Table of Contents

 
 
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: June 30, 2006
 
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 large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer     þ Accelerated filer o Non-accelerated filer     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 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) 25,892,319 as of August 2, 2006
 
 


 

REDWOOD TRUST, INC.
FORM 10-Q
INDEX
             
        Page
         
 PART I. FINANCIAL INFORMATION
   Financial Statements        
     Consolidated Balance Sheets at June 30, 2006 and December 31, 2005 (unaudited)     3  
     Consolidated Statements of Income for the three and six months ended June 30, 2006 and 2005 (unaudited)     4  
     Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2006 and 2005 (unaudited)     5  
     Consolidated Statements of Stockholders’ Equity for the six months ended June 30, 2006 and 2005 (unaudited)     6  
     Consolidated Statements of Cash Flows for the six months ended June 30, 2006 and 2005 (unaudited)     7  
     Notes to Consolidated Financial Statements     8  
   Management’s Discussion and Analysis of Financial Condition and Results of Operations     50  
   Quantitative and Qualitative Disclosures About Market Risk     80  
   Controls and Procedures     80  
 PART II. OTHER INFORMATION
   Unregistered Sales of Equity Securities and Use of Proceeds     81  
   Submission of Matters to a Vote of Security Holders     82  
   Other Information     82  
 
   Exhibits     82  
 SIGNATURES     83  
 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
(In thousands, except share data)
(Unaudited)
                     
    June 30, 2006   December 31, 2005
         
ASSETS
Real estate loans
  $ 10,491,014     $ 13,934,484  
Real estate securities
    2,661,250       2,418,917  
Cash and cash equivalents
    106,491       175,885  
             
 
Total Earning Assets
    13,258,755       16,529,286  
Restricted cash
    86,227       72,421  
Accrued interest receivable
    66,798       76,469  
Interest rate agreements
    53,573       31,220  
Principal receivable
    1,229       225  
Deferred tax asset
    5,391       5,384  
Deferred asset-backed security issuance costs
    45,522       54,125  
Other assets
    12,064       7,830  
             
Total Assets
  $ 13,529,559     $ 16,776,960  
             
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
 
LIABILITIES
               
Redwood debt
  $ 529,383     $ 169,707  
Asset-backed securities issued
    11,897,988       15,585,277  
Accrued interest payable
    46,927       41,027  
Interest rate agreements
    4,203       507  
Accrued expenses and other liabilities
    28,825       27,889  
Dividends payable
    17,967       17,593  
             
   
Total Liabilities
    12,525,293       15,842,000  
             
Commitments and contingencies (Note 11)
               
STOCKHOLDERS’ EQUITY
               
Common stock, par value $0.01 per share, 50,000,000 shares authorized; 25,667,553 and 25,132,625 issued and outstanding
    257       251  
Additional paid-in capital
    853,896       824,365  
Accumulated other comprehensive income
    90,937       73,731  
Cumulative earnings
    740,904       681,479  
Cumulative distributions to stockholders
    (681,728 )     (644,866 )
             
 
Total stockholders’ equity
    1,004,266       934,960  
             
Total Liabilities and Stockholders’ Equity
  $ 13,529,559     $ 16,776,960  
             
The accompanying notes are an integral part of these consolidated financial statements.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except share data)
(Unaudited)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Interest Income
                               
Real estate loans
  $ 152,466     $ 205,944     $ 319,545     $ 406,257  
Real estate securities
    60,395       40,230       116,897       78,284  
Cash and cash equivalents
    2,871       804       5,348       1,384  
                         
Interest income before provision for credit losses
    215,732       246,978       441,790       485,925  
Reversal of provision for credit losses
    2,506       1,527       2,330       502  
                         
Total interest income
    218,238       248,505       444,120       486,427  
Interest Expense
                               
Redwood debt
    (1,822 )     (1,789 )     (3,894 )     (4,483 )
Asset-backed securities issued
    (171,697 )     (193,336 )     (350,280 )     (366,539 )
                         
Total interest expense
    (173,519 )     (195,125 )     (354,174 )     (371,022 )
Net interest income
    44,719       53,380       89,946       115,405  
Operating expenses
    (16,037 )     (11,456 )     (28,619 )     (23,254 )
Net recognized gains and valuation adjustments
    5,993       3,045       4,123       18,057  
                         
Net income before provision for income taxes
    34,675       44,969       65,450       110,208  
Provision for income taxes
    (3,265 )     (4,054 )     (6,025 )     (8,731 )
                         
Net income
  $ 31,410     $ 40,915     $ 59,425     $ 101,477  
                         
Basic earnings per share:
  $ 1.23     $ 1.66     $ 2.34     $ 4.15  
Diluted earnings per share:
  $ 1.20     $ 1.62     $ 2.29     $ 4.04  
Regular dividends declared per common share
  $ 0.70     $ 0.70     $ 1.40     $ 1.40  
Special dividends declared per common share
                       
                         
Total dividends declared per common share
  $ 0.70     $ 0.70     $ 1.40     $ 1.40  
                         
Basic weighted average shares outstanding
    25,496,552       24,591,223       25,349,853       24,474,134  
Diluted weighted average shares outstanding
    26,108,975       25,196,286       25,909,923       25,109,390  
The accompanying notes are an integral part of these consolidated financial statements.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
(Unaudited)
                                   
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Net income
  $ 31,410     $ 40,915     $ 59,425     $ 101,477  
Other Comprehensive Income:
                               
 
Net unrealized gains (losses) on available-for-sale securities
    6,679       33,420       (1,380 )     50,778  
 
Reclassification adjustment for net (gains) losses included in net income
    (1,342 )     (2,921 )     656       (12,963 )
 
Net unrealized gains (losses) on cash flow hedges
    10,128       (17,984 )     24,315       (5,990 )
 
Reclassification of net realized cash flow hedge (gains) losses to interest expense on asset-backed securities issued and net recognized gains and valuation adjustments
    (6,119 )     81       (6,385 )     198  
                         
Total other comprehensive income
    9,346       12,596       17,206       32,023  
                         
Comprehensive income
  $ 40,756     $ 53,511     $ 76,631     $ 133,500  
                         
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 Six Months Ended June 30, 2006:
(In thousands, except share data)
(Unaudited)
                                                             
    Common Stock   Additional   Other       Cumulative    
        Paid-In   Comprehensive   Cumulative   Distributions to    
    Shares   Amount   Capital   Income   Earnings   Stockholders   Total
                             
December 31, 2005
    25,132,625     $ 251     $ 824,365     $ 73,731     $ 681,479     $ (644,866 )   $ 934,960  
                                           
   
Net income
                            59,425             59,425  
   
Net unrealized (loss)/ reclassification on assets AFS
                      (724 )                 (724 )
   
Net unrealized gain/ reclassification on interest rate agreements
                      17,930                   17,930  
Issuance of common stock:
                                                       
   
Dividend Reinvestment & Stock Purchase Plans
    485,101       5       20,497                         20,502  
   
Employee Option & Stock Purchase Plans
    52,257       1       387                         388  
   
Restricted Stock & Stock DERs
    (2,430 )           8,647                         8,647  
Dividends declared:
                                                       
 
Common
                                  (36,862 )     (36,862 )
                                           
June 30, 2006
    25,667,553     $ 257     $ 853,896     $ 90,937     $ 740,904     $ (681,728 )   $ 1,004,266  
                                           
For the Six Months Ended June 30, 2005:
(In thousands, except share data)
(Unaudited)
                                                             
    Common Stock   Additional   Other       Cumulative    
        Paid-In   Comprehensive   Cumulative   Distributions to    
    Shares   Amount   Capital   Income   Earnings   Stockholders   Total
                             
December 31, 2004
    24,153,576     $ 242     $ 773,222     $ 105,357     $ 481,607     $ (496,272 )   $ 864,156  
                                           
Comprehensive income:
                                                       
   
Net income
                            101,477             101,477  
   
Net unrealized gain on assets AFS
                      37,815                   37,815  
   
Net unrealized (loss) on interest rate agreements
                      (5,792 )                 (5,792 )
Issuance of common stock:
                                                       
   
Secondary Offerings
                                         
   
Dividend Reinvestment & Stock Purchase Plans
    469,556       4       25,564                         25,568  
   
Employee Option & Stock Plans
    14,905             1,247                         1,247  
   
Restricted Stock & Stock DERs
    8,926             1,884                         1,884  
Dividends declared:
                                                       
 
Common
                                  (34,598 )     (34,598 )
                                           
June 30, 2005
    24,646,963     $ 246     $ 801,917     $ 137,380     $ 583,084     $ (530,870 )   $ 991,757  
                                           
The accompanying notes are an integral part of these consolidated financial statements

