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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
     
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the quarterly period ended: September 30, 2005
OR
 
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
    For the transition period from           to
Commission file number: 1-13759
REDWOOD TRUST, INC.
(Exact name of Registrant as specified in its Charter)
     
Maryland   68-0329422
(State or other jurisdiction of
  (I.R.S. Employer
incorporation or organization)
  Identification No.)
 
One Belvedere Place, Suite 300
  94941
Mill Valley, California
  (Zip Code)
(Address of principal executive offices)
   
(415) 389-7373
(Registrant’s telephone number, including area code)
     Indicate by check mark whether the Registrant (1) has filed all documents and reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ          No o
      Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).     Yes o          No þ
      Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).     Yes þ          No o
      Indicate the number of shares outstanding of each of the issuer’s classes of stock, as of the last practicable date.
Common Stock ($0.01 par value per share) 24,825,475 as of November 3, 2005
 
 


REDWOOD TRUST, INC.
FORM 10-Q
INDEX
                 
        Page
         
 PART I. FINANCIAL INFORMATION
 Item 1.    Financial Statements     3  
         Consolidated Balance Sheets at September 30, 2005 and December 31, 2004 (unaudited)     3  
         Consolidated Statements of Income for the three and nine months ended September 30, 2005 and 2004 (unaudited)     4  
         Consolidated Statements of Comprehensive Income for the three and nine months ended September 30, 2005 and 2004 (unaudited)     5  
         Consolidated Statements of Stockholders’ Equity for the nine months ended September 30, 2005 and 2004 (unaudited)     6  
         Consolidated Statements of Cash Flows for the nine months ended September 30, 2005 and 2004 (unaudited)     7  
         Notes to Consolidated Financial Statements     8  
 Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations     51  
 Item 3.    Quantitative and Qualitative Disclosures About Market Risk     96  
 Item 4.    Controls and Procedures     96  
 
 PART II. OTHER INFORMATION
 Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds     96  
 Item 6.    Exhibits     96  
 SIGNATURES     97  
 EXHIBIT 11.1
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32.1
 EXHIBIT 32.2

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PART I. FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
                     
    September 30, 2005   December 31, 2004
         
(In thousands, except share data)        
(Unaudited)        
ASSETS
Residential real estate loans
  $ 16,341,180     $ 22,208,417  
Residential home equity lines of credit
    215,137       296,348  
Residential loan credit-enhancement securities
    664,801       561,658  
Commercial real estate loans
    56,102       54,479  
Commercial loan credit-enhancement securities
    43,540       14,498  
Securities portfolio
    1,783,429       1,380,077  
Cash and cash equivalents
    163,160       57,246  
             
   
Total Earning Assets
    19,267,349       24,572,723  
Restricted cash
    58,796       36,038  
Accrued interest receivable
    79,958       72,459  
Interest rate agreements
    25,422       16,144  
Principal receivable
    1,529       2,653  
Deferred tax asset
    7,679       10,572  
Deferred asset-backed security issuance costs
    56,391       60,993  
Other assets
    8,850       6,483  
             
Total Assets
  $ 19,505,974     $ 24,778,065  
             
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
LIABILITIES
               
Redwood debt
  $ 161,739     $ 203,281  
Asset-backed securities issued
    18,237,792       23,630,162  
Accrued interest payable
    42,205       35,064  
Interest rate agreements
    356       1,124  
Accrued expenses and other liabilities
    30,482       28,095  
Dividends payable
    17,335       16,183  
             
   
Total Liabilities
    18,489,909       23,913,909  
             
Commitments and contingencies (Note 11)
               
STOCKHOLDERS’ EQUITY
               
Common stock, par value $0.01 per share, 50,000,000 shares authorized; 24,764,404 and 24,153,576 issued and outstanding
    248       242  
Additional paid-in capital
    808,107       773,222  
Accumulated other comprehensive income
    117,043       105,357  
Cumulative earnings
    638,983       481,607  
Cumulative distributions to stockholders
    (548,316 )     (496,272 )
             
 
Total Stockholders’ Equity
    1,016,065       864,156  
             
Total Liabilities and Stockholders’ Equity
  $ 19,505,974     $ 24,778,065  
             
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
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
(In thousands, except share data)                
(Unaudited)                
Interest Income
                               
Residential real estate loans
  $ 190,599     $ 149,238     $ 589,032     $ 361,688  
Residential home equity lines of credit
    2,206       1,882       7,101       2,685  
Residential loan credit-enhancement securities
    24,368       16,007       63,431       47,617  
Commercial real estate loans
    1,209       1,038       3,819       2,607  
Commercial loan credit-enhancement securities
    453       346       1,690       442  
Securities portfolio
    22,926       12,932       60,356       32,992  
Cash and cash equivalents
    990       175       2,374       414  
                         
Interest income before provision for credit losses
    242,751       181,618       727,803       448,445  
Reversal of (provision for) credit losses
    805       (1,528 )     1,307       (5,539 )
                         
Total interest income
    243,556       180,090       729,110       442,906  
Interest Expense
                               
Redwood debt
    (3,845 )     (2,312 )     (8,398 )     (7,373 )
Asset-backed securities issued
    (192,841 )     (112,499 )     (559,435 )     (277,374 )
                         
Total interest expense
    (196,686 )     (114,811 )     (567,833 )     (284,747 )
Net Interest Income
    46,870       65,279       161,277       158,159  
Operating expenses
    (11,194 )     (8,561 )     (33,450 )     (27,048 )
Net recognized gains and valuation adjustments
    24,916       20,586       42,973       50,281  
                         
Net income before provision for income taxes
    60,592       77,304       170,800       181,392  
Provision for income taxes
    (4,693 )     (4,962 )     (13,424 )     (3,171 )
                         
Net Income
  $ 55,899     $ 72,342     $ 157,376     $ 178,221  
                         
Basic Earnings Per Share:
  $ 2.26     $ 3.30     $ 6.41     $ 8.62  
Diluted Earnings Per Share:
  $ 2.21     $ 3.18     $ 6.26     $ 8.29  
Regular dividends declared per common share
  $ 0.70     $ 0.67     $ 2.10     $ 2.01  
Special dividends declared per common share
                      0.50  
                         
Total dividends declared per common share
  $ 0.70     $ 0.67     $ 2.10     $ 2.51  
                         
Basic weighted average shares outstanding
    24,712,536       21,952,606       24,554,475       20,674,396  
Diluted weighted average shares outstanding
    25,314,315       22,728,369       25,159,619       21,486,208  
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
                                   
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
(In thousands)                
(Unaudited)                
Net income
  $ 55,899     $ 72,342     $ 157,376     $ 178,221  
Other comprehensive income:
                               
 
Net unrealized gains on available-for-sale securities (AFS)
    (16,200 )     14,562       34,578       44,244  
 
Reclassification adjustment for net (gains) included in net income
    (18,137 )     (15,198 )     (31,100 )     (36,026 )
 
Net unrealized gains (losses) on cash flow hedges
    13,891       (13,772 )     7,901       5,768  
 
Reclassification of net realized cash flow hedge losses (gains) to interest expense on asset-backed securities issued
    109       (361 )     307       287  
                         
Total other comprehensive income
    (20,337 )     (14,769 )     11,686       14,273  
                         
Comprehensive Income
  $ 35,562     $ 57,573     $ 169,062     $ 192,494  
                         
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
For the Nine Months Ended September 30, 2005:
                                                             
    Common Stock   Additional   Other       Cumulative    
        Paid-In   Comprehensive   Cumulative   Distributions to    
(In thousands, except share data)   Shares   Amount   Capital   Income   Earnings   Stockholders   Total
(Unaudited)                            
December 31, 2004
    24,153,576     $ 242     $ 773,222     $ 105,357     $ 481,607     $ (496,272 )   $ 864,156  
                                           
Comprehensive income:
                                                       
   
Net income
                            157,376             157,376  
   
Net unrealized gain on assets AFS
                      3,478                   3,478  
   
Net unrealized (loss) on interest rate agreements
                      8,208                   8,208  
                                           
   
Total comprehensive income
                                        169,062  
Issuance of common stock:
                                                       
   
Secondary Offerings
                                         
   
Dividend Reinvestment & Stock Purchase Plans
    582,250       5       31,294                         31,299  
   
Employee Option & Stock Plans
    19,969       1       1,459                         1,460  
   
Restricted Stock & Stock DERs
    8,609             2,132                         2,132  
Dividends declared:
                                                       
 
Common
                                  (52,044 )     (52,044 )
                                           
September 30, 2005
    24,764,404     $ 248     $ 808,107     $ 117,043     $ 638,983     $ (548,316 )   $ 1,016,065  
                                           
For the Nine Months Ended September 30, 2004:
                                                             
    Common Stock   Additional   Other       Cumulative    
        Paid-In   Comprehensive   Cumulative   Distributions to    
    Shares   Amount   Capital   Income   Earnings   Stockholders   Total
                             
December 31, 2003
    19,062,983     $ 191     $ 517,826     $ 82,179     $ 248,972     $ (295,840 )   $ 553,328  
                                           
Comprehensive income:
                                                       
   
Net income
                            178,221             178,221  
   
Net unrealized gain on assets AFS
                      8,218                   8,218  
   
Net unrealized gain on interest rate agreements
                      6,055                   6,055  
                                           
   
Total comprehensive income
                                                    192,494  
Issuance of common stock:
                                                       
   
Secondary Offerings
    2,350,000       24       116,596                         116,620  
   
Dividend Reinvestment & Stock Purchase Plans
    1,545,840       15       81,512                         81,527  
   
Employee Option & Stock Plans
    278,895       3       4,048                         4,051  
   
Restricted Stock & Stock DERs
    107,978             7,162                         7,162  
Dividends declared:
                                                       
 
Common
                                  (53,341 )     (53,341 )
                                           
September 30, 2004
    23,345,696     $ 233     $ 727,144     $ 96,452     $ 427,193     $ (349,181 )   $ 901,841  
                                           
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
                   
    Nine Months Ended
    September 30,
     
(In thousands)   2005   2004
(Unaudited)        
Cash Flows From Operating Activities:
               
 
Net income
  $ 157,376     $ 178,221  
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
 
Net amortization of premiums, discounts, and debt issuance costs
    (61,045 )     (63,570 )
 
Depreciation and amortization of non-financial assets
    622       411  
 
(Reversal of) provision for credit losses
    (1,307 )     5,539  
 
Non-cash stock compensation
    2,132       7,163  
 
Net recognized gains and valuation adjustments
    (42,973 )     (50,281 )
 
Principal payments on real estate loans held-for-sale
    18,283       30  
 
Net sales of real estate loans held-for-sale
    277,667       2,339  
 
Purchases of real estate loans held-for-sale
    (82,977 )      
 
Net change in:
               
 
Accrued interest receivable
    (7,499 )     (22,254 )
 
Principal receivable
    1,124       12,434  
 
Deferred income taxes
    2,893       (9,112 )
 
Other assets
    377       (1,779 )
 
Accrued interest payable
    7,141       11,991  
 
Accrued expenses and other liabilities
    2,387       11,368  
             
 
Net cash provided by operating activities
    274,201       82,500  
             
Cash Flows From Investing Activities:
               
 
Purchases of real estate loans held-for-investment
    (1,529,338 )     (8,275,424 )
 
Proceeds from sales of real estate loans held-for-investment
          112,811  
 
Principal payments on real estate loans held-for-investment
    7,230,178       2,483,075  
 
Purchases of real estate securities available-for-sale
    (757,870 )     (625,595 )
 
Proceeds from sales of real estate securities available-for-sale
    141,442       30,891  
 
Principal payments on real estate securities available-for-sale
    153,755       164,824  
 
Net (increase) decrease in restricted cash
    (22,758 )     (23,098 )
             
 
Net cash provided by (used in) investing activities
    5,215,409       (6,132,516 )
             
Cash Flows From Financing Activities:
               
 
Net borrowings on Redwood debt
    (41,542 )     9,859  
 
Proceeds from issuance of asset-backed securities
    1,998,008       8,438,368  
 
Deferred asset-backed security issuance costs
    (11,259 )     (26,229 )
 
Repayments on asset-backed securities
    (7,307,909 )     (2,507,237 )
 
Net (purchases) proceeds of interest rate agreements
    (2,860 )     686  
 
Net proceeds from issuance of common stock
    32,758       202,197  
 
Dividends paid
    (50,892 )     (50,089 )
             
 
Net cash (used in) provided by financing activities
    (5,383,696 )     6,067,555  
             
 
Net increase (decrease) in cash and cash equivalents
    105,914       17,539  
 
Cash and cash equivalents at beginning of period
    57,246       58,467  
             
 
Cash and cash equivalents at end of period
  $ 163,160     $ 76,006  
             
Supplemental disclosure of cash flow information:
               
 
Cash paid for interest
  $ 560,692     $ 272,756  
 
Cash paid for taxes
  $ 8,765     $ 9,145  
Non-cash financing activity:
               
 
Dividends declared but not paid
  $ 17,335     $ 15,642  
             
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
September 30, 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 real estate assets. We have elected to have Redwood Trust, Inc. taxed as a Real Estate Investment Trust (REIT).
      Redwood acquires credit-enhancement securities (CES) from residential real estate loan securitizations and, to a lesser extent, from commercial real estate loan securitizations. Our residential loan CES portfolio consists of non-rated, B-rated, and BB-rated securities from residential real estate loan securitizations. Our commercial loan CES are all non-rated, first-loss commercial mortgage–backed (CMBS) securities.
Sequoia Residential Mortgage Loan Securitizations
      We acquire residential real estate loans from third party originators for the Sequoia securitization program we sponsor. We then sell these loans to Sequoia entities that finance their purchases through the issuance of asset-backed securities (ABS). Most Sequoia ABS are sold to third parties other than Redwood or Acacia. Certain CES and portions of the interest-only securities (IO securities) created by these securitizations are sold to Redwood. Many of these CES (generally the BB-rated securities) are subsequently sold by Redwood to the Acacia CDO securitization program that Redwood sponsors (see below). Redwood may also acquire other ABS issued by Sequoia entities for re-sale to the Acacia CDO program. Redwood’s on-going investment in Sequoia securities is small relative to the size of each Sequoia entity, and Redwood’s maximum loss is limited to its investment in these Sequoia securities (expect for loan repurchase obligations that may arise in certain limited situations).
Acacia Securitizations
      We acquire various investment grade and non-investment grade residential and commercial real estate securities from third parties and Sequoia for re-sale to the Acacia CDO securitizations we sponsor. We sell securities to Acacia securitization entities that issue ABS. Redwood typically acquires for its own 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 on-going investment in these securities is small relative to the size of each Acacia entity, and Redwood’s maximum loss is limited to its investments in these securities.
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 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 and nine months ended September 30, 2005 are not necessarily indicative of the expected results

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
for the year ending December 31, 2005. Certain amounts for prior periods have been reclassified to conform to the September 30, 2005 presentation.
      The September 30, 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 through Acacia CDO 8, LTD and RWT Holdings, Inc. (Holdings), and Holdings’ wholly-owned subsidiaries, including Sequoia Residential Funding, Inc. and Madrona LLC. 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 Redwood 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 generally accepted accounting principles in the United States of America (GAAP) requires us to make estimates and assumptions. These include fair value of certain assets, amount and timing of credit losses, prepayment assumptions, and other items 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.
Sequoia and Acacia Securitizations
      Redwood treats the securitizations it sponsors 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 and securities. 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 are shown on our Consolidated Balance Sheets under residential real estate loans and the Sequoia ABS issued to third parties are shown on our Consolidated Balance Sheets under ABS issued. Assets owned by the Acacia entities are shown on our Consolidated Balance Sheets either in our securities portfolio (residential real estate backed securities rated BBB and above, commercial real estate securities, CDO, and REIT corporate debt) or our residential loan credit-enhancement securities (lower rated residential real estate securities). ABS issued by the Acacia entities are shown on our Consolidated Balance Sheets as ABS issued. In our Consolidated Statements of Income, we record interest income on the loans and securities and interest expense on the ABS issued. Any Sequoia ABS (CES, investment grade, or interest-only) acquired by Redwood or Acacia from Sequoia entities and any Acacia ABS acquired by Redwood for its own portfolio are eliminated in consolidation and thus are not shown on our Consolidated 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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
method (i.e., using an effective yield method). Gains or losses on the sale of earning assets are based on the specific identification method.
Residential and Commercial Real Estate Loans: Held-for-Investment
      Real estate loans held-for-investment are carried at their unpaid principal balances 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. We may sell real estate loans from time to time to third-parties other than the securitization entities we sponsor.
      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 or discount on loans. For loans acquired prior to July 1, 2004, we use coupon interest rates as they change over time and anticipated principal prepayments to determine an effective yield to amortize the premium or discount. For loans acquired after July 1, 2004, we use the initial coupon interest rate of the loans (without regard to future changes in the underlying indices) and anticipated prepayments to calculate an effective yield to amortize the premium or discount.
      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 balances adjusted for unamortized premium discounts 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 cost or market value on a loan-by-loan basis. Any market valuation adjustments on these loans are recognized in net recognized gains and valuation adjustments in our Consolidated Statements of Income.
Residential and Commercial 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 values. 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 to account for purchase premiums, discounts, and fees 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 estimate future cash flows or the current period’s yield for each asset would not change in the near term.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      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 Staff Accounting Bulletin No. 5(m), Other-Than-Temporary Impairment for Certain Investments in Debt and Equity Securities (SAB 5(m)). Any other-than-temporary impairments 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 (defaults, the timing of defaults, and loss severities upon defaults) that can be specifically applied to each of the consolidated loans, loan pools, or individual loans. 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 residential and commercial loans.
      The following factors are considered and applied in such determinations:
  •  On-going analyses of the pool of loans — including, but not limited to, the age of loans, underwriting standards, business climate, economic conditions, geographical considerations, and other observable data
 
