions, characteristics of the underlying loans, delinquency status, past performance of similar loans, and external credit protection. We use a variety of internal and external credit risk cash flow modeling and portfolio analytical tools to assist in our assessments. Quarterly, we complete our assessments on each individual underlying loan pool and determine the appropriate level of credit protection required for each security we own. The designated credit protection is specific to each residential loan CES.

The following table presents the changes in our unamortized discount and the portion of the discount designated as credit protection for the three months ended March 31, 2005 and 2004.

Yields recognized for GAAP for each security vary as a function of credit results, prepayment rates, and (for our variable rate securities) interest rates. If estimated future credit losses exceed our prior expectations, credit losses occur more quickly than expected, or prepayments occur more slowly than expected, the yield over the remaining life of the security may be adjusted downward. If estimated future credit losses are less than our prior estimate, 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 over time.

For the three months ended March 31, 2005 and 2004, we recognized losses due to other-than-temporary impairment under EITF 99-20 of $0.1 million and $0.6 million, respectively. These losses are included in net recognized gains and valuation adjustments in our Consolidated Statements of Income.

Gross unrealized gains and losses represent the difference between the net amortization cost and the fair value of individual securities. Gross unrealized losses represent a decline in market value for securities not deemed impaired for GAAP. The following table shows the gross unrealized losses, fair value, and length of time that securities have been in a continuous unrealized loss position of all consolidated residential loan CES as of March 31, 2005. These unrealized losses are not considered to be other-than-temporary impairments because these losses are not due to adverse changes in credit or prepayment speeds and we have the intent and ability to hold these securities for a period sufficient for these securities to potentially recover their value.

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The following table provides detail of the activity of our residential loan CES portfolio for the three months ended March 31, 2005 and 2004.

Of the $24 million and $35 million of principal pay downs in the three months ended March 31, 2005 and 2004, $14 million and $21 million, respectively, represented calls of the securities in accordance with the original issue provisions of individual securitization entities.

We generally fund with equity capital the first and second loss interests of residential loan CES. We generally sell the third loss interest of the residential loan CES we acquire to securitization entities (Acacia) that re-securitize these assets by issuing ABS. Prior to sale to Acacia, we may fund some of the securities acquired on a temporary basis with short-term borrowings through various financing facilities available to us (see Note 6).

The table below presents information regarding our residential loan credit CES pledged under borrowing agreements.

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Commercial Real Estate Loans

Commercial real estate loans represent first or second lien interests in multifamily, office, retail, and industrial properties. Commercial real estate loans held-for-investment may represent junior participations in first lien interests where we provide credit enhancement to a senior interest.

The following table provides detail of the activity of our commercial real estate loan portfolio for the three months ended March 31, 2005 and 2004.

Our goal is to finance our commercial real estate loans with equity or to sell them to securitization entities sponsored by us. During the accumulation of these loans prior to sale to Acacia, we may fund some of the loans with short-term borrowings through various financing facilities available to us. The table below presents information regarding our commercial real estate loans pledged under borrowing agreements.

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Securities Portfolio

Securities portfolio assets represent investment-grade security interests in prime residential loans, sub-prime residential loans, commercial real estate loans, second lien residential loans, CDO, and corporate REIT debt securities. Also included in this portfolio are commercial loan CES and non-investment grade interests in CDO’s.

Other-than-temporary impairments (pursuant to EITF 99-20, FAS No. 115 and/or SAB 5(m)) for the three months ended March 31, 2005 and 2004 totaled $0.4 million and $0.0 million, respectively. These are included as part of net recognized gains and valuation adjustments in our Consolidated Statements of Income.

Gross unrealized gains and losses represent the difference between the net amortization cost and the fair value of individual securities. Gross unrealized losses represented a temporary decline in market values.

The following table shows the gross unrealized losses, fair value, and length of time that securities have been in a continuous unrealized loss position of all securities portfolio securities as of March 31, 2005. These unrealized losses are not considered to be other-than-temporary impairments because these losses are not due to adverse changes in credit or prepayment speeds and we have the intent and ability to hold these securities for a period sufficient for these securities to potentially recover their value.

The table below presents changes in the balance of our securities portfolio.

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The following table presents information on the types of securities consolidated on our balance sheets as of March 31, 2005 and December 31, 2004.

The bulk of the securities we acquire are subsequently sold to securitization entities (Acacia) that finance their purchases from us through resecuritization (the issuance of ABS). While we are accumulating securities prior to resecuritization, we may fund some of these securities with short-term borrowings through various financing facilities available to us. The table below presents information regarding our consolidated securities portfolio securities pledged under borrowing agreements.

Net Recognized Gains and Valuation Adjustments

Fluctuations in the market value of certain of our real estate loan and security assets and interest rate agreements may also affect our net income. The table below describes the various components of our net recognized gains and valuation adjustments reported in income during the three months ended March 31, 2005 and 2004.

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