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REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
                   
    Six Months Ended
    June 30,
     
    2006   2005
         
Cash Flows From Operating Activities:
               
 
Net income
  $ 59,425     $ 101,477  
 
Adjustments to reconcile net income to net cash provided by operating activities:
               
 
Net amortization of premiums, discounts, and debt issuance costs
    (31,080 )     (44,169 )
 
Depreciation and amortization of non-financial assets
    545       409  
 
(Reversal of) provision for credit losses
    (2,330 )     (502 )
 
Non-cash stock compensation
    8,647       1,884  
 
Net recognized gains and valuation adjustments
    (4,123 )     (18,057 )
 
Principal payments on real estate loans held-for-sale
          381  
 
Net sales of real estate loans held-for-sale
          14,570  
 
Net change in:
               
 
Accrued interest receivable
    9,671       (12,900 )
 
Principal receivable
    (1,004 )     2,369  
 
Deferred income taxes
    281       3,751  
 
Other assets
    321       1,468  
 
Accrued interest payable
    5,900       7,735  
 
Accrued expenses and other liabilities
    937       (4,426 )
             
 
Net cash provided by operating activities
    47,190       53,990  
             
Cash Flows From Investing Activities:
               
 
Purchases of real estate loans held-for-investment
    (325,316 )     (1,266,047 )
 
Proceeds from sales of real estate loans held-for-investment
    8,408        
 
Principal payments on real estate loans held-for-investment
    3,733,573       4,120,751  
 
Purchases of real estate securities available-for-sale
    (496,822 )     (493,047 )
 
Proceeds from sales of real estate securities available-for-sale
    176,432       42,667  
 
Principal payments on real estate securities available-for-sale
    101,803       93,735  
 
Net (increase) decrease in restricted cash
    (13,806 )     (11,422 )
             
 
Net cash provided by investing activities
    3,184,272       2,486,637  
             
Cash Flows From Financing Activities:
               
 
Net borrowings on Redwood debt
    359,676       249,548  
 
Proceeds from issuance of asset-backed securities
    288,709       1,418,299  
 
Deferred asset-backed security issuance costs
    (3,383 )     (8,189 )
 
Repayments on asset-backed securities
    (3,934,557 )     (4,177,321 )
 
Net sales (purchase) of interest rate agreements
    4,297       (1,304 )
 
Net proceeds from issuance of common stock
    20,890       26,815  
 
Dividends paid
    (36,488 )     (33,528 )
             
 
Net cash (used in) provided by financing activities
    (3,300,856 )     (2,525,680 )
             
Net (decrease) increase in cash and cash equivalents
    (69,394 )     14,947  
Cash and cash equivalents at beginning of period
    175,885       57,246  
             
Cash and cash equivalents at end of period
  $ 106,491     $ 72,193  
             
Supplemental disclosure of cash flow information:
               
 
Cash paid for interest
  $ 348,274     $ 363,412  
 
Cash paid for taxes
  $ 4,099     $ 6,580  
Non-cash financing activity:
               
 
Dividends declared but not paid
  $ 17,967     $ 17,253  
             
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
June 30, 2006
(Unaudited)
NOTE 1. REDWOOD TRUST
Redwood Trust, Inc., together with its subsidiaries (Redwood, we, or us), is a specialty finance company that invests in real estate assets. In general, we invest in real estate assets by acquiring and owning asset-backed securities backed by real estate loans. Our primary focus is investing in first-loss and second-loss credit-enhancement securities issued by real estate loan securitizations, thereby partially guaranteeing (credit-enhancing) the credit performance of residential or commercial real estate loans owned by the issuing securitization entity.
As a real estate investment trust (REIT), we are required to distribute to stockholders as dividends at least 90% of our REIT taxable income, which is our income as calculated for tax purposes, exclusive of income earned in taxable subsidiaries. In order to meet our dividend distribution requirements we have been paying both a regular quarterly dividend and a year-end special dividend. We expect our special dividend amount to be highly variable and we may not pay a special dividend in every year. Our dividend policies and distribution practices are determined by our Board of Directors and may change over time.
Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. Our executive offices are at One Belvedere Place, Suite 300, Mill Valley, California 94941.
NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The consolidated financial statements presented herein are for June 30, 2006 and December 31, 2005 and for the three and six month periods ended June 30, 2006 and 2005. 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 our Annual Report on Form 10-K for the year ended December 31, 2005. The results for the three and six months ended June 30, 2006 are not necessarily indicative of the expected results for the year ended December 31, 2006. Certain amounts for prior periods have been reclassified to conform to the June 30, 2006 presentation.
Due diligence expenses are costs for services related to re-underwriting and analyzing the loans we acquire or the loans we credit-enhance through the purchase of certain securities. In previous financial statements we recognized these expenses as a reduction in interest income. After reviewing again the nature of these costs it was determined that they did not directly relate to the specific creation of a securitization and were dependent on specific asset acquisition analysis (which may or may not result in our acquiring assets). Therefore, beginning in this quarter, we are recognizing these due diligence costs as an operating expense, and these amounts for prior periods have been reclassified to conform to this presentation.
These consolidated financial statements include the accounts of Redwood and its wholly-owned subsidiaries, Sequoia Mortgage Funding Corporation, Acacia CDO 1, Ltd. through Acacia CDO 9, Ltd., Acacia CDO CRE1, Ltd., RWT Holdings, Inc. (Holdings), and Holdings’ wholly-owned subsidiaries, including Sequoia Residential Funding, Inc. and Madrona Residential Funding LLC. References to Sequoia mean Sequoia Mortgage Funding Corporation and Sequoia Residential Funding, Inc. References to Acacia mean all the Acacia CDO entities. References to the Redwood REIT mean Redwood exclusive of its taxable subsidiaries. The taxable subsidiaries of Redwood are Holdings, Holdings’ wholly owned sub-

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
sidiaries, and the Acacia entities. 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 a significant number of estimates in the preparation of financial statements. 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 as of the date of the consolidated financial statements and the reported amounts of certain revenues and expenses during the reported period. It is likely that changes in these estimates (e.g., market values due to changes in supply and demand, credit performance, prepayments, interest rates, or other reasons; yields due to changes in credit outlook and loan prepayments) will occur in the near term. Our estimates are inherently subjective in nature and actual results could differ from our estimates and the differences may be material.
Sequoia and Acacia Securitizations
We treat the securitizations we sponsor as financings under the provisions of Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (FAS 140), as under these provisions we have retained effective control over these loans and securities. Control is maintained through our active management of the assets in the securitization entities, our retained asset transfer discretion, our ability to direct certain servicing decisions, or a combination of the foregoing. These securitization entities issue asset-backed securities (ABS) to fund their acquisitions of loans and securities. Accordingly, the underlying loans owned by the Sequoia entities are shown on our Consolidated Balance Sheets under 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 in our real estate securities portfolio. 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 security (IO)) 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 separately on our Consolidated Balance Sheets.
Earning Assets
Earning assets (as consolidated for GAAP purposes) consist primarily of 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 to generate an effective yield, considering the actual and future estimated prepayments of the assets. Gains or losses on the sale of earning assets are based on the specific identification method.
Real estate loans combines our consolidated residential and commercial real estate loans. Real estate securities combines our consolidated residential and commercial real estate securities including those securities we define as credit-enhancement securities (CES). CES includes below-investment grade (BB-,B-, and non-rated) residential securities and non-rated commercial securities. Also included in our securities portfolio are residential sub-prime, collateral debt obligation (CDO), residential second lien, and REIT corporate debt securities.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Real Estate Loans: Held-for-Investment
The majority of consolidated 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. 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.
Pursuant to Statement of Financial Accounting Standards 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 payments 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 principal payments to calculate an effective yield to amortize the premium or discount.
Real Estate Loans: Held-for-Sale
We may sell real estate loans from time to time to third parties other than the securitization entities we sponsor. 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 (losses) and valuation adjustments in our Consolidated Statements of Income.
Real Estate Securities: Available-for-Sale
Real estate 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.
For determining other-than-temporary impairment on our real estate securities, we use the guidelines prescribed under EITF 99-20, Statement of Financial Accounting Standards 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 (losses) and valuation adjustments in our Consolidated Statements of Income.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Credit Reserves
For consolidated 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 reporting 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), Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (FAS 5), and Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (FAS 114), in setting credit reserves for our real estate 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 and changes in credit concentrations;
 
•  Information supporting the borrowers’ ability to meet obligations;
 
•  On-going evaluations of fair values of collateral using current appraisals and other valuations; and,
 