  •  Historical loss rates and past performance of similar loans
 
  •  Relevant environmental factors
 
  •  Relevant market research and publicly available third-party reference loss rates
 
  •  Trends in delinquencies and charge-offs
 
  •  Effects of changes in credit concentrations
 
  •  Prepayment assumptions
      Once we determine applicable default amounts, the timing of the defaults, and severities of losses upon the defaults, we estimate expected losses for each pool of loans over its expected life. 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 we 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 analyses of the underlying collateral.
      The credit reserve for credit losses for the commercial real estate loan portfolio includes detailed analyses of each loan and the underlying property. The following factors are considered and applied in such determinations:
  •  On-going analyses of each individual loan — including, but not limited to, the age of loans, underwriting standards, business climate, economic conditions, geographical considerations, and other observable data

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
  •  On-going evaluations of fair values of collateral using current appraisals and other valuations
 
  •  Discounted cash flow analyses
 
  •  Perfection of security interest
 
  •  Borrowers’ ability to meet obligations
      We follow the guidelines of Financial Accounting Statement No. 114, Accounting by Creditors for Impairment of a Loan (FAS 114), in determining impairment on commercial real estate loans. We had no impaired commercial loans as of September 30, 2005 or December 31, 2004.
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 are collateral for or payable to owners of 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 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.
Deferred Asset-Backed Securities Issuance Costs
      Deferred ABS issuance costs are costs associated with the issuance of ABS from 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 schedules of the related ABS issued under the principles prescribed in APB 21, Interest on Receivables and Payables.
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 value.
Accrued Interest Receivable and Principal Receivable
      Accrued interest receivable and principal receivable represents principal and interest that is due and payable to us.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Interest Rate Agreements
      We enter into interest rate agreements to help manage out interest rate risks. See Note 5 for a detailed discussion on interest rate agreements. We report our interest rate agreements at fair value. Those with a positive value to us are reported as an asset. Those with a negative value to us are reported as a liability.
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 assurance that risks and uncertainties are adequately provided for in our financial statements.
Redwood Debt
      Redwood debt is short-term debt collateralized by loans and securities held temporarily for future sale to securitization entities. We carry this debt on our balance sheet at its unpaid principal balance. Redwood currently does not have any long-term debt; all debt matures within one year.
Asset-Backed Securities Issued
      The majority of our consolidated liabilities reported on our Consolidated Balance Sheets represent ABS issued by bankruptcy-remote securitization entities sponsored by Redwood. 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 non-recourse to Redwood.
Other Liabilities
Accrued Interest Payable
      Accrued interest payable represents interest due and payable on Redwood debt and ABS issued. It is generally paid within the next month with the exception of interest due on Acacia ABS which is settled quarterly instead of monthly.
Accrued Expenses and Other Liabilities
      Accrued expenses and other liabilities on our Consolidated Balance Sheets include cash held back from borrowers, accrued employee bonuses, executive deferred compensation, dividend equivalent rights (DERs) payable, excise and income taxes, and accrued legal, accounting, consultants and other miscellaneous expenses.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Dividends Payable
      Dividends payable reflect the regular dividend of $0.70 per share declared by our Board of Directors payable on October 21, 2005 to stockholders of record as of September 30, 2005.
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.
      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.
      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 exercises 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, which accrue dividend equivalent rights, as they were antidilutive during the three and nine months ended September 30, 2005 and 2004. There were no other participating securities, as defined by EITF 03-6 during these periods.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      The following table provides reconciliation of denominators of the basic and diluted net income per share computations.
Basic and Diluted Net Income Per Share
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands, except share data)                
Denominator:
                               
Denominator for basic earnings per share:
                               
Weighted average number of common shares outstanding during the period
    24,712,536       21,952,606       24,554,475       20,674,396  
Net effect of dilutive stock options
    601,779       775,763       605,144       811,812  
                         
Denominator for diluted earnings per share
    25,314,315       22,728,369       25,159,619       21,486,208  
                         
Basic Earnings Per Share:
                               
Net income per share
  $ 2.26     $ 3.30     $ 6.41     $ 8.62  
                         
Diluted Earnings Per Share:
                               
Net income per share
  $ 2.21     $ 3.18     $ 6.26     $ 8.29  
                         
      For the three months ended September 30, 2005 and 2004, the number of common shares that were anti-dilutive totaled 368,522 and 24,198, respectively. For the nine months ended September 30, 2005 and 2004, the number of common shares that were anti-dilutive totaled 167,622 and 20,238, respectively.
     Other Comprehensive Income
      Current period net unrealized gains and losses on residential and commercial loan CES, securities portfolio available-for-sale, and interest rate agreements classified as cash flow hedges are reported as components of other comprehensive income on our Consolidated Statements of Comprehensive Income.
     Stock-Based Compensation
      As of September 30, 2005 and December 31, 2004, we had one stock-based employee compensation plan and one employee stock purchase plan. These plans 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 December 31, 2002 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 fair market value of

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
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:
     Pro-Forma Net Income Under FAS 123
                                   
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands, except share data)                
Net income, as reported
  $ 55,899     $ 72,342     $ 157,376     $ 178,221  
Add: Dividend equivalent right operating expenses under APB 25
    2,029       1,953       5,587       7,547  
Add: Stock option operating (income) expenses under APB 25
    (16 )     213       (98 )     1,021  
Deduct: Stock-based employee compensation expense determined under fair value based method for awards granted prior to January 1, 2003
    (201 )     (256 )     (671 )     (848 )
                         
Pro forma net income
  $ 57,711     $ 74,252     $ 162,194     $ 185,941  
                         
Earnings per share:
                               
 
Basic — as reported
  $ 2.26     $ 3.30     $ 6.41     $ 8.62  
 
Basic — pro forma
  $ 2.34     $ 3.38     $ 6.61     $ 8.99  
 
Diluted — as reported
  $ 2.21     $ 3.18     $ 6.26     $ 8.29  
 
Diluted — pro forma
  $ 2.28     $ 3.27     $ 6.45     $ 8.65  
      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 such as 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. Some of the options granted during the nine months ended September 30, 2005 and the three and nine months ended September 30, 2004 had dividend equivalent rights, and, accordingly, the assumed dividend yield was zero. Other options granted during the first nine months of 2005 and 2004 had no DERs and the assumed dividend yield was 10%. See Note 10 for a further discussion of options. The following table describes the weighted average of assumptions used for calculating the value of options granted in the three months and nine months ended September 30, 2005 and 2004.
Weighted Average Assumptions used for Valuation of Options under FAS 123 Granted during period
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Stock Price Volatility
          22.00%       26.41%       22.00%  
Risk free rate of return (5 yr Treasury Rate)
          3.45%       4.07%       3.30%  
Dividend Yield Assumptions
          0.00%       4.45%       4.87%  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
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 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 SAB 5(m).
      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 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 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 time frame established by the Securities and Exchange Commission in April 2005, we plan to adopt FAS 123R as of January 1, 2006. We are still in the process of evaluating the impact of FAS 123R.
NOTE 3. EARNING ASSETS
      As of September 30, 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 September 30, 2005 and 2004, the average consolidated balance of earning assets was $20.1 billion and $22.5 billion, respectively. For the nine months ended September 30, 2005 and 2004, the average consolidated balance of earning assets was $22.2 billion and $20.3 billion, respectively.
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 (that are shown as liabilities on our Consolidated Balance Sheets). The

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
following table presents the carrying value of consolidated real estate loans as September 30, 2005 and December 31, 2004.
Residential Real Estate Loans Carrying Value
                                                 
    September 30, 2005   December 31, 2004
         
    Held-for-   Held-for-       Held-for-   Held-for-    
    Sale   Investment   Total   Sale   Investment   Total
(In thousands)                        
Current face
  $     $ 16,176,357     $ 16,176,357     $ 2,365     $ 22,021,523     $ 22,023,888  
Unamortized Premium
          185,814       185,814       32       207,575       207,607  
                                     
Amortized Cost
          16,362,171       16,362,171       2,397       22,229,098       22,231,495  
Lower of cost-or- market adjustments
                      (375 )           (375 )
Reserve for Credit Losses
          (20,991 )     (20,991 )           (22,703 )     (22,703 )
                                     
Carrying Value
  $     $ 16,341,180     $ 16,341,180     $ 2,022     $ 22,206,395     $ 22,208,417  
                                     
      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 other than Redwood-sponsored securitization entities and are reported at the lower of cost or market value.
      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.
      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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      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 and nine months ended September 30, 2005 and 2004.
Residential Real Estate Loans Activity
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Residential Real Estate Loans at beginning of period
  $ 19,383,193     $ 19,915,575     $ 22,208,417     $ 16,239,160  
Acquisitions
    332,049       2,898,165       1,591,238       7,923,314  
Sales (other than to consolidated ABS trusts)
    (263,079 )     (112,811 )     (266,457 )     (112,811 )
Principal repayments
    (3,096,721 )     (1,144,320 )     (7,161,015 )     (2,463,802 )
Transfers to REO
    (1,880 )           (3,089 )      
Net discount (premium) amortization
    (13,479 )     2,078       (29,452 )     (23,430 )
Reversal of (provision for) credit losses
    1,315       (1,264 )     1,502       (5,008 )
Net recognized gains (losses) and valuation adjustments
    (218 )     489       36       489  
                         
Residential Real Estate Loans at end of period
  $ 16,341,180     $ 21,557,912     $ 16,341,180     $ 21,557,912  
                         
      The table below presents information regarding residential real estate loans pledged under our borrowing agreements.
Residential Real Estate Loans as Collateral
                                 
    September 30, 2005   December 31, 2004
         
    Face   Carrying   Face   Carrying
    Value   Value   Value   Value
(In thousands)                
Unpledged
  $ 16,680     $ 16,760     $ 3,618     $ 3,288  
Pledged for Redwood debt
                188,707       190,207  
Owned by securitization entities, financed through the issuance of ABS
    16,159,677       16,324,420       21,831,563       22,014,922  
                         
Total Value
  $ 16,176,357     $ 16,341,180     $ 22,023,888     $ 22,208,417  
                         
Residential Home Equity Lines of Credit (HELOCs)
      There were no HELOC purchases during the three months ended September 30, 2005 and $0.1 million during the nine months ended September 30, 2005. We acquired $335 million HELOCs during the nine months ended September 30, 2004. Our goal is to sell the HELOCs we accumulate to securitization entities that raise the proceeds necessary through the issuance of ABS. As of September 30, 2005 and December 31, 2004, substantially all consolidated HELOCs were owned by a securitization entity; the balance was funded with equity. There were no sales during these periods to

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
unrelated third parties. These HELOCs are all indexed to the prime rate. The table below represents the carrying value of consolidated HELOCs.
HELOCs Carrying Value
                 
    September 30, 2005   December 31, 2004
    Held-for-   Held-for-
    Investment   Investment
(In thousands)        
Current face
  $ 210,476     $ 288,954  
Unamortized premium
    5,699       8,087  
             
Amortized cost
    216,175       297,041  
Reserve for credit losses
    (1,038 )     (693 )
             
Carrying value
  $ 215,137     $ 296,348  
             
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 $179 billion and $126 billion high-quality residential real estate loans securitized by entities not sponsored by us as of September 30, 2005 and December 31, 2004, respectively.
Residential Loan CES Carrying Value
                 
    September 30, 2005   December 31, 2004
    Securities   Securities
    Available-for-Sale   Available-for-Sale
(In thousands)        
Current face
  $ 1,052,813     $ 933,772  
Unamortized discount
    (89,429 )     (108,141 )
Portion of discount designated as credit protection
    (382,862 )     (342,706 )
             
Amortized cost
    580,522       482,925  
Gross unrealized gains
    91,949       84,390  
Gross unrealized losses
    (7,670 )     (5,657 )
             
Carrying value
  $ 664,801     $ 561,658  
             
      As a result of the concentrated credit risk associated with residential loan CES, we are generally able to acquire these securities at a discount to their face (principal) value. A portion of this discount is designated as credit protection and the remainder is accreted into income over the remaining life of the security.
      The amount of designated credit protection equals the amount of credit losses within the underlying loan pool that we expect to incur over the life of the loans. This estimate 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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      The following table presents the changes in our unamortized discount and the portion of the discount designated as credit protection for the three and nine months ended September 30, 2005 and 2004.
Residential Loan CES Unamortized Discount and Designated Credit Protection
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Beginning balance of unamortized discount
  $ 96,488     $ 121,808     $ 108,141     $ 123,329  
Amortization of discount
    (11,193 )     (8,181 )     (27,695 )     (25,666 )
Calls, sales, and other
    (14,153 )     (16,560 )     (29,695 )     (39,977 )
Re-designation of credit protection to discount
    19,242       5,733       44,015       34,163  
Acquisitions
    (955 )     6,567       (5,337 )     17,518  
                         
Ending balance of unamortized discount
  $ 89,429     $ 109,367     $ 89,429     $ 109,367  
                         
Beginning balance of designated credit protection
  $ 404,180     $ 235,535     $ 342,706     $ 200,970  
Realized credit losses
    (1,502 )     (534 )     (3,303 )     (2,343 )
Calls, sales, and other
    (33,420 )     (3,830 )     (44,768 )     (10,430 )
Re-designation of credit protection to discount
    (19,242 )     (5,733 )     (44,015 )     (34,163 )
Acquisitions
    32,846       73,487       132,242       144,891  
                         
Ending balance of designated credit protection
  $ 382,862     $ 298,925     $ 382,862     $ 298,925  
                         
      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 (meaning the present value of projected cash flows is less than previously 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 (meaning the present value of projected cash flows is greater then previously expected), the yield over the remaining life of the security may be adjusted upwards over time.
      For three months ended September 30, 2005, we did not recognize any other-than-temporary impairments (EITF 99-20). For the nine months ended September 30, 2005, we recognized losses due to other-than-temporary impairments of $0.1 million. For the three and nine months ended September 30, 2004, we recognized losses due to other-than-temporary impairments of $0.1 million and $3.3 million, respectively. These recognized 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 amortized 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 September 30, 2005. These unrealized losses are not consid-

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
ered 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 values.
Residential Loan CES with Unrealized Losses as of September 30, 2005
                                                 
    Less Than 12 Months   12 Months or More   Total
             
    Fair   Unrealized   Fair   Unrealized   Fair   Unrealized
    Value   (Losses)   Value   (Losses)   Value   (Losses)
(In thousands)                        
Residential loan credit- enhancement securities
  $ 132,941     $ (7,422 )   $ 2,978     $ (248 )   $ 135,919     $ (7,670 )
      The following table provides detail of the activity in our residential CES portfolio for the three and nine months ended September 30, 2005 and 2004.
Residential Loan CES Activity
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Residential CES at beginning of period
  $ 706,195     $ 442,239     $ 561,658     $ 378,727  
Acquisitions
    57,481       82,918       213,139       195,553  
Sales (other than to consolidated ABS trusts)
    (98,775 )           (126,068 )     (22,416 )
Principal repayments (including calls)
    (18,403 )     (44,822 )     (62,735 )     (126,459 )
Discount amortization
    11,193       8,181       27,695       25,666  
Net unrealized balance sheet gains (losses)
    (18,848 )     (12,097 )     5,545       (4,758 )
Net recognized gains and valuation adjustments
    25,958       20,390       45,567       50,496  
                         
Residential Loan CES at end of period
  $ 664,801     $ 496,809     $ 664,801     $ 496,809  
                         
      Of the $18 million and $63 million of principal pay downs in the three and nine months ended September 30, 2005, $5 million and $28 million, respectively, represented calls of the securities in accordance with the original issue provisions of individual securitization entities. Of the $45 million and $126 million of principal pay downs in the three and nine months ended September 30, 2004, $32 million and $80 million, respectively, represented calls of securities.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      We generally fund the first-loss and second-loss interests of residential CES with equity capital. We generally sell the third-loss interests (and some of the second-loss interests) 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 CES pledged under borrowing agreements and securitizations.
Residential Loan CES as Collateral
                 
        December 31,
    September 30, 2005   2004
(In thousands)        
Unpledged
  $ 336,067     $ 350,756  
Pledged for Redwood debt
    2,406        
Owned by securitization entities, financed through issuance of ABS
    326,328       210,902  
             
Total Carrying Value
  $ 664,801     $ 561,658  
             
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.
Commercial Real Estate Loans Carrying Value
                                                 
    September 30, 2005   December 31, 2004
         
    Held-   Held-for-       Held-   Held-for-    
    for-Sale   Investment   Total   for-Sale   Investment   Total
(In thousands)                        
Current face
  $     $ 66,348     $ 66,348     $     $ 65,598     $ 65,598  
Unamortized (discount) premium
          (2,105 )     (2,105 )           (2,478 )     (2,478 )
Portion of discount designated as credit protection
          (8,141 )     (8,141 )           (8,141 )     (8,141 )
Lower of cost-or-market adjustments
                                   