•  Discounted cash flow analysis.
Once we determine applicable default amounts, the timing of the defaults, and severity 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 estimated 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.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
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 and cash pledged as collateral on interest rate agreements. Restricted cash may also include cash retained in Acacia or Sequoia securitization trusts prior to purchase of real estate loans and securities. See Note 7 for additional information on restricted cash.
Deferred Tax Assets
Net deferred tax assets represent the net benefit of net operating loss (NOL) carry forwards, real estate asset basis differences, recognized tax gains on whole loan securitizations, interest rate agreement basis differences, and other temporary GAAP and tax timing differences. These temporary timing differences will be recognized in different periods for GAAP and tax purposes. Certain current period net unrealized gains and losses on securities and interest rate agreements that are reported in other comprehensive income are adjusted for the effects of tax, thus creating deferred tax assets (liabilities).
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 Accounting Practice Bulletin 21, Interest on Receivables and Payables (APB 21).
Other Assets
Other assets on our Consolidated Balance Sheets include REO, fixed assets, purchased 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 represent principal and interest that is due and payable to us. These are generally received within the next month.
Interest Rate Agreements and Derivatives
We enter into interest rate agreements to help manage our interest rate risks. We report our interest rate agreements at fair value. Those with a positive value to us are reported as an asset and those with a negative value to us are reported as a liability. We may elect hedge accounting treatment under Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133), or we may account for these as trading instruments. See Note 5 for a further discussion on interest rate agreements.
We enter into commitments to purchase loans. These commitments are accounted for as derivatives under Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (FAS 149), when applicable. These are classified as trading instruments on our Consolidated Balance Sheets until the date of settlement and changes in fair value are recorded through Net Recognized Gains and Valuation Adjustments in the Consolidated Statements of Income.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
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 Consolidated Balance Sheets at its unpaid principal balance.
Asset-Backed Securities Issued
The majority of the liabilities reported on our Consolidated Balance Sheets represents 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.
Accrued Expenses and Other Liabilities
Accrued expenses and other liabilities on our Consolidated Balance Sheets include cash held back from borrowers, derivatives margin liability, accrued employee bonuses, executive deferred compensation, dividend equivalent rights (DERs) payable, excise and income taxes, and accrued legal, accounting, consulting, and other miscellaneous expenses.
Dividends Payable
Dividends payable reflect any dividend declared by us but not yet distributed to our stockholders as of the financial statement date.
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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
of taxes recorded for financial reporting purposes and amounts actually payable 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 a 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.
The following table provides reconciliation of denominators of the basic and diluted net income per share computations.
Basic and Diluted Net Income Per Share
(In thousands, except share data)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Denominator:
                               
Denominator for basic earnings per share:
                               
Weighted average number of common shares outstanding during the period
    25,496,552       24,591,223       25,349,853       24,474,134  
Net effect of dilutive stock options
    612,423       605,063       560,070       635,256  
                         
Denominator for diluted earnings per share
    26,108,975       25,196,286       25,909,923       25,109,390  
                         
Basic Earnings Per Share:
                               
Net income per share
  $ 1.23     $ 1.66     $ 2.34     $ 4.15  
                         
Diluted Earnings Per Share:
                               
Net income per share
  $ 1.20     $ 1.62     $ 2.29     $ 4.04  
                         
Pursuant to EITF 03-6, Participating Securities and the Two — Class Method under FASB No. 128 (EITF 03-6), we determined that there was no allocation of income for our outstanding stock options as they were antidilutive during the three and six months ended June 30, 2006 and 2005. There were no other participating securities, as defined by EITF 03-6, during the three and six months ended June 30, 2006 and 2005. For the three and six months ended June 30, 2006, the number of outstanding stock options that were antidilutive totaled 465,980 and 466,166, respectively. For the three and six months ended June 30, 2005, the number of outstanding stock options that were antidilutive totaled 370,805 and 168,636, respectively.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Other Comprehensive Income
Current period net unrealized gains and losses on real estate loan CES, real estate securities 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. Certain current period net unrealized gains and losses on securities and interest rate agreements that are reported in other comprehensive income are adjusted for the effects of tax, thus creating deferred tax assets (liabilities).
Stock-Based Compensation
As of June 30, 2006 and December 31, 2005, we had one stock-based employee compensation plan and one employee stock purchase plan. These plans, and associated stock options and other equity awards, are described more fully in Note 10.
For stock options granted as well as other share-based payment awards, we adopted Statement of Financial Accounting Standards No. 123R, Share-Based Payment (FAS 123R), on January 1, 2006. With the adoption of FAS 123R, the grant date fair value of all remaining unvested stock compensation awards (stock options, deferred stock units, and restricted stock) are expensed on the Consolidated Statements of Income over the remaining vesting period. At January 1, 2006, upon adoption of FAS 123R, we had $19.3 million of unamortized costs related to non-vested equity awards (stock options, restricted stock, and deferred stock units). At June 30, 2006, the unamortized costs totaled $14.2 million and this will be expensed over the next four years, over half of which will be recognized over the next twelve months.
Beginning in 2003, in accordance with the guidance of Statement of Financial Accounting Standards 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 after December 31, 2002. We accounted 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 APB 25, when we granted option awards we did not include any stock-based employee compensation cost in net income, as all option awards granted had an exercise price equal to the fair market value of the underlying common stock on the date of grant. All other equity awards (deferred stock units and restricted stock), were valued at the grant date and expensed over the vesting period (regardless of when they were granted). Had we also applied Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (FAS 123), to option awards granted prior to 2003, net income and net income per share would have been the pro-forma amounts indicated in the table below for the three and six months ended June 30, 2005. There is no pro-forma presentation for the six months ended June 30, 2006, as we adopted FAS 123R as of January 1, 2006, as discussed above.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Pro-Forma Net Income Under FAS 123
(In thousands, except share data)
                   
    Three Months   Six Months
    Ended   Ended
    June 30, 2005   June 30, 2005
         
Net income, as reported
  $ 40,915     $ 101,477  
Add: Dividend equivalent right operating expenses under APB 25
    1,779       3,558  
Deduct: Stock option operating (expense) income under APB 25
    2       (81 )
Deduct: Stock-based employee compensation expense determined under fair value based method for awards granted prior to January 1, 2003
    (219 )     (470 )
             
Pro forma net income
  $ 42,477     $ 104,484  
             
Earnings per share:
               
 
Basic — as reported
  $ 1.66     $ 4.15  
 
Basic — pro forma
  $ 1.73     $ 4.27  
 
Diluted — as reported
  $ 1.62     $ 4.04  
 
Diluted — pro forma
  $ 1.69     $ 4.16  
The Black-Scholes option-pricing model was used in determining fair values of option grants accounted for under FAS 123R and FAS 123. The model requires the use of assumptions such as strike price, expected life, risk free rate of return, and stock price volatility. Options are generally granted over the course of the calendar year. Certain options have dividend equivalent rights (DERs) and, accordingly, the assumed dividend yield was zero for these options. Other options granted have no DERs and the assumed dividend yield was 10%. There were no options granted during the three months ended June 30, 2006. The following table describes the weighted average of assumptions used for calculating the value of options granted during the three and six months ended June 30, 2006 and 2005. Similar assumptions were used to calculate the pro forma information presented in the table above.
Weighted Average Assumptions used for Valuation of Options Under FAS 123R and FAS 123 Granted during period
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Stock price volatility
          26.4 %     25.7 %     26.4 %
Risk free rate of return (Treasury Rate)
          3.93 %     4.75 %     4.07 %
Average life
          5 Years       5  years       5  years  
Dividend yield assumptions
          10.00 %     10.00 %     4.45 %
Recent Accounting Pronouncements
On June 30, 2005, the FASB issued Derivatives Implementation Group (DIG) Issue B38, Evaluation of Net Settlement with Respect to the Settlement of a Debt Instrument through Exercise of an Embedded Put Option or Call Option (DIG B38) and DIG Issue B39, Application of Paragraph 13(b) to Call Options That Are Exercisable Only by the Debtor (DIG B39). DIG B38 addresses an application issue when applying FAS 133, paragraph 12(c), to a put option or call option (including a prepayment option) embedded in a debt instrument. DIG B39 addresses the conditions in FAS 133, paragraph 13(b), as

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
they relate to whether an embedded call option in a hybrid instrument containing a host contract is clearly and closely related to the host contract if the right to accelerate the settlement of debt is exercisable only by the debtor. DIG B38 and DIG B39 became effective for us on January 1, 2006. The adoption of DIG B38 and DIG B39 did not have an impact on our financial statements.
In February 2006, the FASB issued Statement 155, Accounting for Certain Hybrid Financial Instruments, (FAS 155), to amend FAS 133 and FAS 140. This Statement simplifies the accounting for certain hybrid financial instruments by allowing an entity to make an irrevocable election on a specific instrument basis for certain financial assets and liabilities that contain embedded derivatives that would otherwise require bifurcation and to recognize and re-measure at fair value these instruments so elected. Thus, under this election, an entity would measure the entire hybrid financial instrument at fair value with changes in fair value recognized in earnings. FAS 155 will become effective for us as of January 1, 2007. We believe FAS 155 will not have any material impact on our financial statements.
In March 2006, the FASB issued Statement 156, Accounting for Servicing of Financial Assets — an amendment of FASB Statement No. 140 (FAS 156). This Statement amends FAS 140 with respect to the accounting for separately recognized servicing assets and servicing liabilities. FAS 156 requires an entity to either (i) recognize servicing assets or servicing liabilities initially at fair value and amortize this value over the period of servicing, or (ii) measure servicing assets or liabilities at fair value at each reporting date with changes in fair value reported in earnings. FAS 156 will become effective for us as of January 1, 2007. We believe FAS 156 will not have a material impact on our financial statements.
In July 2006, the FASB released Accounting for Uncertainty In Income Taxes (FIN 48). FIN 48 addresses the recognition and measurement of uncertain income tax positions using a “more-likely-than-not” threshold and introduces a number of new disclosure requirements. The differences between current practice and the requirements of FIN 48 are significant, and a substantial effort will be required by most companies to properly assess all material uncertain positions. Further, the impact of FIN 48 is not just technical; the interpretation may cause companies to modify their tax-related strategies. The new guidance will become effective for us January 1, 2007. We are currently assessing the impact on our financial statements.
In the first quarter of 2006, we became aware of a potential technical interpretation of GAAP that differs from our current accounting presentations. This issue relates to the accounting for transactions where assets are purchased from a counterparty and simultaneously financed through a repurchase agreement with that same counterparty and whether these transactions create derivatives instead of the acquisition of assets with related financing (which is how we currently present these transactions). This potential technical interpretation of GAAP does not affect the economics of the transactions but may affect how the transactions would be reported in our financial statements. Our cash flows, our liquidity, and our ability to pay a dividend would be unchanged, and we do not believe our taxable income would be affected. We have not changed our accounting treatment for this potential issue. However, if we were to change our current accounting presentations based on this interpretation, we do not believe there would be a material impact on our consolidated financial statements.
NOTE 3. EARNING ASSETS
As of June 30, 2006 and December 31, 2005 our reported earning assets (owned by us or by consolidated securitization entities) consisted of investments in adjustable-rate, hybrid, and fixed-rate real estate loans and securities. Adjustable-rate loans have coupons that reset at least annually. 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 home equity lines of credit (HELOCs) is generally ten years. The original maturity of our commercial real

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
estate loans and commercial real estate securities is generally ten years. The actual maturity is subject to change based on the prepayments of the underlying loans.
For the three months ended June 30, 2006 and 2005, the average consolidated balance of earning assets was $13.6 billion and $22.6 billion, respectively. For the six months ended June 30, 2006 and 2005, the average consolidated balance of earning assets was $14.4 billion and $23.3 billion, respectively.
Real Estate Loans
We acquire real estate loans from third party originators for sale to securitization entities sponsored by us under our Sequoia program which, in turn, issue ABS (that are shown as liabilities on our Consolidated Balance Sheets). The following tables summarize the carrying value of real estate loans, which include residential real estate loans, HELOCs, and commercial real estate loans as reported on our Consolidated Balance Sheets at June 30, 2006 and December 31, 2005.
Real Estate Loans Composition
(In thousands)
                 
    June 30, 2006   December 31, 2005
         
Residential real estate loans
  $ 10,314,414     $ 13,693,833  
HELOCs
    139,878       180,959  
Commercial real estate loans
    36,722       59,692  
             
Carrying value
  $ 10,491,014     $ 13,934,484  
             
We may exercise our right to call ABS issued by entities sponsored by us and subsequently sell the loans to third parties. Once we determine which loans will be sold to third parties and if these sales are not completed by the end of a reporting period, we reclassify held-for-investment loans to held-for-sale loans on our Consolidated Balance Sheets. Our Consolidated Statements of Cash Flows record the proceeds from any principal payments or sales in the same category as our original acquisition was recorded.
Real Estate Loans Carrying Value
(In thousands)
                 
    June 30, 2006   December 31, 2005
    Held for   Held for
    Investment   Investment
         
Current face
  $ 10,365,600     $ 13,789,333  
Unamortized premium
    153,005       175,948  
Discount designated as credit protection
    (8,141 )     (8,141 )
             
Amortized cost
    10,510,464       13,957,140  
Reserve for credit losses
    (19,450 )     (22,656 )
             
Carrying value
  $ 10,491,014     $ 13,934,484  
             
Of the $10.4 billion of face and $153 million of unamortized premium on our real estate loans at June 30, 2006, $7.2 billion of face and $124 million of unamortized premium relates to loans acquired prior to July 1, 2004. The loans acquired prior to July 1, 2004 had face and unamortized premium balances of $9.9 billion and $142 million, respectively, at December 31, 2005. During the first half of 2006, 27% of these loans prepaid and we amortized 13% of the premium over the first half of 2006. For

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
these loans acquired prior to July 2004, we use coupon interest rates as they change over time and anticipated principal payments to determine an effective yield to amortize the premium or discount. For real estate loans acquired after July 1, 2004, the face and unamortized premium was $3.2 billion and $29 million at June 30, 2006 and $3.8 billion and $36 million at December 31, 2005, respectively. For these 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 principal payments to calculate an effective yield to amortize the premium or discount.
The following table provides detail of the activity of reported real estate loans for the three and six months ended June 30, 2006 and 2005.
Real Estate Loans Activity
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Balance at beginning of period
  $ 12,045,383     $ 21,829,300     $ 13,934,484     $ 22,559,244  
Acquisitions
    272,627       426,933       325,316       1,266,048  
Sales (other than to consolidated ABS trusts)
    (8,408 )     (14,570 )     (8,408 )     (14,570 )
Principal repayments
    (1,805,570 )     (2,560,836 )     (3,733,573 )     (4,121,134 )
Transfers to REO
    (3,879 )     (608 )     (5,933 )     (1,329 )
Net premium amortization
    (12,047 )     (9,857 )     (24,029 )     (17,531 )
Reversal of provision for credit losses, net of charge-offs
    2,922       1,493       3,171       622  
Net recognized gains (losses) and valuation adjustments
    (14 )     504       (14 )     1,009  
                         
Balance at end of period
  $ 10,491,014     $ 19,672,359     $ 10,491,014     $ 19,672,359  
                         
Our goal is to sell all of the real estate loans we acquire to securitization entities that finance their purchases of loans from us through the issuance of ABS. During the period that we accumulate loans for securitization, we fund these loans with equity and with short-term debt sourced through various whole loan-financing facilities available to us. The table below presents information regarding real estate loans pledged under our borrowing agreements and owned by securitization entities.
Real Estate Loans Pledged and Unpledged
(In thousands)
                                 
    June 30, 2006   December 31, 2005
         
    Face   Carrying   Face   Carrying
    Value   Value   Value   Value
                 
Unpledged
  $ 116,681     $ 108,410     $ 60,259     $ 51,924  
Pledged for Redwood debt
    244,446       245,414              
Owned by securitization entities, financed through the issuance of ABS
    10,004,473       10,137,190       13,729,074       13,882,560  
                         
Carrying value
  $ 10,365,600     $ 10,491,014     $ 13,789,333     $ 13,934,484  
                         

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Real Estate Securities
The real estate securities shown on our Consolidated Balance Sheets include residential and commercial real estate securities acquired from securitizations sponsored by others and certain other securities.
Real Estate Securities Composition
The following table summarizes the carrying value of real estate securities. Our real estate securities portfolio includes residential CES (BB, B, and unrated residential real estate loan securities), commercial CES (unrated commercial real estates securities), and various other securities, as reported on our Consolidated Balance Sheets at June 30, 2006 and December 31, 2005.
Real Estate Securities Composition
(In thousands)
                 
    June 30, 2006   December 31, 2005
         
Residential CES
  $ 715,360     $ 612,649  
Commercial CES
    75,889       57,687  
Other securities
    1,870,001       1,748,581  
             
Carrying value
  $ 2,661,250     $ 2,418,917  
             
The table below presents information on the types of securities that are included in our Consolidated Balance Sheets as of June 30, 2006 and December 31, 2005, and their current credit ratings.
Real Estate Securities — Underlying Collateral Characteristics
At June 30, 2006
(In millions)
                                                                 