Reserve for credit losses
                            (500 )     (500 )
                                     
Carrying Value
  $     $ 56,102     $ 56,102     $     $ 54,479     $ 54,479  
                                     

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      The following table provides detail of the activity of our commercial real estate loan portfolio for the three and nine months ended September 30, 2005 and 2004.
Commercial Real Estate Loans Activity
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Commercial real estate loans at beginning of period
  $ 41,794     $ 33,546     $ 54,479     $ 22,419  
Acquisitions
    14,219             20,951       17,066  
Principal capitalized (payments)
    158       (29 )     (8,878 )     (3,307 )
Net premium amortization
    (69 )     (128 )     (198 )     (352 )
Reversal of provisions for credit losses
                185        
Sales (other than to consolidated ABS trusts)
    (17 )           (11,209 )     (2,339 )
Net recognized gains (losses) and valuation adjustments
    17             772       (98 )
                         
Commercial real estate loans at end of period
  $ 56,102     $ 33,389     $ 56,102     $ 33,389  
                         
      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.
Commercial Real Estate Loans as Collateral
                                 
    September 30, 2005   December 31, 2004
         
    Face   Carrying   Face   Carrying
    Value   Value   Value   Value
(In thousands)                
Unpledged
  $ 15,591     $ 7,192     $ 40,868     $ 32,119  
Pledged for Redwood debt
    14,401       14,206              
Owned by securitization entities, financed through issuance of ABS
    36,356       34,704       24,730       22,360  
                         
Total carrying value
  $ 66,348     $ 56,102     $ 65,598     $ 54,479  
                         
Commercial Loan CES
      The commercial loan CES shown on our Consolidated Balance Sheets include non-rated securities acquired from securitizations sponsored by others and a re-REMIC that is a resecuritization of several first and second loss securities of other CMBS. Our commercial loan CES provided some level of credit enhancement on $21 billion and $6 billion high-quality commercial real estate loans securitized by entities not sponsored by us as of September 30, 2005 and December 31, 2004, respectively. In addition, the underlying loans in the re-REMIC included in this portfolio totaled $18 billion and $20 billion at September 30, 2005 and December 31, 2004, respectively.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Commercial Loan CES Carrying Value
                 
    September 30, 2005   December 31, 2004
    Securities   Securities
    Available-for-Sale   Available-for-Sale
(In thousands)        
Current face
  $ 138,530     $ 45,639  
Unamortized premium
    41,127       12,883  
Portion of discount designated as credit protection
    (138,530 )     (45,639 )
             
Amortized cost
    41,127       12,883  
Gross unrealized gains
    3,264       1,615  
Gross unrealized losses
    (851 )      
             
Carrying value
  $ 43,540     $ 14,498  
             
      As a result of the concentrated credit risk associated with commercial loan CES, we generally are able to acquire these securities at a discount to their face (principal) value. A portion of this discount is designated as credit protection and the remainder is accreted into income or expense over the remaining life of the security.
      The amount of designated credit protection equals the amount of credit losses within the underlying loan pool that we expect to incur over the life of the loans. This estimate 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 commercial loan CES.
      The following table presents the changes in our unamortized premium and the portion of the discount designated as credit protection for the three and nine months ended September 30, 2005 and 2004.
Commercial Loan CES Unamortized Discount and Designated Credit Protection
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Beginning balance of unamortized (premium) discount
  $ (24,847 )   $ (2,084 )   $ (12,883 )   $  
Amortization of premium (discount)
    902       (60 )     1,657       (18 )
Calls, sales, and other
          85       151       12  
Re-designation of credit protection to discount
                       
Acquisitions
    (17,182 )     (6,397 )     (30,052 )     (8,450 )
                         
Ending balance of unamortized premium
  $ (41,127 )   $ (8,456 )   $ (41,127 )   $ (8,456 )
                         
Beginning balance of designated credit protection
  $ 87,210     $ 8,175     $ 45,639     $  
Realized credit losses
    (3 )           (1,464 )      
Calls, sales and other
                       
Re-designation of credit protection to discount
                       
Acquisitions
    51,323       18,755       94,355       26,930  
                         
Ending balance of designated credit protection
  $ 138,530     $ 26,930     $ 138,530     $ 26,930  
                         

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      Yields recognized for GAAP purposes 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 September 30, 2005 and for the three and nine months ended September 30, 2004, we did not recognize losses due to other-than-temporary impairment. For the nine months ended September 30, 2005, we recognized losses due to other-than-temporary impairments of $0.2 million.
      Gross unrealized gains and losses represent the difference between the net amortized cost and the fair value of individual securities. Gross unrealized losses represent a decline in market value for securities not deemed impaired for GAAP purposes. 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 commercial loan CES as of September 30, 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.
Commercial Loan CES with Unrealized Losses as of September 30, 2005
                                                 
    Less Than 12 Months   12 Months or More   Total
             
    Fair   Unrealized   Fair   Unrealized   Fair   Unrealized
    Value   (Losses)   Value   (Losses)   Value   (Losses)
(In thousands)                        
Commercial Loan CES
  $ 3,407     $ (851 )   $     $     $ 3,407     $ (851 )
      The following table provides detail of the activity in our commercial loan CES portfolio for the three and nine months ended September 30, 2005 and 2004.
Commercial Loan CES Activity
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Commercial Loan CES at beginning of period
  $ 29,397     $ 2,094     $ 14,498     $  
Acquisitions
    17,182       6,311       30,052       8,438  
Sales (other than to consolidated ABS trusts)
                       
Principal repayments (including calls)
                       
Net discount (premium) amortization
    (902 )     60       (1,657 )     18  
Net unrealized balance sheet gains (losses)
    (2,136 )     677       799       686  
Net recognized gains and valuation adjustments
                (151 )      
                         
Commercial Loan CES at end of period
  $ 43,541     $ 9,142     $ 43,541     $ 9,142  
                         
      We generally fund the commercial loan CES with equity capital. There were no commercial loan CES pledged as collateral at September 30, 2005 or December 31, 2004.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
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’s, and REIT corporate debt securities. Also included in this portfolio are below investment-grade commercial mortgage backed securities (except for non-rated securities shown under commercial CES), securities backed by manufactured housing loans, REIT corporate debt, and various real estate interests in CDOs sponsored by others.
Securities Portfolio Carrying Value
                 
    September 30, 2005   December 31, 2004
    Securities   Securities
    Available-for-Sale   Available-for-Sale
(In thousands)        
Current face
  $ 1,818,295     $ 1,378,924  
Unamortized discount
    (69,105 )     (41,125 )
Unamortized premium
    4,310       5,548  
Unamortized premium — interest-only certificates
    17,747       21,682  
             
Amortized cost
    1,771,247       1,365,029  
Gross unrealized gains
    21,127       20,159  
Gross unrealized losses
    (8,945 )     (5,111 )
             
Carrying value
  $ 1,783,429     $ 1,380,077  
             
      Other-than-temporary impairments (EITF 99-20) for the three and nine months ended September 30, 2005 totaled $1.2 million and $3.1 million, respectively. Other-than-temporary impairments totaled $0.3 million and $1.5 million for the three and nine months ended September 30, 2004, respectively. These other-than-temporary impairments 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 amortized cost and the fair value of individual securities. Gross unrealized losses represent 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 September 30, 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 values.
Securities Portfolio with Unrealized Losses as of September 30, 2005
                                                 
    Less Than 12 Months   12 Months or More   Total
             
    Fair   Unrealized   Fair   Unrealized   Fair   Unrealized
    Value   (Losses)   Value   (Losses)   Value   (Losses)
(In thousands)                        
Securities portfolio
  $ 477,696     $ (5,630 )   $ 118,064     $ (3,315 )   $ 595,760     $ (8,945 )

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      The table below provides detail of the activity in our securities portfolio for the three and nine months ended September 30, 2005 and 2004.
Securities Portfolio Activity
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Securities Portfolio at beginning of period
  $ 1,648,838     $ 1,093,374     $ 1,380,077     $ 844,714  
Acquisitions
    190,160       144,753       514,679       421,604  
Sales (other than to consolidated ABS trusts)
                (15,374 )     (8,475 )
Principal repayments
    (41,618 )     (18,489 )     (91,020 )     (38,365 )
Net discount (premium) amortization
    566       (146 )     832       (1,293 )
Net unrealized balance sheet gains (losses)
    (13,569 )     10,784       (3,081 )     12,289  
Net recognized gains (losses) and valuation adjustments
    (948 )     (340 )     (2,684 )     (538 )
                         
Securities Portfolio at end of period
  $ 1,783,429     $ 1,229,936     $ 1,783,429     $ 1,229,936  
                         
      The following table presents information on the types of securities consolidated on our balance sheets as of September 30, 2005 and December 31, 2004.
Securities Portfolio Asset Types
                 
    September 30,   December 31,
    2005   2004
(In thousands)        
Commercial real estate
  $ 310,907     $ 228,643  
Residential prime
    647,781       400,047  
Residential sub prime
    477,266       428,610  
Residential second lien
    118,409       131,197  
Manufactured housing
    14,695       14,016  
REIT Corporate debt
    63,381       64,479  
Real estate CDOs
    150,990       113,085  
             
Total securities portfolio
  $ 1,783,429     $ 1,380,077  
             
      At September 30, 2005, non-investment grade securities totaled $172 million, including commercial real estate securities ($146 million), manufactured housing securities ($6 million), and real estate CDOs ($20 million). At December 31, 2004, non-investment grade securities in this portfolio totaled $87 million, including commercial real estate securities ($70 million), REIT corporate debt ($8 million), manufactured housing securities ($6 million), and real estate CDOs ($3 million).

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      The bulk of the securities we acquire are subsequently sold to securitization entities (Acacia) that finance their purchases through resecuritization (the issuance of ABS). While we are accumulating securities prior to resecuritization, we may finance some of these securities with short-term borrowings through various financing facilities. The table below presents information regarding our consolidated securities portfolio securities pledged under borrowing agreements and securitizations.
Securities Portfolio as Collateral
                 
    September 30,   December 31,
    2005   2004
(In thousands)        
Unpledged
  $ 90,169     $ 93,472  
Pledged for Redwood debt
    144,432       21,283  
Owned by securitization entities, financed through the issuance of ABS
    1,548,828       1,265,322  
             
Total Carrying Value
  $ 1,783,429     $ 1,380,077  
             
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 and nine months ended September 30, 2005 and 2004.
Net Recognized Gains and Valuation Adjustments
                                   
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Realized gains on calls:
                               
 
Residential loan CES
  $ 2,704     $ 20,472     $ 14,643     $ 47,534  
 
Securities portfolio
    210             240        
Realized gains (losses) on sales:
                               
 
Residential real estate loans
    (218 )     489       36       489  
 
Commercial real estate loans
    17             772       (23 )
 
Residential loan CES
    23,254             30,979       6,242  
 
Securities portfolio
                129       1,007  
Valuation adjustments — impairment (EITF 99-20 and others):
                               
 
Residential loan CES
          (82 )     (55 )     (3,281 )
 
Securities portfolio
    (1,158 )     (340 )     (3,053 )     (1,545 )
 
Commercial loan CES
                (151 )      
Lower-of-cost-or-market (LOCOM) valuation adjustments on real estate loans:
                               
 
Residential real estate loans
                       
 
Commercial real estate loans
                      (75 )
Gains (losses) on interest rate agreements
    107       47       (567 )     (67 )
                         
Net recognized gains and valuation adjustments
  $ 24,916     $ 20,586     $ 42,973     $ 50,281  
                         

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
NOTE 4. RESERVES FOR CREDIT LOSSES
      We establish and maintain credit reserves that we believe represent probable credit losses in our consolidated residential and commercial real estate loans held for investment as of the date of the financial statements. The reserves for credit losses are reflected as a component of residential and commercial real estate loans on our Consolidated Balance Sheets. The following table summarizes the activity in reserves for credit losses for the three and nine months ended September 30, 2005 and 2004.
      Delinquencies in our consolidated residential real estate loan portfolio were $23 million and $13 million, respectively, as of September 30, 2005 and December 31, 2004. Delinquencies include loans delinquent more than 90 days, in bankruptcy, in foreclosure, and REO. As a percentage of our residential real estate loan portfolio, delinquencies remained at low levels relative to residential real estate loans in the U.S. and stood at 0.14% and 0.06% of our current loan balances as of September 30, 2005 and December 31, 2004, respectively. Our residential loan servicers advance payment on delinquent loans to the extent they deem them recoverable. The following table summarizes the activity in reserves for credit losses for our consolidated residential real estate loans for the three and nine months ended September 30, 2005 and 2004.
Residential Real Estate Loans
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Balance at beginning of period
  $ 22,396     $ 20,080     $ 22,703     $ 16,336  
(Reversal of) provision for credit losses
    (1,315 )     1,264       (1,502 )     5,008  
Charge-offs
    (90 )           (210 )      
                         
Balance at end of period
  $ 20,991     $ 21,344     $ 20,991     $ 21,344  
                         
      Delinquencies in our HELOC portfolio totaled $1.0 million, or 0.48% of the outstanding balance as of September 30, 2005, and totaled $0.3 million, or 0.10% of the outstanding balance as of December 31, 2004. The following table summarizes the activity in reserves for credit losses for our HELOCs for the three and nine months ended September 30, 2005 and 2004.
HELOCs
                                 
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Balance at beginning of period
  $ 563     $ 267     $ 693     $  
Provision for credit losses
    510       264       380       531  
Charge-offs
    (35 )           (35 )      
                         
Balance at end of period
  $ 1,038     $ 531     $ 1,038     $ 531  
                         

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      We had no delinquent or impaired commercial real estate loans as of September 30, 2005 and December 31, 2004. The following table summarizes the activity in reserves for credit losses for our commercial real estate loans for the three and nine months ended September 30, 2005 and 2004.
Commercial Real Estate Loans
                                 
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Balance at beginning of period
  $     $ 500     $ 500     $ 500  
(Reversal of) credit losses
                (185 )      
Charge-offs
                (315 )      
                         
Balance at end of period
  $     $ 500     $     $ 500  
                         
NOTE 5. 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. 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.
      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). We currently have elected cash flow hedging treatment for certain interest rate agreements and treat other interest rate agreements as trading instruments.
      In a cash flow hedge, the effective portion of the change in the fair value of the hedging derivative is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings when the hedging relationship is terminated. The ineffective portion of the hedging derivative is recognized immediately in earnings.
      If we do not elect hedge accounting treatment (i.e., we designate the interest rate agreement as a “trading instrument”) changes in the market value of the interest rate agreement and all associated income and expenses are reported through earnings through net recognized gains and valuation adjustments.
      We report our interest rate agreements at fair value as determined using third-party models and confirmed by Wall Street dealers. As of September 30, 2005, the net fair value of our interest rate agreements was $25.1 million. As of December 31, 2004, the net fair value of interest rate agreements was $15.0 million. Our total unrealized gain included in accumulated other comprehensive income on interest rate agreements was $18.2 million at September 30, 2005 and $10.0 million at December 31, 2004.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      The following table shows the aggregate fair value of our interest rate agreements as of September 30, 2005 and December 31, 2004.
Interest Rate Agreements
                                                 
    September 30, 2005   December 31, 2004
         
    Fair   Notional   Credit   Fair   Notional   Credit
    Value   Amount   Exposure   Value   Amount   Exposure
(In thousands)                        
Trading Instruments
                                               
Interest rate caps purchased
  $ 1,529     $ 116,400           $ 1,861     $ 105,400     $  
Interest rate caps sold
    (81 )     (65,000 )           (440 )     (65,000 )      
Interest rate corridors purchased
          1,124,217             63       1,340,331        
Interest rate swaps
    229       57,400                          
Cash Flow Hedges
                                               
Interest rate swaps
    23,389       6,898,984             13,536       11,081,719       280  
                                     
Total Interest Rate Agreements
  $ 25,066     $ 8,132,001           $ 15,020     $ 12,462,450     $ 280  
                                     
      We incur 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, we may not receive the cash to which we would otherwise be entitled under the interest rate agreement. In order to mitigate this risk, we only enter 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 Treasury as a primary government dealer, ii) affiliates of primary government dealers, or iii) rated BBB or higher. Furthermore, we generally enter into interest rate agreements with several different counterparties in order to diversify our credit risk exposure.
      Certain of our interest rate agreements accounted for as cash flow hedges may be terminated prior to the completion of the forecasted transactions. In these cases, since the forecasted transaction is still likely to occur, the net gain or loss on the interest rate agreement remains in accumulated other comprehensive income, and will be reclassified from accumulated other comprehensive income to our Consolidated Statements of Income during the period the forecasted transaction occurs. Of the $18.2 million in accumulated other comprehensive income at September 30, 2005, $1.2 million was associated with cash flow hedges that were terminated and $0.5 million of this amount will be recognized as interest expense on our Consolidated Statements of Income in the next twelve months. In the case when the hedge is terminated and the forecasted transaction is not expected to occur, we would immediately recognize the gain or loss through our Consolidated Statements of Income; there were no such instances in the three and nine months ended September 30, 2005 and 2004.
      To the extent our interest rate agreements accounted as cash flow hedges are ineffective the net ineffective portion is recorded as an interest expense. We use the dollar-offset method to determine the amount of ineffectiveness recorded in the Consolidated Statements of Income. We anticipate having