        Rating
         
    Total   AAA   AA   A   BBB   BB   B   Unrated
                                 
Commercial real estate
  $ 401     $ 6     $ 2     $ 18     $ 101     $ 159     $ 39     $ 76  
Residential prime real estate
    1,567       72       251       259       270       379       169       167  
Residential sub-prime real estate
    407       5       86       237       79                    
Residential second lien real estate
    93       3       46       38       6                    
REIT corporate debt
    9                         1       8              
Real estate CDOs
    184       44       28       37       60       14             1  
                                                 
Total securities
  $ 2,661     $ 130     $ 413     $ 589     $ 517     $ 560     $ 208     $ 244  
                                                 

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
At December 31, 2005
(In millions)
                                                                 
        Rating
         
    Total   AAA   AA   A   BBB   BB   B   Unrated
                                 
Commercial real estate
  $ 380     $ 11     $ 2     $ 20     $ 129     $ 130     $ 30     $ 58  
Residential prime real estate
    1,302       29       243       196       232       331       116       155  
Residential sub-prime real estate
    442       5       86       292       59                    
Residential second lien real estate
    108             49       54       5                    
REIT corporate debt
    32                         24       8              
Real estate CDOs
    155       37       25       37       44       11             1  
                                                 
Total securities
  $ 2,419     $ 82     $ 405     $ 599     $ 493     $ 480     $ 146     $ 214  
                                                 
The table below presents the face value, unamortized discount, the portion of the discount designated as credit protection, the unrealized gains and losses, and the carrying value of real estate securities reported on our Consolidated Balance Sheets.
Residential and Commercial Real Estate Securities — June 30, 2006
(In millions)
                         
        Residential and    
        Commercial Credit-    
    Total Real   Enhancement    
    Estate Securities   Securities   Other Securities
    Available-for-Sale   Available-for-Sale   Available-for-Sale
             
Current face
  $ 3,393,492     $ 1,432,613     $ 1,960,879  
Unamortized premium — interest-only certificates
    9,203             9,203  
Unamortized discount, net
    (180,385 )     (90,925 )     (89,460 )
Discount designated as credit protection
    (617,712 )     (617,712 )      
                   
Amortized cost
    2,604,598       723,976       1,880,622  
Gross unrealized gains
    97,385       82,062       15,323  
Gross unrealized losses
    (40,733 )     (14,789 )     (25,944 )
                   
Carrying value
  $ 2,661,250     $ 791,249     $ 1,870,001  
                   

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Residential and Commercial Real Estate Securities — December 31, 2005
(In thousands)
                         
        Residential and    
        Commercial Credit-    
    Total Real Estate   Enhancement    
    Securities   Securities   Other Securities
    Available-for-Sale   Available-for-Sale   Available-for-Sale
             
Current face
  $ 3,021,363     $ 1,211,217     $ 1,810,146  
Unamortized premium — interest-only certificates
    14,866             14,866  
Unamortized discount, net
    (177,438 )     (107,337 )     (70,101 )
Discount designated as credit protection
    (496,416 )     (496,416 )      
                   
Amortized cost
    2,362,375       607,464     $ 1,754,911  
Gross unrealized gains
    93,322       80,122       13,200  
Gross unrealized losses
    (36,780 )     (17,250 )     (19,530 )
                   
Carrying value
  $ 2,418,917     $ 670,336     $ 1,748,581  
                   
At June 30, 2006, our securities provided credit-enhancement on $213 billion residential real estate loans, $29 billion of commercial real estate loans, and $16 billion of commercial real estate loans through a re- Real Estate Mortgage Investment Conduit (REMIC). At December 31, 2005, we credit-enhanced $170 billion of residential real estate loans, $26 billion of commercial real estate loans, and $17 of billion commercial real estate loans through a re-REMIC.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
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 security. The following table presents the changes in our unamortized discount and the portion of the discount designated as credit protection for the three and six months ended June 30, 2006 and 2005.
Residential and Commercial Unamortized Discount and Designated Credit Protection
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Beginning balance of unamortized discount
  $ 91,290     $ 64,061     $ 107,337     $ 97,841  
Amortization of discount
    (11,319 )     (7,429 )     (23,198 )     (15,747 )
Calls, sales, and other
    (520 )     (2,483 )     418       (15,391 )
Re-designation of credit protection to discount
    19,808       23,518       17,204       22,190  
Acquisitions
    (8,334 )     (6,026 )     (10,836 )     (17,252 )
                         
Ending balance of unamortized discount
  $ 90,925     $ 71,641     $ 90,925     $ 71,641  
                         
Beginning balance of designated credit protection
  $ 541,553     $ 454,669     $ 496,416     $ 385,762  
Realized credit losses
    (903 )     (2,008 )     (3,482 )     (3,231 )
Calls, sales and other
    (330 )     (1,767 )     (5,039 )     (11,379 )
Re-designation of credit protection to discount
    (19,808 )     (23,518 )     (17,204 )     (22,190 )
Acquisitions
    97,200       64,014       147,021       142,428  
                         
Ending balance of designated credit protection
  $ 617,712     $ 491,390     $ 617,712     $ 491,390  
                         
Yields recognized for GAAP for each security vary as a function of credit results, prepayment rates, and, for our securities with variable rate coupons, interest rates. 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. 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 or we may have an other-than-temporary impairment. For the three and six months ended June 30, 2006, we recognized other-than-temporary impairments of $2.3 million and $5.5 million, respectively. For the three and six months ended June 30, 2005, we recognized other-than-temporary impairments of $1.7 million and $2.1 million, respectively. These impairments are included in net recognized gains and valuation adjustments in our Consolidated Statements of Income.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
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 any real estate securities have been in a continuous unrealized loss position as of June 30, 2006. These unrealized losses are not considered to be other-than-temporary impairments because these losses are not due to adverse changes in cash flows and we have the intent and ability to hold these securities for a period sufficient for these securities to potentially recover their values.
Real Estate Securities with Unrealized Losses as of June 30, 2006
(In thousands)
                                                 
    Less Than 12 Months   12 Months or More   Total
             
    Fair   Unrealized   Fair   Unrealized   Fair   Unrealized
    Value   (Losses)   Value   (Losses)   Value   (Losses)
                         
Real estate securities
  $ 920,174     $ (33,486 )   $ 131,048     $ (7,247 )   $ 1,051,222     $ (40,733 )
The following table provides detail of the activity in our real estate securities portfolio for the three and six months ended June 30, 2006 and 2005.
Real Estate Securities Activity
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Balance at beginning of period
  $ 2,528,099     $ 2,145,341     $ 2,418,917     $ 1,956,233  
Acquisitions
    333,223       244,031       496,822       493,047  
Sales (other than to consolidated ABS trusts)
    (162,798 )     (3,012 )     (176,432 )     (42,667 )
Principal repayments (including calls)
    (56,720 )     (42,733 )     (101,803 )     (93,735 )
Discount amortization
    12,790       7,580       25,319       16,013  
Net unrealized gains
    6,173       30,499       111       37,816  
Net recognized gains and valuation adjustments
    483       2,723       (1,684 )     17,722  
                         
Balance at end of period
  $ 2,661,250     $ 2,384,429     $ 2,661,250     $ 2,384,429  
                         
Of the $57 million and $102 million of principal pay downs in the three and six months ended June 30, 2006, $4 million and $6 million, respectively, represented calls of the securities in accordance with the original issue provisions of individual securitization entities. Of the $43 million and $94 million of principal pay downs in the three and six months ended June 30, 2005, $9 million and $27 million, respectively, represented calls of the securities.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
The following tables provide the activity for the components of the securities portfolios; residential CES, commercial CES, and other securities.
Residential Credit-Enhancement Securities Activity
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Balance at beginning of period
  $ 643,823     $ 611,394     $ 612,649     $ 561,658  
Acquisitions
    89,217       87,849       142,039       155,658  
Sales (other than to consolidated ABS trusts)
    (10,317 )           (19,967 )     (27,293 )
Principal repayments (including calls)
    (28,102 )     (20,400 )     (45,571 )     (44,332 )
Discount amortization
    12,410       7,775       25,565       16,502  
Net unrealized gains (losses)
    6,317       15,207       (2,421 )     24,393  
Net recognized gains and valuation adjustments
    2,012       4,370       3,066       19,609  
                         
Balance at end of period
  $ 715,360     $ 706,195     $ 715,360     $ 706,195  
                         
Commercial Credit-Enhancement Securities Activity
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Balance at beginning of period
  $ 66,648     $ 28,570     $ 57,687     $ 14,498  
Acquisitions
    8,125             15,036       12,870  
Sales (other than to consolidated ABS trusts)
                       
Principal repayments (including calls)
                       
Discount amortization
    (1,091 )     (346 )     (2,367 )     (755 )
Net unrealized gains
    3,458       1,324       6,822       2,935  
Net recognized gains and valuation adjustments
    (1,251 )     (151 )     (1,289 )     (151 )
                         