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
some ineffectiveness in our hedging program, as not all terms of our hedges and not all terms of our hedged items match perfectly. For both the three and nine months ended September 30, 2005, the amount of ineffectiveness was $0.1 million. For the three and nine months ended September 30, 2004, the amount of such ineffectiveness was $0.3 million and $0.6 million of expense, respectively.
      The following table depicts the interest income (expense) and net recognized gains (losses) and valuation adjustments activity for the three and nine months ended September 30, 2005 and 2004 for our interest rate agreements.
Interest Rate Agreements
                                 
    Three Months    
    Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Realized net gains (losses) reclassified from other comprehensive income
  $ (109 )   $ 361     $ (307 )   $ (287 )
Realized net (losses) due to net ineffective portion of hedges
    (49 )     (269 )     (93 )     (632 )
Net cash receipt (payment) on Interest Rate Swaps
    782       (2,981 )     3,369       (12,910 )
                         
Total
  $ 624     $ (2,889 )   $ 2,969     $ (13,829 )
                         
Net Recognized Gains (Losses) and Valuation Adjustments
                                 
Realized net gains (losses) on trading instruments
  $ 107     $ 47     $ (567 )   $ (67 )
                         
      We will discontinue hedge accounting when (1) we determine that the derivative is no longer expected to be effective in offsetting changes in the fair value or cash flows of the designated hedged item; (2) the derivative expires or is sold, terminated, or exercised; (3) the derivative is de-designated as a fair value or cash flow hedge; or (4) it is probable that the forecasted transaction will not occur by the end of the originally specified time period.
NOTE 6. SHORT-TERM DEBT
      Redwood debt is currently all short-term debt. We generally enter into repurchase agreements, bank borrowings, and other forms of collateralized short-term borrowings (short-term debt) to finance assets under accumulation for future sale to securitization entities. We also have $60 million unsecuritized lines of credit available from two banks and have a commercial paper facility (discussed below). The table below summarizes Redwood debt by collateral type as of September 30, 2005 and December 31, 2004.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Redwood Debt
                                                 
    September 30, 2005   December 31, 2004
         
        Weighted   Weighted       Weighted   Weighted
        Average   Average       Average   Average
    Amount   Interest   Days Until   Amount   Interest   Days Until
    Borrowed   Rate   Maturity   Borrowed   Rate   Maturity
(In thousands)                        
Residential real estate loan collateral
  $                 $ 181,999       2.92 %     126  
Residential loan CES collateral
    2,410       4.27 %     75                    
Commercial real estate loan collateral
    14,247       5.32 %     75                    
Commercial loan CES collateral
                                   
Securities portfolio collateral
    145,082       4.28 %     75       21,282       4.05 %     69  
                                     
Total Redwood debt
  $ 161,739       4.37 %     75     $ 203,281       3.03 %     120  
                                     
      For the three and nine months ended September 30, 2005, the average balance of Redwood debt was $298 million and $264 million with a weighted-average interest cost of 5.16% and 4.24%, respectively. For the three and nine months ended September 30, 2004, the average balance of Redwood debt was $405 million and $464 million with a weighted average cost of 2.29% and 2.12%, respectively. At September 30, 2005 and December 31, 2004, accrued interest payable on Redwood debt was $0.1 million and $0.1 million, respectively.
      As of September 30, 2005 and December 31, 2004, Redwood debt had the following remaining maturities.
Redwood Debt
                 
    September 30,   December 31,
    2005   2004
(In thousands)        
Within 30 days
  $     $ 868  
31 to 90 days
    161,739       115,841  
Over 90 days
          86,572  
             
Total Redwood debt
  $ 161,739     $ 203,281  
             
      In March 2005, we formed Madrona Residential Funding, LLC (“Madrona”), a special purpose entity and wholly owned subsidiary of RWT Holdings. Madrona gives us the flexibility to access the capital markets and issue short-term debt instruments to finance the accumulation of loans prior to sale to sponsored securitization entities. Madrona is designed to fund residential loans accumulated for eventual sale to our Sequoia securitization program by issuing A1+/ P1 rated commercial paper. Madrona was established to accumulate up to $1.5 billion of loans (although the current authorization is for $300 million) and can warehouse each loan up to 270 days. There are specific eligibility requirements for financing loans in this facility that are similar to our existing financing facilities with several banks and large investment banking firms. There is a credit reserve account for approximately 70 basis points that will serve as credit-enhancement to the commercial paper investors. In addition, we issued $5.4 million of a BBB-rated Madrona ABS to provide further credit support. This facility has a three-year term. During the third quarter of 2005 Madrona issued commercial paper which was purchased by Redwood. As of September 30, 2005 there was no commercial paper issuance outstanding.
      We have uncommitted facilities available with several banks and major investment banking firms for financing residential and commercial real estate securities and loans. The table below summarizes the outstanding balances as of September 30, 2005 and December 31, 2004 by collateral type.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Redwood Debt
                                 
    September 30, 2005
     
    Number    
    of    
    Facilities   Outstanding   Limit   Maturity
(In thousands)                
Facilities by Collateral
                               
Real Estate Loans
    4     $     $ 1,800,000       10/05-9/06  
Real Estate Securities
    2       161,739       360,000       3/06-8/06  
Unsecured Line of Credit
    2             60,000       10/05-8/06  
Madrona Commercial Paper Facility
    1             300,000       4/08  
                         
Total Facilities
    9     $ 161,739     $ 2,520,000          
                         
                                 
    December 31, 2004
     
    Number    
    of    
    Facilities   Outstanding   Limit   Maturity
                 
Facilities by Collateral
                               
Real Estate Loans
    4     $ 181,999     $ 1,600,000       3/05-10/05  
Real Estate Securities
    3       21,282       410,000       3/05-8/05  
Unsecured Line of Credit
    0                   n/a  
Madrona Commercial Paper Facility
    0                   n/a  
                         
Total Facilities
    7     $ 203,281     $ 2,010,000          
                         
      Borrowings under these facilities generally bear interest based on a specified margin over the one-month LIBOR interest rate. We continue to be in compliance with all of our debt covenants for all of our borrowing arrangements and credit facilities. Covenants associated with our debt generally relate to our tangible net worth, liquidity reserves, and leverage requirements. We have not had, nor do we currently anticipate having, any problems in meeting these covenants. It is our intention to renew committed and uncommitted facilities as needed, as well as pursue additional facilities and other types of financing.
NOTE 7. ASSET-BACKED SECURITIES ISSUED
      Securitization entities sponsored by us issue ABS to raise the funds to acquire assets from us and others. Each series of asset ABS consists of various classes that pay interest at variable and fixed rates. The bulk of the ABS is indexed to one-, three- or six-month LIBOR. A lesser amount of the ABS are fixed for a term and then will adjust to a LIBOR rate (hybrid ABS) or are fixed for their entire term. Some of the ABS Interest-Only (IO) securities issued have a fixed spread, while others earn a coupon based on the spread between collateral owned by and the ABS issued by a securitized entity. The maturity of each class is directly affected by the rate of principal prepayments on the assets of the issuing entity. Each series is also subject to redemption (call) according to the specific terms of the respective governing documents. As a result, the actual maturity of any class of ABS is likely to occur earlier than its stated maturity.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      The components of ABS issued by consolidated securitization entities as of September 30, 2005 and December 31, 2004, along with other selected information, are summarized in the table below.
Asset-Backed Securities Issued
                   
    September 30, 2005   December 31, 2004
(In thousands)        
Sequoia ABS issued — certificates with principal value
    $15,901,546       $21,681,229  
Sequoia ABS issued — interest-only certificates
    163,332       210,385  
Acacia ABS issued
    2,138,200       1,691,592  
Commercial ABS issued
    4,250       9,523  
Madrona ABS issued
    5,400        
Unamortized premium on ABS
    25,064       37,433  
             
 
Total consolidated ABS issued
    $18,237,792       $23,630,162  
             
 
Range of weighted average interest rates, by series — Sequoia
    3.63% to 5.64%       2.22% to 5.54%  
 
Stated Sequoia maturities
    2007-2039       2007-2035  
 
Number of Sequoia series
    42       39  
 
Range of weighted average interest rates, by series — Acacia
    4.03%-4.72%       2.69%-3.35%  
 
Stated Acacia maturities
    2018-2045       2018-2040  
 
Number of Acacia series
    8       6  
 
Weighted average interest rates — Commercial
    12.00%       9.08%  
 
Stated commercial maturities
    2009       2005 and 2009  
 
Number of commercial series
    1       2  
      The following table summarizes the accrued interest payable on ABS issued as of September 30, 2005 and December 31, 2004.
Accrued Interest Payable on Asset-Backed Securities Issued
                 
    September 30,   December 31,
    2005   2004
(In thousands)        
Sequoia
  $ 28,207     $ 28,879  
Acacia
    13,279       6,025  
Commercial
    43       65  
             
Total accrued interest payable on ABS issued
  $ 41,529     $ 34,969  
             
      The ABS issued by securitization entities sponsored by us are collateralized by residential and commercial real estate loans and securities. The ABS collateralized by residential real estate loans (and some residential securities) are typically securitized through entities with the brand name Sequoia. Residential real estate loan collateral consists primarily of adjustable-rate and hybrid, conventional, 25-or 30-year residential real estate loans secured by first liens on one- to four-family residential properties. HELOC collateral consists of adjustable-rate first and second lien residential loans with a ten-year revolving period and a maturity from origination of ten years. The ABS issued that are collateralized by residential and commercial real estate securities and commercial real estate loans are typically issued

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
through entities with the brand name Acacia. Other ABS collateralized by commercial loans are issued on an individual basis. For financial reporting purposes the assets and liabilities of these entities are consolidated on our balance sheets.
      During the three and nine months ended September 30, 2005, Sequoia entities issued $0.3 billion and $1.5 billion, respectively, of Sequoia ABS to fund Sequoia’s acquisitions of residential real estate loans from us. During the three and nine months ended September 30, 2004, Sequoia entities issued $2.7 billion and $7.5 billion, respectively. During the three and nine months ended September 30, 2005, Sequoia did not issue any ABS secured by interest-only certificates that we had retained from prior Sequoia securitizations. During the three and nine months ended September 30, 2004, Sequoia entities issued $0 and $0.2 billion of ABS secured by interest-only securities we had retained, respectively.
      During both the three and nine months ended September 30, 2005 and 2004, Acacia entities issued $300 and $600 million of Acacia ABS, respectively.
      During the nine months ended September 30, 2005, we issued $4.3 million of commercial ABS, and paid off commercial ABS in full of $9.5 million. No commercial ABS issuances or payoffs occurred during the three months ended September 30, 2005 and during the three and nine months ended September 30, 2004.
      The carrying value components of the collateral for ABS issued and outstanding as of September 30, 2005 and December 31, 2004 are summarized in the table below:
Collateral for Asset-Backed Securities Issued
                 
    September 30,   December 31,
    2005   2004
(In thousands)        
Residential real estate loans
  $ 16,324,420     $ 22,014,922  
Residential home equity lines of credit
    215,010       296,348  
Residential loan CES
    326,328       210,902  
Commercial real estate loans
    34,704       22,360  
Securities portfolio securities
    1,548,828       1,265,322  
Real estate owned (REO)
    2,438        
Restricted cash owned by consolidated securitization entities
    56,696       35,740  
Accrued interest receivable
    75,580       65,951  
             
Total collateral for ABS issued
  $ 18,584,004     $ 23,911,545  
             
NOTE 8. TAXES
      As a REIT, Redwood can deduct dividends paid from REIT taxable income, and thus effectively reduce or eliminate corporate-level income taxes. However, a REIT can retain up to 10% of its REIT taxable income and still maintain its REIT status. We currently plan to retain up to 10% of our 2005 REIT ordinary taxable income and we will be subject to corporate level income taxes on this retained income for the 2005 calendar tax year.
      Our Federal tax provision for corporate income tax for the REIT for the three and nine months ended September 30, 2005 was $0.9 million and $3.4 million, respectively. The Federal provision was $1.2 million and $3.8 million for the three and nine months ended September 30, 2004, respectively. This Federal provision is estimated based on the amount of anticipated REIT ordinary income to be permanently retained for each year.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      Holdings, Redwood’s taxable subsidiary, is subject to corporate income taxes on its taxable income. Our current Federal tax provision for corporate income tax for Holdings for the three and nine months ended September 30, 2005, was $2.7 million and $3.7 million, respectively. Our current Federal tax provision for corporate income tax for Holdings for both the three and nine months ended September 30, 2004, was $4.8 million. Federal NOL’s were fully utilized during the year ended December 31, 2004.
      The Redwood and Holdings combined current unitary state provision for corporate income taxes for the three and nine months ended September 30, 2005 was $2.0 million and $3.5 million, respectively. The Redwood and Holdings current combined unitary state tax provision for the three and nine months ended September 30, 2004 was $2.9 million and $3.7 million, respectively. Holdings’ state NOL’s were $10.7 million at September 30, 2005 and December 31, 2004. These state NOLs will expire between 2005 and 2012 if not utilized.
      Holdings recorded a net deferred tax benefit for the three months ended September 30, 2005 of $0.9 million and a deferred tax provision of $2.9 million for the nine months ended September 30, 2005. Deferred tax provisions are attributable to securitization gain temporary differences between GAAP and tax accounting treatments and the utilization of prior period deferred tax assets. For the three and nine months ended September 30, 2004, Holdings recognized deferred tax benefits of $3.9 million and $9.1 million, respectively.
      As a result of current and deferred tax provisions, we recognized a total net tax provision of $4.7 million and $13.4 million for the three and nine months ended September 30, 2005, respectively. We recognized a total net tax provision of $5.0 million and $3.2 million for the three and nine months ended September 30, 2004, respectively.
      The following table summarizes the tax provisions for Redwood REIT and Holdings for the three and nine months ended September 30, 2005 and 2004.
Provision for Income Tax
                                   
    Three Months    
    Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Current Tax Provision:
                               
 
Redwood REIT — Federal
  $ 864     $ 1,167     $ 3,364     $ 3,791  
 
Holdings — Federal
    2,673       4,800       3,683       4,800  
 
State
    2,014       2,927       3,484       3,692  
                         
Total current tax provision
    5,551       8,894       10,531       12,283  
                         
Deferred tax provision/(benefit):
                               
Redwood REIT
                       
Holdings
    (858 )     (3,932 )     2,893       (9,112 )
                         
Total deferred tax (benefit) provision
    (858 )     (3,932 )     2,893       (9,112 )
                         
Total provision for income tax
  $ 4,693     $ 4,962     $ 13,424     $ 3,171  
                         

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      As of September 30, 2005 and December 31, 2004, Holdings had the following deferred tax asset and liability balances.
Deferred Tax Assets/(Liabilities)
                 
    September 30,   December 31,
    2005   2004
(In thousands)        
Net operating loss carry forward — Federal
  $     $  
Net operating loss carry forward — State
    763       721  
Real estate assets
    2,734       315  
Gains from Sequoia securitizations
    4,182       9,536  
             
Total deferred tax assets
  $ 7,679       10,572  
Valuation allowance
           
             
Total benefited deferred tax assets
  $ 7,679     $ 10,572  
             
Deferred tax liabilities
           
Net deferred tax assets
  $ 7,679     $ 10,572  
             
      Under the Internal Revenue Code, a dividend declared by a REIT in October, November, or December of a calendar year and payable to stockholders of record as of a specified date in such year will be deemed to have been paid by the REIT and received by the stockholders 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 REIT taxable income on the record date. Therefore, the regular dividends declared in the fourth quarter of 2004 that were paid in January 2005 are considered taxable income to stockholders in 2004 (the year declared).
      Similar to 2004, our 2005 dividend distributions declared before December 31, 2005 and distributed on or before January 31, 2006, are expected to be less than 85% of our estimated 2005 REIT taxable income. This will result in a 4% excise tax provision on the shortfall. Thus, for the three and nine months ended September 30, 2005, we provided for excise tax of $0.3 million and $0.9 million, respectively, which is reflected as a component of operating expenses on our Consolidated Statements of Income. For the three and nine months ended September 30, 2004, excise tax totaled $0.3 million and $0.8 million, respectively. As of September 30, 2005 and December 31, 2004, accrued excise tax payable was $0.9 million and $0.5 million, respectively, and was reflected as a component of accrued expenses and other liabilities on our Consolidated Balance Sheets.
NOTE 9. FAIR VALUE OF FINANCIAL INSTRUMENTS
      We estimate the fair value of our financial instruments using available market information and other appropriate valuation methodologies. These fair value estimates generally incorporate discounted future cash flows at current market discount rates for comparable investments. We validate our fair value estimates on a quarterly basis by obtaining fair value estimates from dealers who make a market in these financial instruments. We believe the estimates we use reasonably reflect the values we may be able to receive should we choose to sell them. Many factors must be considered in order to estimate market values, including, but not limited to interest rates, prepayment rates, amount and timing of credit losses, supply and demand, liquidity, and other market factors. Accordingly, our estimates are inherently subjective in nature and involve uncertainty and judgment to interpret relevant market and other data. Amounts realized in actual sales may differ from the fair values presented.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      The following table presents the carrying values and estimated fair values of our financial instruments as of September 30, 2005 and December 31, 2004.
Fair Value of Financial Instruments
                                   
    September 30, 2005   December 31, 2004
         
    Carrying       Carrying    
    Value   Fair Value   Value   Fair Value
(In thousands)                
Assets
Real Estate Loans
                               
 
Residential real estate loans: held-for-investment
  $ 16,341,180     $ 16,266,463     $ 22,206,395     $ 22,395,296  
 
Residential real estate loans: held-for-sale
  $     $  —     $ 2,022     $ 2,022  
 
HELOC: held-for-investment
  $ 215,137     $ 216,791     $ 296,348     $ 297,623  
 
Commercial real estate loans: held-for-investment
  $ 56,102     $ 57,327     $ 54,479     $ 55,258  
Real Estate Loan Securities
                               
 
Residential loan credit-enhancement securities:
                               
 
available-for-sale
  $ 664,801     $ 664,801     $ 561,658     $ 561,658  
 
Commercial loan credit-enhancement securities, available-for-sale
  $ 43,540     $ 43,540     $ 14,498     $ 14,498  
 
Securities portfolio: available-for-sale
  $ 1,783,429     $ 1,783,429     $ 1,380,077     $ 1,380,077  
Interest Rate Agreements
  $ 25,066     $ 25,066     $ 15,020     $ 15,020  
Cash and Cash Equivalents
  $ 163,160     $ 163,160     $ 57,246     $ 57,246  
Restricted Cash
  $ 58,796     $ 58,796     $ 36,038     $ 36,038  
 
Liabilities
Redwood debt
  $ 161,739     $ 161,739     $ 203,281     $ 203,281  
ABS issued
  $ 18,237,792     $ 18,233,496     $ 23,630,162     $ 23,701,977  
      Methodologies we use to estimate fair market values for various asset types are described below.
  •  Real estate loans
  •  Residential and HELOC loans fair values are determined by available market quotes and discounted cash flow analyses and are confirmed by third party/dealer pricing indications.
 