Balance at end of period
  $ 75,889     $ 29,397     $ 75,889     $ 29,397  
                         

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Other Securities Activity
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Balance at beginning of period
  $ 1,817,628     $ 1,505,377     $ 1,748,581     $ 1,380,077  
Acquisitions
    235,881       156,182       339,747       324,519  
Sales (other than to consolidated ABS trusts)
    (152,481 )     (3,012 )     (156,465 )     (15,374 )
Principal repayments (including calls)
    (28,618 )     (22,333 )     (56,232 )     (49,403 )
Discount amortization
    1,471       151       2,121       266  
Net unrealized gains (losses)
    (3,602 )     13,968       (4,290 )     10,488  
Net recognized gains and valuation
                               
Adjustments
    (278 )     (1,496 )     (3,461 )     (1,736 )
                         
Balance at end of period
  $ 1,870,001     $ 1,648,837     $ 1,870,001     $ 1,648,837  
                         
We generally fund the first-loss and second-loss interests of residential securities and first-loss commercial securities with equity capital. We sell the other interests we acquire to securitization entities (generally, Acacia) that re-securitize these assets by issuing ABS. Prior to sale to these securitization entities, we may fund some of the securities acquired on a temporary basis with short-term borrowings through various financing facilities available to us. The table below presents information regarding our securities pledged under borrowing agreements and owned by securitization entities as of June 30, 2006 and December 31, 2005.
Real Estate Securities Pledged and Unpledged
(In thousands)
                 
    June 30, 2006   December 31, 2005
         
Unpledged
  $ 442,059     $ 371,225  
Pledged for Redwood debt
    282,740       164,426  
Owned by securitization entities, financed through issuance of ABS
    1,936,451       1,883,266  
             
Carrying value
  $ 2,661,250     $ 2,418,917  
             
Net Recognized Gains (Losses) 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 (losses) and valuation adjustments reported in income for the three and six months ended June 30, 2006 and 2005.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Net Recognized Gains and Valuation Adjustments
(In thousands)
                                   
    Three Months   Six Months
    Ended   Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Realized gains on calls:
                               
 
Real estate securities
  $ 747     $ 4,421     $ 747     $ 11,969  
Realized gains (losses) on sales:
                               
 
Real estate loans
    (14 )     504       (14 )     1,009  
 
Real estate securities
    2,041       12       3,100       7,854  
Valuation adjustments — Impairment:
                               
 
Real estate securities
    (2,305 )     (1,710 )     (5,531 )     (2,101 )
Gains (losses) on interest rate agreements
    9,160       (182 )     9,457       (674 )
Purchase commitments
    (3,636 )           (3,636 )      
                         
Net recognized gains and valuation adjustments
  $ 5,993     $ 3,045     $ 4,123     $ 18,057  
                         
During the course of preparing the financial statements for the second quarter, we discovered that accrual rates for interest income on certain securities and interest expense on certain ABS issued had been incorrectly applied and not correctly adjusted to the appropriate amount once the cash had been received or paid. The impact of this error was that on a cumulative basis we had overstated interest income by $1.3 million and understated interest expense by $0.2 million.
Also, due diligence expenses for certain securities purchased had been incorrectly capitalized and not expensed as incurred. The incorrectly capitalized due diligence expenses were $0.6 million.
Under the provisions of Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3 (FAS 154), we analyzed the errors for each period affected. After carefully assessing the effect of this error on previously reported earnings and the effect of recording a total cumulative correcting adjustment of $2.1 million in the second quarter of 2006, we determined that the errors were not material to the financial statements for the three and six months ended June 30, 2006. Accordingly, a cumulative correcting adjustment of $1.5 million was recorded and resulted in a decrease in interest income, an increase in interest expense in the Consolidated Statements of Income and a decrease in accrued interest receivable and an increase in accrued interest payable balances on the Consolidated Balance Sheets. For due diligence expenses, the cumulative correcting adjustment of $0.6 million was recorded and resulted in an increase in operating expenses in the Consolidated Statements of Income and a decrease in mortgage securities on the Consolidated Balance Sheets. The correction of this error did not materially affect taxable income or our dividend distribution.
NOTE 4. RESERVES FOR CREDIT LOSSES
We establish and maintain credit reserves that we believe represent probable credit losses in our consolidated 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 real estate loans on our Consolidated Balance Sheets.
Our loan servicers advance payment on delinquent loans to the extent they deem them recoverable. We generally accrue interest on delinquent loans to the extent cash is received; any potential loss is included in our credit reserve. When a loan becomes REO, we estimate the specific loss, based on

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
estimated net proceeds from the sale of the property (including accrued but unpaid interest), and charge this specific estimated loss against the reserve for credit losses. A majority of the residential loans consolidated on our balance sheet have interest-only payments for an initial term. Any increased credit risk that these loans may contain is reflected in our analysis and determination of the appropriate credit reserves.
The following table summarizes the activity in reserves for credit losses for our consolidated real estate loans for the three and six months ended June 30, 2006 and 2005.
Real Estate Loans
(In thousands)
                                 
    Three Months   Six Months
    Ended   Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Balance at beginning of period
  $ 22,372     $ 24,452     $ 22,656     $ 23,896  
Reversal of provision for credit reserve
    (2,506 )     (1,527 )     (2,330 )     (502 )
Net recoveries (charge-offs)
    (416 )     34       (876 )     (435 )
                         
Balance at end of period
  $ 19,450     $ 22,959     $ 19,450     $ 22,959  
                         
Delinquencies in our consolidated residential real estate loans were $47 million and $37 million as of June 30, 2006 and December 31, 2005, respectively. Delinquencies include loans delinquent more than 90 days, in bankruptcy, in foreclosure, and REO. As a percentage of our residential real estate loans, delinquencies stood at 0.46% and 0.27% of our current loan balances as of June 30, 2006 and December 31, 2005, respectively. We had no delinquent commercial real estate loans as of June 30, 2006 and December 31, 2005.
During the quarter we reduced our loss confirmation period (see Note 2) by one month based on the change in our real estate loan portfolio composition. The mix of the portfolio changed as the loans prepaid and acquisitions of new loans were at a slow pace. We determined that the time period from initial deterioration in a borrower’s condition to charge-off of the loan had been reduced based on the profile of the borrowers in the portfolio. Total losses estimated over the life of the loan did not change; however, the estimated timing of these total losses was adjusted. The effect of this change in confirmation period was to reverse $1.0 million of reserves for credit losses to the Consolidated Statements of Income for the three months ended June 30, 2006.
Reserve for Deferred Interest
For negatively amortizing loans that we credit-enhance, we intend to recognize interest income when we receive the cash — either currently, or at a later date, according to the terms of the loan.
To the extent we own any first- or second-loss securities with underlying loans that do not make the fully amortized payment, we do not recognize any unpaid interest as income. That is, we only recognize the actual interest paid by establishing a reserve for the amounts the loans negatively amortize. These reserves are netted against our accrued interest receivable. During the three and six months ended June 30, 2006, we increased our reserve for deferred interest by $0.9 million and $1.7 million, respectively, against interest income on these securities. We did not provide for a reserve against interest income on these securities for the three and six months ended June 30, 2005. At June 30, 2006, the outstanding reserve was $2.6 million.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
One commercial loan that we own, in accordance with the contractual arrangements, began deferring interest payments in 2006, though we may receive these amounts at a later date. Consistent with our accounting practice on negatively amortizing loans, we did not recognize the $0.1 million and $0.4 million of interest accrued and not paid on this loan, during the three and six months ended June 30, 2006, respectively.
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. Currently, the majority of our interest rate agreements are used to match the duration of liabilities to assets. 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 purchase commitments.
On the date on which 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.
We 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.
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 AA or higher. Furthermore, we generally enter into interest rate agreements with several different counterparties in order to diversify our credit risk exposure and maintain margin accounts with them.
We report our interest rate agreements at fair value as determined using third-party models and confirmed by Wall Street dealers. As of June 30, 2006 and December 31, 2005, the net fair value of interest rate agreements was $49.4 million and $30.7 million, respectively, and are summarized in the table below. See Note 10 for the impact of these fair value changes on Accumulated Other Comprehensive Income.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Interest Rate Agreements
(In thousands)
                                                 
    June 30, 2006   December 31, 2005
         
    Fair   Notional   Credit   Fair   Notional   Credit
    Value   Amount   Exposure   Value   Amount   Exposure
                         
Trading Instruments
                                               
Interest rate caps purchased
  $ 1,924     $ 76,400     $     $ 1,913     $ 116,400     $  
Interest rate caps sold
    (233 )     (25,000 )           (239 )     (65,000 )      
Interest rate corridors purchased
          1,079,885                   1,059,851        
Interest rate swaps
    3,354       776,307             148       80,400        
Purchase commitments
    (3,636 )     850,000                          
Cash Flow Hedges
                                               
Interest rate swaps
    47,961       4,201,088       (6,509 )     28,891       5,399,653       (2,672 )
                                     
Total Interest Rate Agreements
  $ 49,370     $ 6,958,680     $ (6,509 )   $ 30,713     $ 6,591,304     $ (2,672 )
                                     
The following table depicts the amounts included in interest expense and net recognized gains (losses) and valuation adjustments activity for the three and six months ended June 30, 2006 and 2005 for our interest rate agreements.
Interest Rate Agreements
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Net Amounts Credited to (Included in) Interest Expense for Cash Flow Hedges
                               
Realized net gains (losses) due to net ineffective portion of hedges
  $ (350 )   $ (441 )   $ 133     $ (45 )
Realized net loss reclassified from other comprehensive income
    206       (81 )     472       (198 )
Net cash payment (receipt) on interest rate swaps
    3,823       1,397       6,054       2,587  
                         
Total
  $ 3,679     $ 875     $ 6,659     $ 2,344  
                         
Net Recognized Gains (Losses) and Valuation Adjustments                
Realized net gains (losses) on trading instruments
  $ 5,524     $ (182 )   $ 5,821     $ (674 )
                         
We have elected cash flow hedging treatment for many of our existing interest rate agreements. For these interest rate agreements, the ineffective portion of the hedging derivative is recognized immediately in earnings. We anticipate having some ineffectiveness in our hedging program, as not all terms of our hedges and not all terms of our hedged items match perfectly. We use the dollar-offset method to determine the amount of ineffectiveness. For the three and six months ended June 30, 2006, the amount of ineffectiveness was $0.4 million of expense and $0.1 million of income, respectively. For the three and six months ended June 30, 2005, the amount of ineffectiveness was $0.4 million and $0.1 million of expense, respectively.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Should we choose to terminate a cash flow hedge, the value of that hedge will be reclassified from accumulated other comprehensive income into earnings over time. For the three and six months ended June 30, 2006, the amount reclassified from other comprehensive income to interest expense totaled positive $0.2 million and positive $0.5 million, respectively. For the three and six months ended June 30, 2005, the amount reclassified from other comprehensive income to interest expense totaled negative $0.1 million and negative $0.2 million, respectively. The timing of the reclassification depends on the status of the hedged or forecasted transaction. If the hedged transaction no longer exists, or the forecasted transaction is no longer expected to occur, then the reclassification occurs immediately. If the hedged transaction still exists, or the forecasted transaction is still expected to occur, then the reclassification occurs over the original period of such transaction. To date we have terminated several cash flow hedges where the hedged transaction still exists or is still expected to occur. As a result, included in accumulated other comprehensive income at June 30, 2006, was a net gain balance of $0.8 million related to these terminated cash flow hedges to be reclassified into earnings over the original period of the transaction. This net gain consisted of $5.8 million of hedges terminated at a gain and $5.0 million of hedges terminated at a loss. Of this net amount, $0.4 million will be recognized as interest income on our Consolidated Statements of Income over the next twelve months. At June 30, 2006, the maximum length of time over which we are hedging our exposure to the variability of future cash flows for forecasted transactions is ten years, and all forecasted transactions are expected to occur within the next year.
Also included in our interest expense in our Consolidated Statements of Income is the net cash receipts on interest rate agreements designated as cash flow hedges. For the three and six months ended June 30, 2006, the net cash receipts credited to interest expense totaled $3.8 million and $6.1 million, respectively. For the three and six months ended June 30, 2005, the net cash receipts credited to interest expense totaled $1.4 million and $2.6 million, respectively.
We did not elect hedge accounting treatment for some of our existing interest rate agreements and these are accounted for as “trading” instruments. Thus, changes in the market value of these interest rate agreements and associated income and expenses are reported through our earnings and appear in net recognized gains (losses) and valuation adjustments in our Consolidated Statements of Income. For the three and six months ended June 30, 2006, the amount of market value changes associated with interest rate agreements accounted for as trading instruments totaled positive $5.5 million and positive $5.8 million, respectively. For the three and six months ended June 30, 2005, the amount of market value changes associated with interest rate agreements accounted for as trading instruments totaled negative $0.2 million and negative $0.7 million, respectively.
During the three months ended June 30, 2006 we entered into commitments to purchase $850 million of residential hybrid loans that will settle in the third quarter of 2006. These commitments are accounted for as derivatives under Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (FAS 149), where applicable. These commitments are classified as trading instruments on our Consolidated Balance Sheets until the date of settlement and changes in fair value are recorded through Net Recognized Gains and Valuation Adjustments in the Consolidated Statements of Income. Included in Net Recognized Gains and Valuation Adjustments for the three months ended June 20, 2006 is $3.6 million of negative fair value change on these hybrid loan commitments and a positive $3.0 million fair value change on related interest rate agreements, for a net loss of $0.6 million.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
NOTE 6. SHORT-TERM DEBT
At June 30, 2006 the balance of outstanding Redwood debt was $529 million and at December 31, 2005 the outstanding balance was $170 million. We generally enter into repurchase agreements, bank borrowings, and other forms of collateralized short-term borrowings to finance assets under accumulation for future sale to securitization entities. The table below summarizes Redwood debt by collateral type as of June 30, 2006 and December 31, 2005.
Redwood Debt
(In thousands)
                                                 
    June 30, 2006   December 31, 2005
         
        Weighted   Weighted       Weighted   Weighted
        Average   Average       Average   Average
    Amount   Interest   Days Until   Amount   Interest   Days Until
    Borrowed   Rate   Maturity   Borrowed   Rate   Maturity
                         
Residential real estate loan collateral
  $ 238,445       5.71 %     173     $              
Residential loan CES collateral
    69,349       5.99 %     34       38,707       4.99 %     73  
Real estate securities collateral
    221,589       5.85 %     34       131,000       5.07 %     73  
                                     
Total Redwood debt
  $ 529,383       5.81 %     97     $ 169,707       5.05 %     73  
                                     
For both the three and six months ended June 30, 2006, the average balance of Redwood debt was $0.1 billion and the weighted-average interest cost was 8.51% and 7.00%, respectively. For both the three and six months ended June 30, 2005, the average balance of Redwood debt was $0.2 billion and the weighted-average interest cost was 3.30% and 3.63%, respectively. At June 30, 2006 and December 31, 2005, accrued interest payable on Redwood debt was $1.8 million and $1.0 million, respectively.
As of June 30, 2006 and December 31, 2005, Redwood debt had the following remaining maturities.
Redwood Debt
(In thousands)
                 
    June 30,   December 31,
    2006   2005
         
Within 30 days
  $     $  
31 to 90 days
    290,938       169,707  
Over 90 days
    238,445        
             
Total Redwood debt
  $ 529,383     $ 169,707  
             
In 2005, we formed Madrona Residential Funding, LLC (“Madrona”), a special purpose entity and wholly owned subsidiary of 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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
BBB-rated Madrona ABS to provide further credit support. This facility has a three-year term. As of June 30, 2006 there was no commercial paper outstanding.
We have uncommitted facilities available with several banks and major investment banking firms for financing real estate securities and loans and an unsecured line of credit with a bank. Additional collateral in the form of additional qualifying assets or cash may be required to meet changes in market values from time to time under these agreements. The table below summarizes the outstanding balances as of June 30, 2006 and December 31, 2005 by collateral type.
Redwood Debt
(In thousands)
                                 
    June 30, 2006
     
    Number of    
    Facilities   Outstanding   Limit   Maturity
                 
Facilities by collateral:
                               
Real estate loans
    4     $ 238,445     $ 1,800,000       8/06-1/07  
Real estate securities
    1       290,938       500,000       8/06  
Unsecured line of credit
    1             10,000       8/06  
Madrona commercial paper facility
    1             300,000       4/08  
                         
Total facilities
    7     $ 529,383     $ 2,610,000          
                         
                                 
    December 31, 2005
     
    Number of    
    Facilities   Outstanding   Limit   Maturity
                 
Facilities by collateral:
                               
Real estate loans
    4     $     $ 1,800,000       1/06-9/06  
Real estate securities
    1       169,707       300,000       3/06  
Unsecured line of credit
    1             10,000       8/06  
Madrona commercial paper facility
    1             300,000       4/08  
                         