  •  Commercial loans fair values are determined by appraisals on underlying collateral and discounted cash flow analyses.
  •  Real estate securities
  •  Residential credit enhancement portfolio and securities portfolio fair values are determined by discounted cash flow analyses and other valuation techniques using market pricing assumptions confirmed by third party dealer pricing indications.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
  •  Interest rate agreements
  •  Fair values on interest rate agreements are determined by third party vendor modeling software and from valuations provided by dealers active in the derivatives markets.
  •  Cash and cash equivalents
  •  Includes cash on hand and highly liquid investments with original maturities of three months or less. Fair values equal carrying values.
  •  Restricted cash
  •  Includes interest earning cash balances in ABS entities for the purpose of distribution to bondholders and reinvestment. Due to the short-term nature of the restrictions, fair values equal carrying values.
  •  Redwood debt
  •  All Redwood debt is adjustable and matures within one year; fair values equal face values.
  •  Asset-backed securities issued
  •  Fair values are determined by discounted cash flow analyses and other valuations techniques confirmed by third party dealer pricing indications.
NOTE 10. STOCKHOLDERS’ EQUITY
Stock Option Plan
      In March 2004, we amended the previously approved 2002 Redwood Trust, Inc. Incentive Stock Plan (the Plan) for executive officers, employees, and non-employee directors. This amendment was approved by our stockholders in May 2004. The Plan authorizes our Board of Directors (or a committee appointed by our 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 eligible recipients other than non-employee directors. ISOs and NQSOs awarded to employees have a maximum term of ten-years and generally vest ratably over a four-year period. NQSOs awarded to non-employee directors have a maximum term of ten years and generally vest immediately or ratably over a three- or four-year period. Non-employee directors are automatically provided annual awards under the Plan. The Plan has been designed to permit the Compensation Committee of our Board of Directors to grant and certify awards that qualify as performance-based and otherwise satisfy the requirements of Section 162(m) of the Code; however, not all awards may so qualify. As of September 30, 2005 and December 31, 2004, 453,053 and 614,608 shares of common stock, respectively, were available for grant.
ISOs
      Of the total shares of common stock available for grant, no more than 963,637 shares of common stock are cumulatively available for grant as ISOs. As of September 30, 2005 and December 31, 2004, 551,697 ISOs had been granted. 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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
DERs
      Redwood has granted stock options that accrue and pay stock or cash DERs. Stock DERs represent shares of stock that are issuable when the holders exercise the underlying stock options, the amount of which is based on prior dividends paid per share on common stock and the market value of the stock on the various dividend payable dates. All stock options with stock DERs issued before January 1, 2003 are considered variable stock awards under the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25). As of September 30, 2005, 5,411 options remained that are considered variable stock awards. For the three and nine months ended September 30, 2005, we recognized variable stock option income of $16,000 and $98,000, respectively, on these stock options. For the three and nine months ended September 30, 2004, we recognized variable stock option expense of $0.2 million and $1.0 million, respectively on these stock options. In addition, we expense the stock DERs on these options. Options granted since January 1, 2003 that provide for stock DERs are accounted for under the provision of FAS 123 and are not considered variable stock options. Cash DERs per applicable option are cash payments made that are equal to the dividends paid in common stock per share. For options granted prior to January 1, 2003 that provide for cash DERs, we expense the cash DER’s on these options. Stock options granted since January 1, 2003 that provide for cash DERs are accounted for when the provisions of FAS 123; thus, there are no DER expenses associated with these options as future DER’s were included in the valuation of the stock options at the grant date. These expenses are included in operating expenses in our Consolidated Statements of Income. Options with cash DERs are participating securities under EITF 03-6 and were determined to be antidilutive in all reported periods. For the three and nine months ended September 30, 2005, we accrued cash and stock DER expenses of $2.0 million and $5.6 million, respectively. For the three and nine months ended September 30, 2004, we accrued cash and stock DER expenses of $2.0 million and $7.5 million, respectively.
      As of September 30, 2005 and December 31, 2004, there were 389,787 and 387,404 unexercised options with stock DERs, respectively. As of September 30, 2005 and December 31, 2004, there were 1,155,715 and 1,176,010 unexercised options with cash DERs, respectively. As of September 30, 2005 and December 31, 2004, there were 57,622 and 61,050 unexercised options with no DERs, respectively.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      A summary of the status of the Plan and changes during the three and nine months ended September 30, 2005 and 2004 are presented below.
                                     
    Three Months Ended September 30,
     
    2005   2004
         
        Weighted Average       Weighted Average
    Shares   Exercise Price   Shares   Exercise Price
                 
Stock Options Outstanding
                               
Outstanding options at beginning of period
    1,602,040     $ 31.71       1,656,998     $ 28.71  
   
Options granted
                3,000       54.87  
   
Options exercised
    (3,525 )     36.86       (128,473 )     14.00  
   
Options forfeited
    (494 )     31.84       (6,370 )     39.72  
 
Stock dividend equivalent rights earned
    5,103             3,792        
                         
 
Outstanding options at end of period
    1,603,124     $ 31.59       1,528,947     $ 29.88  
                         
Options exercisable at period-end
    1,197,548     $ 27.40       1,064,329     $ 25.90  
Weighted average fair value of options granted during the period
                $ 54.87          
                                     
    Nine Months Ended September 30,
     
    2005   2004
         
        Weighted Average       Weighted Average
    Shares   Exercise Price   Shares   Exercise Price
                 
Stock Options Activity
                               
Outstanding options at beginning of period
    1,624,465     $ 31.77       1,935,599     $ 26.48  
   
Options granted
    3,601       51.70       49,698       55.00  
   
Options exercised
    (26,070 )     21.33       (455,556 )     17.00  
   
Options forfeited
    (13,853 )     43.22       (16,054 )     34.76  
 
Stock dividend equivalent rights earned
    14,981             15,260        
                         
 
Outstanding options at end of period
    1,603,124     $ 31.59       1,528,947     $ 29.88  
                         
Options exercisable at period-end
    1,197,548     $ 27.40       1,064,329     $ 25.90  
Weighted average fair value of options granted during the period
  $ 51.70             $ 55.00          

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      The following table summarizes information about stock options outstanding at September 30, 2005.
Stock Options Exercise Prices As of September 30,2005
                                             
    Options Outstanding   Options Exercisable
         
Range of       Weighted-Average        
Exercise   Number   Remaining   Weighted-Average   Number   Weighted-Average
Prices   Outstanding   Contractual Life   Exercise Price   Exercisable   Exercise Price
                     
  $ 0 to $10       49,180       7.98     $       18,635     $  
  $10 to $20       355,846       3.93       12.74       355,846       12.74  
  $20 to $30       462,269       5.14       24.28       364,310       23.64  
  $30 to $40       267,060       1.66       37.47       259,427       37.50  
  $40 to $50       98,247       2.96       45.49       97,185       45.52  
  $50 to $60       369,721       8.40       55.08       101,344       53.98  
  $60 to $63       801       6.87       62.54       801       62.54  
                                 
  $ 0 to $63       1,603,124                       1,197,548          
                                 
Restricted Stock
      As of September 30, 2005 and December 31, 2004, 3,299 and 5,912 shares, respectively, of restricted stock were outstanding. For the three and nine months ended September 30, 2005 and 2004, we did not grant any shares of restricted stock to employees. No restrictions lapsed during the three months ended September 30, 2005. During the nine months ended September 30, 2005, restrictions on 1,750 of these shares lapsed. During the three and nine months ended September 30, 2004, restrictions on 1,750 and 5,250 of these shares lapsed, respectively. Restrictions on the remaining shares of outstanding restricted stock lapse through January 1, 2009.
Restricted Stock Outstanding
                                 
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
                 
Restricted stock outstanding at the beginning of period
    3,616       6,324       5,912       10,003  
Restricted stock granted
                       
Stock for which restrictions lapsed
          (1,750 )     (1,750 )     (5,250 )
Restricted stock forfeited
    (317 )           (863 )     (179 )
                         
Restricted stock outstanding at end of period
    3,299       4,574       3,299       4,574  
                         

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Deferred Stock Units
      The Incentive Stock Plan allows for the granting of Deferred Stock Units (DSUs). These are discussed below under Executive Deferred Compensation Plan.
Executive Deferred Compensation Plan
      In May 2002, our Board of Directors approved the 2002 Redwood Trust, Inc. Executive Deferred Compensation Plan (EDCP). The EDCP allows eligible employees and directors to defer portions of current salary and certain other forms of compensation. Redwood may match some deferrals up to certain levels. Compensation deferred under the EDCP are assets of Redwood and subject to the claims of the general creditors of Redwood. For the three and nine months ended September 30, 2005, deferrals of $0.1 million and $0.8 million, respectively, were made under the EDCP. For the three and nine months ended September 30, 2004, deferrals of $0.2 million and $0.8 million were made, respectively. The EDCP allows for the investment of deferrals in either an interest crediting account or deferred stock units. The rate of accrual in the interest crediting account is set forth in the EDCP. For deferrals prior to July 1, 2004, the accrual rate is based on a calculation of the marginal rate of return on our portfolio of earning assets. This accrual rate will continue for these deferred amounts through July 1, 2007 and then will be based on references to publicly traded mutual funds or the applicable federal rate (AFR). For deferrals after July 1, 2004, the accrual rate is based on references to publicly traded mutual funds or the AFR. For the three and nine months ended September 30, 2005, accrued interest of $0.3 million and $1.0 million was credited to participants under the Plan, respectively. For the three and nine months ended September 30, 2004, accrued interest credited totaled $0.2 million and $0.8 million, respectively. Withdrawals of $0 and $0.2 million were made during the three and nine months ended September 30, 2005, respectively. Withdrawals of $13,000 were made during the three and nine months ended September 30, 2004.
      The following table provides detail on changes in participants’ accounts in the EDCP for the three and nine months ended September 30, 2005 and 2004.
EDCP Activity
                                 
    Three Months    
    Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Cash Accounts Transfer in of participants’ payroll deductions from the EDCP
  $ 83     $ 159     $ 786     $ 833  
Accrued interest earned in EDCP
    265       221       959       778  
Participant withdrawals
          (13 )     (225 )     (13 )
                         
Net change in participants’ equity
  $ 348     $ 367     $ 1,520     $ 1,598  
                         
Balance at beginning of period
  $ 6,100     $ 3,865     $ 4,928     $ 2,634  
Balance at end of period
  $ 6,448     $ 4,232     $ 6,448     $ 4,232  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      The following table provides detail on the financial position of the EDCP at September 30, 2005 and December 31, 2004.
Net Assets Available for EDCP Participant Benefits
                 
    September 30,   December 31,
    2005   2004
(In thousands)        
Cash Accounts
               
Participants’ payroll deductions receivable
  $ 3,877     $ 3,286  
Accrued interest receivable
    2,571       1,642  
             
Net assets available for participant benefits
  $ 6,448     $ 4,928  
             
Deferred Stock Units
      For the three and nine months ended September 30, 2005, 10,000 and 44,564 Deferred Stock Units (DSUs), respectively, were granted through deferrals under the Plan, which represented a value of $0.5 million and $2.4 million at the time of the grants, respectively. Forfeitures totaled $0.1 million during the nine months ended September 30, 2005. There were no forfeitures during the three months ended September 30, 2005. No such grants were awarded or forfeitures occurred during the three and nine months ended September 30, 2004. The tables below provide summaries of the balance and activities of the DSU’s in the EDCP.
Deferred Stock Units
                 
    September 30,   December 31,
    2005   2004
(In thousands)        
Value of DSUs at Grant
  $ 7,031     $ 4,656  
Participant forfeitures
    (110 )      
Change in Value at Period End since Grant
    (367 )     1,066  
             
Value of DSUs at Period End
  $ 6,554     $ 5,722  
             
Deferred Stock Units Activity
                                 
    Three Months Ended September 30,
     
    2005   2004
         
    Units   Value   Units   Value
(In thousands, except unit amounts)                
Balance at Beginning of Period
    124,836     $ 6,442       25,417     $ 1,415  
Transfer in of DSUs (value of grants)
    10,000       508              
Change in Valuation during Period
          (396 )           172  
Participant forfeitures
                       
                         
                         
Net Change in Number/ Value of DSUs
    10,000       112             172  
                         
Balance at End of Period
    134,836     $ 6,554       25,417     $ 1,587  
                         

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Deferred Stock Units Activity
                                 
    Nine Months Ended September 30,
     
    2005   2004
         
    Units   Value   Units   Value
(In thousands, except unit amounts)                
Balance at Beginning of Period
    92,161     $ 5,722       25,417     $ 1,292  
Transfer in of DSUs (value of grants)
    44,564       2,375              
Change in Valuation during Period
          (1,433 )           295  
Participant forfeitures
    (1,889 )     (110 )            
                         
Net Change in Number/ Value of DSUs
    42,675       832             295  
                         
Balance at End of Period
    134,836     $ 6,554       25,417     $ 1,587  
                         
Employee Stock Purchase Plan
      In May 2002, our stockholders approved the 2002 Redwood Trust, Inc. Employee Stock Purchase Plan (ESPP), effective July 1, 2002. The purpose of the ESPP is to give our employees an opportunity to acquire an equity interest in Redwood through the purchase of shares of common stock at a discount. The ESPP allows eligible employees to have up to 15% of their annual gross compensation (including base salary, bonus, and cash DERs, and subject to certain other limitations) withheld to purchase common stock at 85% of its market value. The maximum gross compensation any participant can contribute to the ESPP in any calendar quarter is $6,250. Market value as defined under the ESPP is the lesser of the closing market price of the common stock as of the start of an offering period in the ESPP or the closing market price on the quarterly purchase date. The offering period starts on January 1st of each calendar year and consists of four quarterly purchase periods.
      The ESPP allows a maximum of 100,000 shares of common stock to be purchased. As of September 30, 2005, 22,083 shares have been purchased. For the three and nine months ended September 30, 2005, employees acquired an aggregate of 1,539 and 4,040 shares of common stock, respectively, at an average purchase price of $41.32 and $42.77 per share, respectively. For the three and nine months ended September 30, 2004, employees acquired an aggregate of 1,243 and 3,644, shares, at an average price of $43.53 and $43.36 per share, respectively. As of September 30, 2005 and December 31, 2004, there remained a negligible amount of uninvested employee contributions in the ESPP.
Employee Stock Purchase Plan (ESPP)
                                 
    Three Months   Nine Months
    Ended   Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Balance at beginning of period
  $ 6     $ 2     $ 3     $ 1  
Transfer in of participants’ payroll deductions from the ESPP
    68       54       179       158  
Cost of common stock issued to participants under the terms of the ESPP
    (64 )     (54 )     (172 )     (157 )
                         
Net change in participants’ equity
    4       0       7       1  
Balance at end of period
  $ 10     $ 2     $ 10     $ 2  
                         

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Common Stock Repurchases
      Our Board of Directors has approved the repurchase of a total of 7,455,000 shares of our common stock. A total of 6,455,000 shares were repurchased in 1998 and 1999. As of September 30, 2005 and December 31, 2004, there remained 1,000,000 shares available under the authorization for repurchase. Repurchased shares have been returned to the status of authorized but unissued shares of common stock.
Direct Stock Purchase and Dividend Reinvestment Plan
      For the three and nine months ended September 30, 2005, we issued 112,694 and 582,250 shares of common stock, respectively, through our Direct Stock Purchase and Dividend Reinvestment Plan for net proceeds of $5.7 million and $31.3 million, respectively. For the three and nine months ended September 30, 2004, we issued 601,750 and 1,545,840 shares for total proceeds of $33.7 million and $81.5 million, respectively.
Equity Offerings
      For the three and nine months ended September 30, 2005, we did not undertake any secondary equity offerings. For the three months ended September 30, 2004, we completed one secondary equity offering and issued 1.2 million shares for net proceeds of $65 million. For the nine months ended September 30, 2004, we completed two secondary equity offerings and issued 2.4 million shares for net proceeds of $117 million.
Accumulated Other Comprehensive Income
      Certain assets are marked to market through accumulated other comprehensive income on our Consolidated Balance Sheets; these adjustments affect our book value but not our net income. As of September 30, 2005 and December 31, 2004, we reported net accumulated other comprehensive income of $117.0 million and $105.4 million, respectively. Changes in this account reflect increases or decreases in the fair value of our earning assets or interest rate agreements during the period, and also reflect changes due to calls of our securities, write downs to fair value of a portion of our securities, premium or discount amortization of our securities, and amortization of realized gains or losses on our interest rate agreements.
      The following table provides reconciliation of accumulated other comprehensive income as of September 30, 2005 and December 31, 2004.
Accumulated Other Comprehensive Income
                   
    September 30,   December 31,
    2005   2004
(In thousands)        
Net unrealized gains on available-for-sale securities:
               
 
Residential loan CES
  $ 84,279     $ 78,733  
 
Commercial loan CES
    2,413       1,615  
 
Securities portfolio
    12,182       15,048  
             
 
Total available-for-sale securities
  $ 98,874     $ 95,396  
Net unrealized gains (losses) on interest rate agreements:
               
 
Interest rate agreements accounted for as cash flow hedges
    18,169       9,961  
             
 
Total accumulated other comprehensive income
  $ 117,043     $ 105,357  
             

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
NOTE 11. COMMITMENTS AND CONTINGENCIES
      As of September 30, 2005, we were obligated under non-cancelable operating leases with expiration dates through 2013 for $6.2 million. The majority of the future lease payments are related to the operating lease for our executive offices to which we relocated in 2003 and signed a ten year lease. Also included in the future lease commitments below are future lease payments through May 2006 for our former executive offices in Mill Valley that we vacated in 2003. Remaining payments related to this lease are $0.1 million in 2005 and $0.2 million in 2006. This office space is currently being subleased through May 2006. The anticipated sublease payments are not included in the table below.
Future Lease Commitments By Year
         
    September 30,
    2005
(In thousands)    
2005 (fourth quarter)
  $ 371  
2006
    996  
2007
    695  
2008
    702  
2009
    718  
2010 and thereafter
    2,705  
       
Total
  $ 6,187  
       
      As of September 30, 2005, there were no pending legal proceedings to which we were a party or to which any of our property was subject.
      The table below shows our commitments to purchase loans and securities as of September 30, 2005. The loan purchase commitments represent derivative instruments under FAS No. 149 amendment of Statement 133 on Derivative Instruments and Hedging Activities (FAS No. 149). The fair value of these commitments was negligible as of September 30, 2005.
Commitments to Purchase
         
    September 30,
    2005
(In thousands)    
Residential real estate loans
  $ 1,076  
Residential loan CES
     
Securities portfolio securities
    3,355  
       
Total
  $ 4,431  
       
NOTE 12. RECENT DEVELOPMENTS
      This Note provides information on activity during the fourth quarter of 2005, through November 3, 2005.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
      In the fourth quarter through November 3, we committed to sell $77 million market value residential CES for anticipated GAAP gains of $9 million and estimated taxable gains of $5 million. These were all second-loss securities, primarily rated single-B.
      During October 2005, residential CES with a principal value of $7 million were called, generating estimated gains of $3 million for GAAP purposes and $2 million for tax purposes.
      In the fourth quarter through November 3, 2005, we committed to acquire $7 million residential CES and $4 million commercial CES. We also committed to buy $29 million residential real estate securities, $16 million residential real estate loans, $21 million commercial real estate securities, and $4 million commercial real estate loans as inventory assets for future securitization.
      In October, prepayment rates for loans underlying our residential CES and interest-only securities remained at or near third quarter speeds.
      To recycle and redeploy capital, during the fourth quarter we exercised our option to call the Acacia 1 CDO transaction that we sponsored in 2002. We plan to sell or re-securitize the Acacia 1 collateral.

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
CAUTIONARY STATEMENT
      This Form 10-Q contains forward-looking statements within the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Statements that are not historical in nature, including the words “anticipated,” “estimated,” “should,” “expect,” “believe,” “intend,” and similar expressions, are intended to identify forward-looking statements. These forward-looking statements are subject to risks and uncertainties, including, among other things, those described in our Annual Report on Form 10-K for the year ended December 31, 2004 under the caption “Risk Factors.” 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 (SEC), including Forms 10-K and 8-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 mentioned, discussed in, or incorporated by reference into this Form 10-Q might not occur. Accordingly, our actual results may differ from our current expectations, estimates, and projections.
      Important factors that may impact our actual results include changes in interest rates and market values; changes in prepayment rates; general economic conditions, particularly as they affect the price of earning assets and the credit status of borrowers; the level of liquidity in the capital markets as it affects our ability to finance our real estate asset portfolio; and other factors not presently identified. This Form 10-Q contains statistics and other data that in some cases have been obtained from, or compiled from information made available by, servicers and other third-party service providers.
SUMMARY AND OUTLOOK
Summary
      Redwood Trust, Inc. is a financial institution located in Mill Valley, California. We invest in, credit-enhance, and securitize residential and commercial real estate loans and securities.
      Our primary source of revenue is interest income from the real estate securities we own. This interest income consists of the monthly loan payments made by homeowners (and to a lesser degree, commercial property owners) on the real estate loans that underlie these securities. In addition, from time to time we earn call income (a form of gain-on-sale income) from residential credit-enhancement securities (CES) and realize gains or losses from the sale of assets.
      The residential real estate loan portfolio consolidated on Redwood’s balance sheet includes all of the residential loans that we own temporarily prior to sale to a securitization plus loans that are consolidated onto our balance sheet from ABS securitization entities that have been sponsored by us. Securitizations by sponsored entities are structured for Redwood’s Consolidated Balance Sheets as financings under Generally Accepted Accounting Principles (GAAP) and are not accounted for as sales for GAAP reporting purposes — the underlying assets and liabilities are consolidated on Redwood’s balance sheets and associated income and expense are consolidated in Redwood’s income statements. The consolidated residential real estate loan portfolio generally consists of “prime” quality residential loans that generally have high-quality characteristics such as relatively low loan-to-value ratios and borrowers with relatively high credit scores (in each case relative to U.S. residential real estate loans as a whole). The majority of these loans are jumbo loans that had loan balances at origination that exceeded the loan limits imposed on Fannie Mae and Freddie Mac, so they were not eligible at origination for purchase or credit-enhancement by these government-sponsored enterprises.
      Better than expected credit results on the loans we credit enhance has been the primary driver of our continued strong earnings results. Housing prices continue to increase, which reduces our risk of

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credit loss in the future for our existing assets. Our portfolio of assets as a whole has the ability to generate attractive earnings, cash flows, and dividends in the future, assuming real estate credit losses do not increase materially. Delinquencies on loans in our portfolio remain at historically low levels and credit losses continue to be less than one basis point (0.01%) of our credit-enhanced loans on an annual basis.
      Recent changes in interest rates have resulted in a flatter yield curve, causing faster prepayments for adjustable-rate residential loans and a reduced supply of new adjustable-rate loan originations (as homeowners are opting for hybrid-rate and fixed-rate loans). In addition, new forms of adjustable-rate mortgages (negative amortization, “option ARMs”, and Moving Treasury Average ARMs) have increased their share of the ARM market, and have increased prepayment rates on the ARM loans we credit-enhance due to ARM-to-ARM refinancing and other factors. These faster prepayment patterns affect both the residential ARM loans securitized via the Sequoia program and our portfolio of securities backed by ARM loans purchased from other securitization entities not sponsored by us. Overall, we believe we benefit over time from faster prepayment rates on our net ARM loans and securities.
      Faster prepayments for the residential ARM loans consolidated from Sequoia entities have adversely affected our near-term results of operations. Prepayment rates for these loans averaged 17% conditional prepayment rate (CPR) in 2004, 25% CPR in the first quarter of 2005, 39% CPR in the second quarter of 2005, 51% CPR in the third quarter of 2005, and 49% CPR in October 2005. Our net effective premium for GAAP purposes for the $16 billion of loans consolidated on our Consolidated Balance Sheets from Sequoia securitization entities (including HELOCs) was $22 million at September 30, 2005. Our effective net price for these Sequoia ARM loans for GAAP purposes was 100.13% of principal value, and consists of unamortized purchase premium ($191 million) and deferred ABS issuance costs ($41 million) offset by premiums received from the sale of ABS at a premium ($25 million), premium received from the sale of interest-only ABS ($163 million), and credit reserves ($22 million). Although our effective net premium for GAAP purposes for these loans is low, changes in prepayment rates on these loans can create volatility in our quarterly GAAP net income results because GAAP treatment is not necessarily parallel for the amortization of these largely offsetting premium and discount balances. In addition to increasing premium amortization expenses, the faster Sequoia ARM prepayment rates reduce our overall investment in our older, more profitable Sequoia transactions, thus lowering our overall earnings.
      Our net effective discount on all consolidated residential and commercial real estate loans and securities (ARM, fixed, and hybrid) is $590 million, or $24 per share outstanding at September 30, 2005. The net effective discount on commercial real estate assets is $140 million ($6 per share). The net effective discount on residential real estate assets is $450 million ($18 per share outstanding at September 30, 2005). The net effective commercial and residential discount consists of purchase premiums ($255 million) and deferred ABS issuance costs ($56 million), less purchase discounts currently being amortized into income ($161 million), purchase discounts not currently being amortized into income because it is designated as credit reserve ($552 million), premiums received from the sale of ABS at a premium ($25 million), and premiums received from the sale of interest-only ABS ($163 million). We will realize this $590 million net discount as income over time to the extent it is not diminished by credit losses. In addition to the cash net interest income we earn, the realization of this discount as income over the next 5 to 7 years could (in the absence of an increase in credit losses) result in attractive earnings and dividends for stockholders. With faster prepayments we will realize this income more quickly.
      During the third quarter of 2005, we sold a portion of our residential loan CES and we have completed the sale of additional securities in the fourth quarter of 2005. These sales were completed primarily as a means to increase our cash balances now so we will be prepared to capitalize on future investment opportunities, which we think may improve over the next few years if real estate or capital markets come under stress. As a result of these sales, we anticipate ending this year with reduced credit risks, an even stronger balance sheet, and significant levels of excess capital (uninvested cash).

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Thus, our on-going earnings will likely be reduced (relative to what they would have been otherwise) during the period this cash remains uninvested.
      Our commercial real estate and CDO businesses continue to develop, diversifying our opportunities for growth as well as diversifying our risks.
      In our view, the long-term outlook for our business is good. We believe our existing assets can generate attractive returns and special dividends for stockholders over the next few years if credit losses remain at current low levels. If the environment becomes more difficult, we believe we are well prepared with a strong balance sheet and cash to invest. We will maintain our disciplined investment process, and we will continue to acquire only those assets that we believe will generate attractive long-term cash flows for the benefit of our stockholders.
      Our GAAP earnings totaled $56 million ($2.21 per share) for the third quarter of 2005, a decrease from the $72 million ($3.18 per share) we earned for the third quarter of 2004. Our earnings totaled $157 million ($6.26 per share) for the first nine months of 2005 and $178 million ($8.29 per share) for the first nine months of 2004. Our earnings are still at a level that we consider attractive. Our GAAP return on equity was 22% for both the third quarter and the first nine months of 2005.
      Our results for the third quarter of 2005 were not as strong as the extraordinary results we achieved during the third quarter of 2004. Lower earnings resulted from a lower yield on our portfolio of residential credit-enhancement securities (the older, higher-yielding securities have prepaid, been called, or sold), a reduction in net interest income from consolidated residential loans and matched ABS issued due in part to increased ARM prepayment rates, and high levels of uninvested cash. These factors were partially offset by an increase in income realized as the result of calls and sales.
      Premium amortization expense on our consolidated residential whole loans was $15.6 million greater during the third quarter of 2005 than in the third quarter of 2004 as a result of faster prepayments and a one-time cumulative adjustment of $4.1 million to premium amortization expense which effectively increased our reported earnings in the third quarter of 2004.
      For loans acquired prior to July 1, 2004, when amortizing the purchase premiums under Financial Accounting Statement No. 91 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 or discount on loans assuming changes in interest rates. As a result, during periods of rising short-term rates our effective yields on these loans increase, and the amount of premium we amortize in the period prior to the coupon rate readjustments is generally lower than it will be in later periods for each pool of loans. For loans acquired after July 1, 2004, we determine an effective yield under FAS 91 using the initial coupon interest rate of the loans (without regard to future changes in the interest rates and underlying indices) as well as anticipated prepayment rates. For these residential loans, higher coupon interest rates will increase net realized yields when the coupon readjusts. Periodic premium amortization expenses will not be reduced as a result of coupon interest rate increases. For these loans, as a result, premium amortization expenses will be higher (relative to the older loans) in a period of rising interest rates.
      In the third quarter of 2004 we made a one-time adjustment of $4.1 million to premium amortization expense as a result of some technical errors discovered with respect to the application of FAS 91. This adjustment was not deemed material. It did, however, increase our earnings for that period, and in contrast to comparisons with results for the third quarter of 2005.
      Redwood has elected to be taxed as a REIT. As such, we are not required to pay corporate income taxes on the REIT taxable income that we distribute to stockholders as dividends. We are required to distribute to stockholders as dividends at least 90% of the REIT taxable income (our taxable income excluding income earned in non-REIT taxable subsidiaries) that we earn. Through September 30, 2005, we continued to satisfy our dividend distribution requirements as a REIT. Our regular quarterly dividend during the first three quarters of 2005 was $0.70 per share.

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      Estimated total taxable income, estimated core taxable income, and estimated REIT taxable income are not GAAP performance measures but are important measures as they are the basis of our required minimum dividend distributions to stockholders. A reconciliation of these measures to the most comparable GAAP measure appears in Table 18 below. Our GAAP income is reduced by credit provision expenses provided for credit losses while taxable income is reduced by credit losses only when they are realized. Additionally, unrealized market price valuation adjustments for GAAP purposes are generally not included in taxable income, and certain compensation-related items are treated differently for GAAP and tax purposes (both in terms of timing and also total expenses over time). Most of the securitizations we sponsor are treated as sales of assets for tax purposes but are treated as a financing for GAAP purposes. Securitizations we sponsor generally create a realized gain or loss for tax purposes (generally a component of the taxable income we earn in our taxable subsidiaries) but no such gain or loss for GAAP purposes. Essentially, when we recognize gains on securitizations that we sponsor, we accelerate for tax purposes income that we will recognize for GAAP purposes over time in the form of the net interest income from residential real estate loans and associated ABS issued.
      For the third quarter of 2005, we earned an estimated $55 million ($2.23 per share) total taxable income (pre-tax income as calculated for tax purposes), of which an estimated $47 million ($1.91 per share) was real estate investment trust (REIT) taxable income. For the third quarter of 2004, we earned an estimated $59 million ($2.53 per share) of total taxable income, of which an estimated $49 million ($2.10 per share) was REIT taxable income.
      For the nine months ending September 30, 2005, we earned an estimated $142 million ($5.78 per share) total taxable income, of which an estimated $132 million ($5.34 per share) was REIT taxable income. For the nine months ended September 30, 2004, we earned an estimated $182 million total taxable income ($8.45 per share), of which $152 million ($7.05 per share) was REIT taxable income.
      Taxable income before calls, sales, and deductions for stock options (estimated core taxable income) was $41 million ($1.66 per share) and $33 million ($1.41 per share) for the three months ended September 30, 2005 and 2004, respectively. Estimated core taxable income was $105 million ($4.27 per share) and $122 million ($5.73 per share) for the nine months ended September 30, 2005 and 2004, respectively.
      We currently project that the first three regular quarterly dividends we declared in 2005 consisted of REIT taxable income earned in 2004 ($37 million) plus a portion of REIT taxable income earned in 2005 ($15 million). Based on our estimates of REIT taxable income during the first nine months of 2005, we entered the fourth quarter of 2005 with $107 million of undistributed 2005 REIT taxable income ($4.31 per share outstanding at September 30, 2005). Assuming we follow our past practice with respect to declaring a special dividend (and it is our current plan to do so), the amount of REIT taxable income potentially available for a year-end 2005 special dividend would equal:
        (a) 90% of 2005 ordinary REIT income ($3.65 per share outstanding as of September 30, 2005 that has been earned plus any fourth quarter ordinary REIT taxable income), plus
 
        (b) 100% of capital gains REIT income ($0.66 per share outstanding as of September 30, 2005 that has been earned plus any fourth quarter capital gains REIT income), less
 
        (c) the fourth quarter 2005 regular dividend, less
 
        (d) 2 to 3 quarters of regular dividends deferred into 2006, and
 
        (e) as adjusted for any stock issuance during the fourth quarter.
      Income from call and sales activity is long-term capital gain income for tax purposes. Our tax-paying stockholders may benefit to the degree they can take advantage of the lower tax rate on our distributions of capital gains versus ordinary income. We provide information annually on the tax characteristics of our dividends and this information is also posted on our website at www.redwoodtrust.com.
      We currently face, and expect to continue to face, increased competition, higher acquisition pricing, and a reduced supply of high-quality residential credit-enhancement acquisition and loan securitization opportunities. There are fewer high-quality fixed rate, hybrid rate, and ARM securitizations as the

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quantity of new originations of quality jumbo loans has decreased and as banks and other financial institutions have increased their purchases of residential real estate loans (and continue to hold these loans unsecuritized). There is an abundance of capital in and demand for assets from banks, hedge funds, mortgage REITs, and other investors, resulting in higher prices for the assets in which we invest. This has increased the value of many of our existing portfolio assets and continues to make the acquisition of attractive new high-quality assets more challenging.
      The existing market conditions of reduced high-quality supply, increased competition, and high acquisition prices may continue, although there are signs that the level of speculation in housing and related capital markets may be easing. We have sold assets to build a relatively large balance of uninvested cash as we believe acquisition opportunities may improve over the next two years. While we carry this excess cash, our overall risk levels will be reduced, however absent major credit losses our on-going earnings also will be reduced relative to what they would have been otherwise. During the period we are seeking to maintain excess cash levels for future opportunities, we will likely significantly reduce our rate of new asset acquisitions.
      After taking into consideration our internal risk-based capital guidelines that suggest how much capital we need to support our assets and operations, we had $250 million excess capital (unutilized cash) at September 30, 2005. As we measure it internally, our capital was 69% utilized at September 30, 2005. As we move forward, this amount will be reduced by dividends and asset acquisitions and will be increased by cash flows earned, asset pay downs, asset sales, and proceeds from equity issuance.
      We may continue to issue new equity in this environment, most likely through our direct stock purchase and dividend reinvestment plan. By issuing new shares, we can maintain our desired level of excess cash while also taking advantage of the attractive asset acquisition opportunities that still exist today, maintaining a strong presence in our markets, and serving our customers’ needs. If our share price were to drop to a level below our reported book value (approximately $41 per share at September 30, 2005), we would be less likely to issue new shares unless there was a compelling reason to do so. At a reasonable discount to this value, we would consider stock repurchases while also being mindful of our desire to maintain cash balances.
      In this environment of reduced stock prices for mortgage REITs and other specialty finance companies, it may make sense for us to consider undertaking corporate transactions such as an acquisition or equity investment, either to further the development of our businesses or to gain cheap assets.
      In general in the past, the real estate loans on which we have taken first-loss credit risk have been high-quality loans relative to U.S. real estate loans as a whole. In the future, we may credit-enhance and/or securitize other credit grades of residential loans (near-prime, Alt-A, sub-prime, etc.), especially if prices for these assets dropped significantly as a result of a stressed real estate credit and capital markets liquidity environment. In such an environment, we may also acquire distressed assets with high levels of delinquencies and credit losses if we believe we can evaluate and invest in these assets to the benefit of our stockholders. In addition, we may invest in distressed commercial real estate and CDO assets.
      In general, our hurdle rate for new acquisitions is 14% internal rate of return, We will not buy an asset unless we believe there is a high likelihood that the asset will produce cash flows that discount back to a 14% cash-on-cash return per-overhead and pre-tax (making what we believe to be relatively conservative assumptions about credit losses, prepayments, etc.). If we can achieve this minimum hurdle rate for all of our assets and we are fully invested, we estimate we can earn a 10% to 11% return on equity on average over time and generate sufficient cash to support our regular dividend rate.

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RESULTS OF OPERATIONS
Acquisitions, Securitizations, Sales, and Calls
      During the third quarter of 2005, we acquired $332 million adjustable-rate and hybrid residential real estate loans for our residential conduit’s Sequoia securitization program, loan sales to Sequoia entities totaled $327 million, and Sequoia entities created and issued $327 million ABS. For the first nine months of 2005, residential real estate loan acquisitions totaled $1.6 billion, sales to Sequoia entities totaled $1.5 billion, and Sequoia entities issued $1.5 billion ABS. All these securitizations are sales for legal and tax purposes but are treated as financings under GAAP. Accordingly, in our GAAP financial statements, we consolidate the assets and liabilities of the Sequoia entities and record interest income on the loans sold to securitization entities and interest expense on ABS issued by securitization entities. At September 30, 2005, our loans held for future sale to Sequoia were $17 million; these loans are classified as held-for-investment for GAAP purposes as Sequoia has the intent to hold them to maturity.
      During the third quarter of 2005, we acquired $57 million residential loan CES. During the first nine months of 2005, we acquired $213 million residential loan CES. The loans underlying the CES we acquired during the third quarter of 2005 were generally consistent with our usual high-quality standards. The average FICO score was 735 and the average loan-to-value (LTV) was 69%. The geographic distribution was 49% in California, with Florida, Virginia, New Jersey, Illinois, and New York together representing a total of 20% of the total (and no other state representing more than 2% of the loans). The property types for these loans were 89% primary residence, 9% second homes, and 2% investment properties. These loans had an average loan balance of $445,000. Increasingly, we are credit-enhancing loans that have balances that are lower than the jumbo loan balance limit imposed on Fannie Mae and Freddie Mac — these lower-balance loans were 17% of the loans we credit-enhanced in the third quarter. Loans with balances over $1 million represented 5% of the dollar balance. Loan types credit-enhanced in the third quarter included 27% hybrid, 46% fixed, and 27% adjustable-rate. A total of 19% of newly credit-enhanced loans were interest-only, negative amortization, or similar type loans where a fully amortizing loan payment is not required. We consider these types of loans to be prime loans when there is a significant down payment made and the borrower is strong and not over-leveraged.
      We acquired $14 million commercial real estate loans during the third quarter of 2005 and $21 million during the nine months ended September 30, 2005. We had no sales of commercial real estate loans during the third quarter of 2005. We sold $11 million during the first nine months of 2005. We did not acquire or sell commercial real estate loans during the three months ended September 30, 2004. We acquired $17 million commercial real estate loans during the nine months ended September 30, 2004 and sold $2 million during this period.
      During the third quarter of 2005, we acquired $17 million commercial loan CES, and during the first nine months of 2005 we acquired $30 million commercial loan CES. No commercial loan CES were sold during these periods.
      We acquired $190 million of other residential and commercial real estate securities during the third quarter of 2005 for our Acacia CDO securitization program. During the first nine months of 2005, we acquired $515 million of these securities for our Acacia CDO securitization program. We sold $244 million of securities to Acacia entities during the third quarter of 2005; total securities sales to Acacia entities for the first nine months of 2005 were $516 million. We finished the third quarter with securities of $268 million held for future sale to future Acacias. Acacia entities issued $300 million CDO ABS during the third quarter of 2005, and $600 million during the nine months ended September 30, 2005. All of the assets and liabilities of Acacia entities are consolidated onto our Consolidated Balance Sheets.
      In the third quarter of 2005, we had calls of our residential CES of $5 million principal value for GAAP gains of $3 million and taxable gains of $2 million. For the first nine months of 2005, we had $28 million principal value of calls, generating GAAP call income gains of $15 million and taxable income gains of $11 million. The principal value of residential CES currently callable at September 30,

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2005 was $7 million. A substantial portion of our GAAP and taxable income in 2003 and 2004 came from gains from calls and gains from sales of residential CES. Returns from these sources are highly variable and not predictable. As we started 2005 with a smaller amount of securities that are callable, we expect call income in 2005 to be at significantly lower levels than achieved in the past two years.
      Occasionally, we sell loans and securities from our portfolio. Sales generate one-time gains (or losses), which add to (subtract from) reported GAAP earnings, taxable earnings, and perhaps our total future required dividend payments. Asset sales and calls may adversely impact our future earnings, as the lost ongoing income from these high-yield securities is often higher than the yield generated by new assets we may acquire. In the third quarter of 2005, we sold $362 million market value residential real estate and residential and commercial securities and loans, generating GAAP gains of $23 million and taxable gains of $15 million. During the first nine months, sales of securities and loans of $419 million market value generated GAAP gains of $32 million and taxable gains of $21 million. We have continued to sell assets during the fourth quarter of 2005.
Net Income
      Net income decreased to $56 million in the third quarter of 2005 compared to $72 million in the third quarter of 2004. This decrease was primarily the result of a decline in net interest income. Higher premium amortization expense on our residential real estate loans (due to faster prepayments) and lower yields on our residential loan CES portfolio on newer assets (relative to the older assets that were called or sold), less efficient capital utilization (we operated with more uninvested cash in 2005 than in 2004), and an increase operating expenses (as we continue to scale up, professionalize, and diversify our operations). Earnings in the third quarter of 2004 were positively affected by a one-time adjustment to premium amortization expense of $4.1 million. For similar reasons (and including a one-time tax benefit of $5.2 million recorded for GAAP purposes in the second quarter of 2004), earnings in the first nine months of 2005 decreased to $157 million from the $178 million earned during the first nine months of 2004.
      Taxable net income totaled $55 million in the third quarter of 2005 and $142 million for the first nine months of 2005. These were both decreases from the $59 million earned in the third quarter of 2004 and $182 million earned in the first nine months of 2004. The decrease was caused primarily by a drop in taxable gains from calls and asset sales, fewer IO securities owned (we have not been acquiring the IO securities created by the securitization entities sponsored by us, and the older IO securities we own are paying down), and higher operating expenses. As discussed more fully below, operating expenses increased primarily as a result of additional staff and systems, and increased accounting, consultant, and other costs relating to the enhancement of our internal controls.
      We provide for income taxes for GAAP purposes based on our estimates of our taxable income, the amount of taxable income we currently plan to permanently retain, and the amount of taxable income we estimate to be earned at our taxable subsidiaries. In the first nine months of 2004, we benefited from Federal and state net operating loss carry forwards and did not have any current tax provisions for income generated at our taxable REIT subsidiaries. During 2005, by contrast, our tax provision under GAAP benefited only slightly from some remaining state net operating losses. In addition, in the first nine months of 2004, we recognized a one-time deferred tax asset, thus recognizing the future value of remaining net operating losses at that time.
      In addition, in prior years, we generated taxable gains-on-sales from our securitization activities at the taxable subsidiaries. Gains on these activities were much lower in 2005 due to decreased volumes and a significant decrease in the gains generated by each securitization. Since these securitizations were treated as financings under GAAP, deferred tax assets were created. A portion of these deferred tax assets was expensed in the 2005 periods.

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Table 1     Net Income
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands, except share data)                
Total interest income
  $ 243,556     $ 180,090     $ 729,110     $ 442,906  
Total interest expense
    (196,686 )     (114,811 )     (567,833 )     (284,747 )
                         
Net interest income
    46,870       65,279       161,277       158,159  
Operating expenses
    (11,194 )     (8,561 )     (33,450 )     (27,048 )
Net recognized gains and valuation adjustments
    24,916       20,586       42,973       50,281  
Provision for income taxes
    (4,693 )     (4,962 )     (13,424 )     (3,171 )
                         
Net income
  $ 55,899     $ 72,342     $ 157,376     $ 178,221  
                         
Diluted Common Shares
    25,314,315       22,728,369       25,159,619       21,486,208  
Net income per share
  $ 2.21     $ 3.18     $ 6.26     $ 8.29  
Interest Income
      Total interest income consists of interest earned on consolidated earning assets, plus income from amortization of discount for assets acquired at prices below principal value, less expenses for amortization of premium for assets acquired at prices above principal value, less credit provision expenses.
Table 2     Interest Income and Yield
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(Dollars in thousands)                
Interest income
  $ 245,735     $ 171,804     $ 731,361     $ 446,827  
Discount amortization
    12,714       9,012       30,425       26,925  
Premium amortization
    (15,698 )     802       (33,983 )     (25,307 )
Reversal of (provision for) credit losses
    805       (1,528 )     1,307       (5,539 )
                         
Total interest income
  $ 243,556     $ 180,090     $ 729,110     $ 442,906  
                         
Average earning assets
  $ 20,085,393     $ 22,460,500     $ 22,230,168     $ 20,308,547  
Yield as a result of:
                               
Interest income
    4.89 %     3.07 %     4.38 %     2.94 %
Discount amortization
    0.25 %     0.16 %     0.18 %     0.18 %
Premium amortization
    (0.31 )%     0.01 %     (0.20 )%     (0.17 )%
Reversal of (provision for) credit losses
    0.02 %     (0.03 )%     0.01 %     (0.04 )%
                         
Yield on earning assets
    4.85 %     3.21 %     4.37 %     2.91 %
                         
      For the three months ended September 30, 2005 as compared to the same period in 2004, interest income increased primarily due to an overall increase in yield caused by an increase in short-term interest rates. A majority of the assets are adjustable-rate residential real estate loans, and yields on these assets increase as short-term interest rates rise as has occurred over the past twelve months. Total consolidated earning assets balance decreased during the third quarter of 2005 as compared to the third quarter of 2005 primarily as a result of decreased sponsorship of securitizations of residential real estate loans over the past twelve months from the nine months ended September 30, 2004. For the

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nine months ended September 30, 2005, the increase in interest income was due to both higher interest rates and a larger average balance of earning assets.
      The table below presents the contribution to interest income and yield from each of our portfolios. Further discussions of changes in yields and balances are presented below by portfolio.
Table 3     Interest Income and Yield by Portfolio
                                                                 
    Three Months Ended September 30, 2005   Three Months Ended September 30, 2004
         
        Percent of           Percent of    
        Total           Total    
    Interest   Interest   Average       Interest   Interest   Average    
(Dollars in   Income   Income   Balance   Yield   Income   Income   Balance   Yield
thousands)                                
Residential real estate loans, net of provision for credit losses
  $ 191,914       78.80 %   $ 17,373,023       4.42 %   $ 147,974       82.16 %   $ 20,484,287       2.89 %
HELOCs, net of provision for credit losses
    1,696       0.70 %     224,884       3.02 %     1,618       0.90 %     323,100       2.00 %
Residential loan credit-enhancement securities
    24,368       10.00 %     585,663       16.64 %     16,007       8.89 %     368,887       17.36 %
Commercial loans, net of provision for credit losses
    1,209       0.50 %     47,703       10.14 %     1,038       0.58 %     33,461       12.40 %
Commercial loan credit-enhancement securities
    453       0.19 %     32,192       5.63 %     346       0.19 %     7,372       18.80 %
Securities portfolio
    22,926       9.41 %     1,687,506       5.43 %     12,932       7.18 %     1,141,456       4.53 %
Cash and cash equivalents
    990       0.40 %     134,422       2.95 %     175       0.10 %     101,937       0.69 %
                                                 
Totals
  $ 243,556       100.00 %   $ 20,085,393       4.85 %   $ 180,090       100.00 %   $ 22,460,500       3.21 %
                                                 

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    Nine Months Ended September 30, 2005   Nine Months Ended September 30, 2004
         
        Percent of           Percent of    
        Total           Total    
    Interest   Interest   Average       Interest   Interest   Average    
    Income   Income   Balance   Yield   Income   Income   Balance   Yield
                                 
Residential real estate loans, net of provision for credit losses
  $ 590,534       80.99 %   $ 19,673,866       4.00 %   $ 356,680       80.53 %   $ 18,724,707       2.54 %
HELOCs, net of provision for credit losses
    6,721       0.92 %     255,626       3.51 %     2,154       0.49 %     149,686       1.92 %
Residential loan credit-enhancement securities
    63,431       8.70 %     543,516       15.56 %     47,617       10.75 %     324,563       19.56 %
Commercial loans, net of provision for credit losses
    4,004       0.55 %     49,635       10.76 %     2,607       0.59 %     27,324       12.72 %
Commercial loan credit-enhancement securities
    1,690       0.23 %     25,558       8.82 %     442       0.10 %     3,389       17.37 %
Securities portfolio
    60,356       8.28 %     1,553,993       5.18 %     32,992       7.45 %     994,139       4.42 %
Cash and cash equivalents
    2,374       0.33 %     127,974       2.47 %     414       0.09 %     84,739       0.65 %
                                                 
Totals
  $ 729,110       100.00 %   $ 22,230,168       4.37 %   $ 442,906       100.00 %   $ 20,308,547       2.91 %
                                                 

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      The table below details our interest income by portfolio as a result of changes in consolidated asset balances (“volume”) and yield (“rate”) for the three and nine months ended September 30, 2005 as compared to the three and nine months ended September 30, 2004.
     Table 4     Volume and Rate Changes for Interest Income
                                                 
    Change in Interest Income    
    Three Months Ended   Change in Interest Income
    September 30, 2005 Versus   Nine Months Ended September 30,
    September 30, 2004   2005 Versus September 30, 2004
         
        Total       Total
    Volume   Rate   Change   Volume   Rate   Change
(Dollars in thousands)                        
Residential real estate loans, net of provisions for credit losses
  $ (22,475 )   $ 66,415     $ 43,940     $ 18,080     $ 215,774     $ 233,854  
HELOCs, net provision for credit losses
    (492 )     570       78       1,524       3,043       4,567  
Residential loan credit-enhancement securities
    9,406       (1,045 )     8,361       32,123       (16,309 )     15,814  
Commercial loans, net of provision for credit losses
    441       (270 )     171       2,129       (732 )     1,397  
Commercial loan credit-enhancement securities
    1,165       (1,058 )     107       2,888       (1,640 )     1,248  
Securities portfolio
    6,186       3,808       9,994       18,580       8,784       27,364  
Cash and cash equivalents
    56       759       815       211       1,749       1,960  
                                     
Total interest income
  $ (5,713 )   $ 69,179     $ 63,466     $ 75,535     $ 210,669     $ 286,204  
                                     
 
Volume change is the change in average portfolio balance between periods multiplied by the rate earned in the earlier period. Rate change is the change in rate between periods multiplied by the average portfolio balance in the prior period. Interest income changes that result from changes in both rate and volume were allocated to the rate change amounts shown in the table.
      A discussion of the changes in total income, average balances, and yields for each of our portfolios is provided below.
Table 5     Consolidated Residential Real Estate Loans — Interest Income and Yield
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(Dollars in thousands)                
Interest income
  $ 204,078     $ 147,160     $ 618,484     $ 385,118  
Net (premium) discount amortization
    (13,479 )     2,078       (29,452 )     (23,430 )
Reversal of (provision for) credit losses
    1,315       (1,264 )     1,502       (5,008 )
                         
Total interest income
  $ 191,914     $ 147,974     $ 590,534     $ 356,680  
                         
Average consolidated residential real estate loans
  $ 17,373,023     $ 20,484,287     $ 19,673,866     $ 18,724,707  
Yields as a result of:
                               
Interest income
    4.70 %     2.87 %     4.19 %     2.74 %
Net (premium) discount amortization
    (0.31 )%     0.04 %     (0.20 )%     (0.16 )%
Reversal of (provision for) credit losses
    0.03 %     (0.02 )%     0.01 %     (0.04 )%
                         
Yield
    4.42 %     2.89 %     4.00 %     2.54 %
                         

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      During 2005, as compared to 2004, interest income on residential real estate loans increased primarily as a result of higher yields. Yields on these residential real estate loans are increasing as short-term interest rates are rising as most of these loans have coupon rates that adjust monthly or every six months based on one -or six-month LIBOR interest rate. Higher average balances contributed to the increase in interest income during the nine months of 2005 as compared to the first nine months of 2004; however, average balances had a dampening effect in the third quarter of 2005 as compared to a year earlier as the level of new loans added to this consolidated portfolio was less than the level of prepayments over the last twelve months.
      Premium amortization expense (as a percentage of average loan balances) during 2005 increased from the same periods in 2004. Amortization expense results from the application of FAS 91. In applying the interest method under FAS 91, we make certain elections to determine an effective yield to amortize the premium. For loans acquired prior to July 1, 2004, in our effective yield calculations we use coupon interest rates as they change over time as well as anticipated principal prepayments (actual and projected). Thus, rising rates will cause an increase in effective yield for these adjustable rate residential loans, as the coupon rate is rising or will reset at a higher rate in the near term. For this lag before the reset, the amount of premium expense is generally lower in order to increase the current effective yield to current market levels yield (all other factors being equal). For loans acquired after July 1, 2004, we determine an effective yield under FAS 91 using the initial coupon interest rate of the loans (without regard to future changes in the interest rates and underlying indices) as well as anticipated prepayment rates. For these residential loans, higher coupon interest rates will increase net realized yields when the coupon actually re-adjusts. Periodic premium amortization expenses will not be reduced in the short-term in anticipation of coupon interest rate increases. As a result, these loans premium amortization expenses will be higher (relative to the older loans) in a period of rising interest rates. As of September 30, 2005, loans acquired before July 1, 2004 had a principal value of $11.68 billion and an amortized cost basis of $11.82 billion. Loans acquired after July 1, 2004 had a principal value of $4.50 billion and an amortized cost basis of $4.54 billion.
Table 6     Residential HELOC — Interest Income and Yield
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(Dollars in thousands)                
Interest income
  $ 3,165     $ 2,954     $ 9,489     $ 4,007  
Net premium amortization
    (959 )     (1,072 )     (2,388 )     (1,322 )
Provision for credit losses
    (510 )     (264 )     (380 )     (531 )
                         
Total interest income
  $ 1,696     $ 1,618     $ 6,721     $ 2,154  
                         
Average balance of HELOCs
  $ 224,884     $ 323,100     $ 255,626     $ 149,686  
Yields as a result of:
                               
Interest income
    5.64 %     3.66 %     4.96 %     3.57 %
Net premium amortization
    (1.71 )%     (1.33 )%     (1.25 )%     (1.18 )%
Provision for credit losses
    (0.91 )%     (0.33 )%     (0.20 )%     (0.47 )%
                         
Yield
    3.02 %     2.00 %     3.51 %     1.92 %
                         
      Our return on the HELOC-backed securities we acquired from securitization of HELOCs we sponsored may be materially reduced if prepayment rates (net of draws) on these loans are faster than we originally anticipated. Cumulative prepayments through September 30, 2005 were at a CPR of 28%, which was slightly faster than we originally anticipated.

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Table 7     Residential Loan Credit-Enhancement Securities — Interest Income and Yield
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(Dollars in thousands)                
Interest income
  $ 13,175     $ 7,826     $ 35,736     $ 21,951  
Net discount amortization
    11,193       8,181       27,695       25,666  
                         
Total interest income
  $ 24,368     $ 16,007     $ 63,431     $ 47,617  
                         
Average residential loan credit-enhancement securities
  $ 585,663     $ 368,887     $ 543,516     $ 324,563  
Yield as a result of:
                               
Interest income
    9.00 %     8.49 %     8.77 %     9.02 %
Net discount amortization
    7.64 %     8.87 %     6.79 %     10.54 %
                         
Yield
    16.64 %     17.36 %     15.56 %     19.56 %
                         
      Interest income recognized from residential loan CES during the three and nine months ended September 30, 2005 increased as compared to the same periods in 2004, primarily due to growth in our portfolio over the past year, partially offset by the lower yield on the residential CES portfolio which decreased during the 2005 periods as compared to the 2004 periods. This is the result of the more seasoned, higher yielding assets (higher yielding as a result of several years of strong credit performance and favorable prepayments) being called or sold within the last year. In addition, any newer CES generally have lower yields because we do not expect the same strong credit performance or favorable prepayment patterns to repeat themselves.
      The yields we currently recognize on recently acquired CES (both residential and commercial) may be less than the yields we will actually realize over the lives of these CES. To determine yields on CES, we make assumptions regarding loan losses and prepayments. Since the market generally has a wide range for these assumptions (and not a specific estimate), we apply assumptions within a range that generally result in yields on these assets in early periods of ownership that are lower than what we might realize over the life of the assets. Specifically, the initial yield we book on certain CES may be lower than the market mid-range expectation of performance (and below our hurdle rate of 14%). We review the actual performance of each CES and the market’s and our renewed range of expectations every quarter. We adjust the yield of the assets as a result of the appropriate and supportable changes in assumptions. In addition, if credit performance is better than the original range of expectations, and/or prepayment behavior is favorable relative to initial estimates, the yields on these CES over the remaining lives may be significantly higher then we recorded in the first several quarters of ownership. In many cases, the yield we recognize in any period may prove to be too high or too low, as the actual yield we realize over the life of each of the CES will be dependent upon the actual receipt (both timing and amounts) of cash. Cumulatively, the cash we receive over the life of an asset will be accounted for as either a return of our initial investment or as income. The timing of the recognition of income is based on our estimates and assumptions of future amounts and timing of credit losses and prepayments and may be inexact.
      The determination of the yield is a function of the assumptions used to project the cash flows on each security. One assumption is the estimated credit losses. The amount of credit losses we assume for each security is the amount of designated credit reserve we have for that asset. If our expectations change, we will change the amount of credit losses anticipated and this will impact the effective yield over the remaining life. Our designation of the level of credit reserve is based on many factors, including the credit rating agencies’ determination of required credit-enhancement levels. As our securities season and loan pools have specific default and loss experience, our assumptions will change. While we use the market’s range of expectations, our designated credit reserve and projected timing of losses are subjective in nature.

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      In the third quarter of 2005 and also thus far in the fourth quarter of 2005, we have been selling many of our single B-rated residential loan CES. The restructuring of our balance sheet in this way reflects our belief that now is a good time to reduce overall risk levels and raise cash for future investment opportunities. By retaining most our first-loss (non-rated) CES, we are retaining most of the upside potential within our residential portfolios should credit losses continue to be low.
      These sales are generating gains that will be distributed to our stockholders. We generally are not reinvesting cash at this time. As a result we will likely have a smaller portfolio of residential CES and higher cash balances until our investment strategy changes.
      We believe the risk/reward ratio offered by our recent CES acquisitions is attractive for stockholders. Nevertheless, we believe these new securities are unlikely to generate over their lives the level of interest and call income generated by our older portfolio assets unless the market environment going forward proves to be as attractive (i.e., very fast prepayments and very low credit losses) as over the last several years. We expect that our rate of new asset acquisitions will slow.
Table 8     Commercial Real Estate Loans — Interest Income and Yield
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(Dollars in thousands)                
Interest income
  $ 1,278     $ 1,166     $ 4,017     $ 2,959  
Net premium amortization
    (69 )     (128 )     (198 )     (352 )
Reversal of credit losses
                185        
                         
Total interest income
  $ 1,209     $ 1,038     $ 4,004     $ 2,607  
                         
Average earning assets
  $ 47,703     $ 33,461     $ 49,635     $ 27,324  
Yield as a result of:
                               
Interest income
    10.72 %     13.93 %     10.79 %     14.44 %
Net premium amortization
    (0.58 )%     (1.53 )%     (0.53 )%     (1.72 )%
Reversal of credit losses
                0.50 %      
                         
Yield
    10.14 %     12.40 %     10.76 %     12.72 %
                         
      The interest income earned on our commercial real estate loan portfolio increased in the three and nine months ended September 30, 2005 from the same periods in 2004 primarily due to the growth in our commercial loan portfolio. This increase was partially offset by lower yield assumptions for newer commercial loans. During the first nine months of 2005, we reversed a portion of the credit reserve based on our positive assessment of one loan in the portfolio and reclassified the loan from held-for-investment to held-for-sale in anticipation of a sale, which occurred in the second quarter of 2005.

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Table 9     Commercial Loan Credit-Enhancement Securities Interest Income and Yield
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(Dollars in thousands)                
Interest income
  $ 1,355     $ 286     $ 3,347     $ 424  
Net (premium) discount amortization
    (902 )     60       (1,657 )     18  
                         
Total interest income
  $ 453     $ 346     $ 1,690     $ 442  
                         
Average residential loan credit-enhancement securities
  $ 32,192     $ 7,372     $ 25,558     $ 3,389  
Yield as a result of:
                               
Interest income
    16.84 %     15.53 %     17.46 %     16.65 %
Net discount (premium) amortization
    (11.21 )%     3.27 %     (8.64 )%     0.72 %
                         
Yield
    5.63 %     18.80 %     8.82 %     17.37 %
                         
      Interest income recognized from commercial loan CES during the three and nine months ended September 30, 2005 increased as compared to the same periods in 2004 primarily due to the growth in this portfolio.
      As discussed above, the yields we recognize on recently acquired CES (both residential and commercial) may be less than the yields we will actually realize over the lives of these assets.
      For commercial loan CES, prepayment assumptions generally have less of an impact on the yield because as commercial loans underlying CMBS generally have contractual provisions that make prepayments less likely than residential loans. The timing of the recognition of income is based on our estimates and assumption of future amounts and timing of credit losses and prepayments.
Table 10     Consolidated Securities Portfolio — Interest Income and Yield
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(Dollars in thousands)                
Interest income
  $ 21,697     $ 12,235     $ 57,918     $ 31,951  
Discount amortization
    1,277       831       2,730       1,285  
Premium amortization
    (48 )     (134 )     (292 )     (244 )
                         
Total interest income
  $ 22,926     $ 12,932     $ 60,356     $ 32,992  
                         
Average securities portfolio balance
  $ 1,687,506     $ 1,141,456     $ 1,553,993     $ 994,139  
Yield as a result of:
                               
Interest income
    5.14 %     4.29 %     4.98 %     4.28 %
Discount amortization
    0.30 %     0.29 %     0.23 %     0.17 %
Premium amortization
    (0.01 )%     (0.05 )%     (0.03 )%     (0.03 )%
                         
Yield
    5.43 %     4.53 %     5.18 %     4.42 %
                         
      Total interest income increased from the 2004 periods to the 2005 periods for the securities portfolio as the total size of the portfolio grew and as yields increased over these periods as the coupon rates on adjustable-rate loan securities (which comprise over half of the portfolio) adjusted upward with the increase in short-term interest rates over the past year. Interest income includes cash interest payments we receive on the securities in this portfolio, including the net interest earned on IO securities and less certain underlying due diligence expenses associated with the purchase of certain securities.

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Interest Expense
      Consolidated interest expense consists of interest payments on Redwood debt and ABS issued, plus the amortization of deferred ABS issuance costs and expenses related to certain interest rate agreements less the amortization of ABS premiums. These ABS premiums are created when interest-only and other ABS are issued at prices greater than principal value.
      Total consolidated interest expense increased in 2005 from 2004 due to higher cost of funds as a result of an increase in short-term interest rates and a larger balance of consolidated ABS issued. Furthermore, interest expense associated with interest-only and Sequoia ABS issued at a premium were not reduced this quarter in an amount commensurate with the increase in prepayments on the underlying Sequoia loans due to timing differences on the nature of the ABS outstanding.
Table 11     Total Interest Expense
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(Dollars in thousands)                
Interest expense on Redwood debt
  $ 3,845     $ 2,312     $ 8,398     $ 7,373  
Interest expense on ABS
    192,841       112,499       559,435       277,374  
                         
Total interest expense
  $ 196,686     $ 114,811     $ 567,833     $ 284,747  
                         
Average Redwood debt balance
  $ 297,788     $ 404,589     $ 264,024     $ 463,700  
Average ABS issued balance
    19,542,413       21,606,164       21,630,747       19,426,816  
                         
Average total obligations
  $ 19,840,201     $ 22,010,753     $ 21,894,771     $ 19,890,516  
                         
Cost of funds of Redwood debt
    5.16 %     2.29 %     4.24 %     2.12 %
Cost of funds of ABS issued
    3.95 %     2.08 %     3.45 %     1.90 %
Cost of funds of total obligations
    3.97 %     2.09 %     3.46 %     1.91 %
      For purposes of calculating the weighted average borrowing costs of ABS issued, we include the amortization of the deferred ABS issuance costs with interest expense. We include the average deferred ABS issuance costs in the average balances below.
Table 12     Average Balances of Asset-Backed Securities Issued
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(In thousands)                
Sequoia
  $ 17,453,727     $ 20,278,819     $ 19,727,546     $ 18,356,063  
Acacia
    2,142,869       1,377,574       1,956,423       1,115,171  
Commercial
    4,231       5,416       7,086       5,431  
                         
Average balance of ABS issued
  $ 19,600,827     $ 21,661,809     $ 21,691,055     $ 19,476,665  
                         
Average deferred ABS issuance costs
    (58,414 )     (55,645 )     (60,308 )     (49,849 )
                         
Average balance of ABS issued, net
  $ 19,542,413     $ 21,606,164     $ 21,630,747     $ 19,426,816  
                         

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      The table below details interest expense on debt and consolidated ABS issued as a result of changes in consolidated balances (“volume”) and cost of funds (“rate”) for the three and nine months ended September 30, 2005 as compared to the three and nine months ended September 30, 2004.
     Table 13     Volume and Rate Changes for Interest Expense
                                                 
    Change in Interest Expense   Change in Interest Expense
    Three Months Ended   Nine Months Ended
    September 30, 2005 Versus   September 30, 2005 Versus
    September 30, 2004   September 30, 2004
         
        Total       Total
    Volume   Rate   Change   Volume   Rate   Change
(Dollars in thousands)                        
Interest expense on Redwood debt
  $ (610 )   $ 2,143     $ 1,533     $ (3,175 )   $ 4,200     $ 1,025  
Interest expense on ABS
    (10,746 )     91,088       80,342       31,467       250,594       282,061  
                                     
Total interest expense
  $ (11,356 )   $ 93,231     $ 81,875     $ 28,292     $ 254,794     $ 283,086  
                                     
 
Volume change is the change in average balance of obligations between periods multiplied by the rate paid in the earlier period. Rate change is the change in rate between periods multiplied by the average outstanding obligations in the current period. Interest expense changes that resulted from changes in both rate and volume were allocated to the rate change amounts shown in the table.
      Details of the change in cost of funds of debt and cost of funds on ABS issued are provided below.
     Table 14     Cost of Funds of Redwood Debt
                                 
    Three Months Ended   Nine Months Ended
    September 30,   September 30,
         
    2005   2004   2005   2004
(Dollars in thousands)                
Interest expense on Redwood debt
  $ 3,845     $ 2,312     $ 8,398     $ 7,373  
Average Redwood debt balance
  $ 297,788     $ 404,589     $ 264,024     $ 463,700  
Cost of funds of Redwood debt