Total facilities
    7     $ 169,707     $ 2,410,000          
                         
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 intent to renew facilities and pursue additional facilities and other types of financing as needed.
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 ABS consists of various classes that pay interest at variable and fixed rates. Substantially all 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 adjust to a LIBOR rate (hybrid ABS) or are fixed for their entire term. Some of the ABS IOs issued have a fixed spread, while others earn a coupon based on the spread between collateral owned and the ABS issued by the 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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
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.
The components of ABS issued by consolidated securitization entities as of June 30, 2006 and December 31, 2005, along with other selected information, are summarized in the table below.
Asset-Backed Securities Issued
(In thousands)
                 
    June 30, 2006   December 31, 2005
         
Sequoia ABS issued — certificates with principal value
  $ 9,612,079     $ 13,246,343  
Sequoia ABS issued — interest-only certificates
    106,220       142,788  
Acacia ABS issued
    2,158,444       2,165,840  
Commercial ABS issued
          4,250  
Madrona ABS issued
    5,400       5,400  
Unamortized premium on ABS
    15,845       20,656  
             
Total consolidated ABS issued
  $ 11,897,988     $ 15,585,277  
             
Range of weighted average interest rates, by series — Sequoia
    4.67% to 6.10 %     4.23% to 5.65 %
Stated Sequoia maturities
    2008-2035       2007-2035  
Number of Sequoia series
    41       42  
Range of weighted average interest rates, by series — Acacia
    5.34%-6.17 %     4.32%-5.40 %
Stated Acacia maturities
    2023-2046       2023-2046  
Number of Acacia series
    8       8  
Weighted average interest rates — Commercial
          12.00%  
Stated commercial maturities
          2009  
Number of commercial series
          1  
The following table summarizes the accrued interest payable on ABS issued as of June 30, 2006 and December 31, 2005.
Accrued Interest Payable on Asset-Backed Securities Issued
(In thousands)
                 
    June 30, 2006   December 31, 2005
         
Sequoia
  $ 22,198     $ 26,225  
Acacia
    22,933       13,778  
Commercial
          44  
             
Total accrued interest payable on ABS issued
  $ 45,131     $ 40,047  
             
The ABS issued by securitization entities sponsored by us are collateralized by 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 conventional, 25- or 30-year, adjustable-rate and hybrid 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 real estate securities and

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
commercial real estate loans are typically issued 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 appear on our Consolidated Balance Sheets. The ABS issued by Madrona Residential Funding LLC (Madrona ABS) represents a form of additional credit support potentially available to the purchasers of the commercial paper.
Sequoia entities did not issue any ABS during the six months ended June 30, 2006. During the three and six months ended June 30, 2005, Sequoia entities issued $0.4 billion and $1.1 billion, respectively, of Sequoia ABS to fund Sequoia’s acquisitions of residential real estate loans from us.
Acacia entities did not issue any ABS during the three months ended June 30, 2006 or 2005. During both the six months ended June 30, 2006 and 2005, an Acacia entity issued $300 million of Acacia ABS.
During the six months ended June 30, 2006, and during the three months ended June 30, 2005, there were no issuances of commercial ABS. During the six months ended June 30, 2005, we issued $4.3 million of commercial ABS. During both the three and six months ended June 30, 2006, a commercial ABS of $4.3 million was paid off in full. During the three and six months ended June 30, 2005, commercial ABS of $5.5 million and $9.5 million were paid off, respectively.
The carrying value components of the collateral for ABS issued and outstanding as of June 30, 2006 and December 31, 2005 are summarized in the table below:
Collateral for Asset-Backed Securities Issued
(In thousands)
                 
    June 30, 2006   December 31, 2005
         
Real estate loans
  $ 10,137,190     $ 13,882,560  
Real estate securities
    1,936,451       1,883,266  
Real estate owned (REO)
    5,288       2,589  
Restricted cash owned by consolidated securitization entities
    86,227       70,276  
Accrued interest receivable
    60,614       71,850  
             
Total collateral for ABS issued
  $ 12,225,770     $ 15,910,541  
             
The total restricted cash balance at June 30, 2006 of $86 million and $72 million at December 31, 2005, respectively, represented principal and interest due to owners of ABS issued by securitization entities, cash pledged as collateral on interest rate agreements, and cash held back from borrowers until certain loan agreement requirements were met.
NOTE 8. TAXES
For tax purposes, a REIT can deduct dividends paid from REIT taxable income, and thus effectively reduce or eliminate corporate-level income taxes on REIT income. A REIT can retain up to 10% of its REIT taxable income and still maintain its REIT status but will be taxable at corporate rates on this retained income. As of June 30, 2006, we had met all of the dividend distribution requirements of a REIT.
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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
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 2005 that were paid in January 2006 are considered taxable income to stockholders in 2005 (the year declared).
Our 2005 dividend distributions declared before December 31, 2005 and distributed on or before January 31, 2006, were less than 85% of our estimated 2005 REIT taxable income. This resulted in a 4% excise tax provision on the shortfall. We anticipate following a similar pattern in 2006. For the three and six months ended June 30, 2006, we provided for excise tax of $0.3 million and $0.6 million, respectively, which is reflected as a component of operating expenses on our Consolidated Statements of Income. For the three and six months ended June 30, 2005, we also provided for excise tax of $0.3 million and $0.6 million, respectively. As of June 30, 2006 and December 31, 2005, accrued excise tax payable was $0.6 million and $1.2 million, respectively, and was reflected as a component of accrued expenses and other liabilities on our Consolidated Balance Sheets.
We currently plan to retain approximately 10% of our 2006 REIT ordinary taxable income (as we have in the previous three years) and will be subject to corporate level income taxes on any retained income for the 2006 calendar tax year. We plan to distribute any capital gains income (income generated from calls and sales) that we generate to allow our stockholders to potentially take advantage of a lower tax rate on those distributions.
The following table summarizes the tax provisions for Redwood REIT and Holdings for the three and six months ended June 30, 2006 and 2005.
Provision for Income Tax
(In thousands)
                                   
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Current Tax Provision:
                               
 
Redwood REIT — Federal
  $ 1,400     $ 1,400     $ 2,700     $ 2,500  
 
Holdings — Federal
    1,300       600       1,700       1,010  
State Unitary (Redwood and Holdings)
    802       700       1,344       1,470  
                         
Total current tax provision
  $ 3,502     $ 2,700     $ 5,744     $ 4,980  
                         
Deferred Tax Provision:
                               
 
Holdings
    (237 )     1,354       281       3,751  
                         
Total provision for income tax
  $ 3,265     $ 4,054     $ 6,025     $ 8,731  
                         
The Redwood REIT Federal tax provision for corporate income tax is estimated based on the amount of REIT ordinary income that we permanently retained, or plan to retain. Holdings deferred tax provisions are attributable to temporary differences between GAAP and tax accounting treatments on securitization gains and the utilization of prior period deferred tax assets.
As of June 30, 2006 and December 31, 2005, Holdings had net deferred tax assets as presented in the table below. Realization of the deferred tax asset is dependent on many factors including generating sufficient taxable income prior to the expirations of net operating loss carry forwards. Although realization is not assured, we believe it is more likely than not that most of the deferred tax asset will be realized. The amount of the deferred tax asset considered realizable, however, could be reduced if revised estimates of future taxable income during the carry forward periods are lower than expectations.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Deferred Tax Assets
(In thousands)
                 
    June 30, 2006   December 31, 2005
         
Net operating loss carry forward — State
  $ 623     $ 725  
Capital loss carry forward
    15        
Real estate assets
    2,957       1,970  
Gains from Sequoia securitizations
    1,353       2,536  
State credit carry forward
    229       229  
Negative amortization loan reserve
    106        
Capitalized expenses
    (32 )      
FAS 115 & 133 OCI Mark to Market
    288        
Interest rate agreements
    243       224  
             
Total deferred tax assets
  $ 5,782     $ 5,684  
Valuation allowance
    (391 )     (300 )
             
Total benefited deferred tax assets
  $ 5,391     $ 5,384  
             
Holdings’ state NOLs were $8.8 million and $10.1 million at June 30, 2006 and December 31, 2005, respectively. These state NOLs will expire by 2012, unless utilized. At June 30, 2006 and December 31, 2005, the valuation allowance relates exclusively to Holdings’ state NOLs which may expire before being utilized.
The statutory combined Federal and state corporate tax rate is 42%. This rate is applied to the amount of estimated REIT taxable income retained and to taxable income earned at the taxable subsidiaries. Thus, as a REIT, our effective tax rate is significantly less than the statutory combined rate as we are allowed to deduct dividend distributions. In addition, there are some permanent and temporary differences (including accounting for securitizations, stock options, and other employee compensation expenses) between GAAP income and taxable income that result in changes in our effective rate from the statutory rates.
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 June 30, 2006 and December 31, 2005.
Fair Value of Financial Instruments
(In thousands)
                                 
    June 30, 2006   December 31, 2005
         
    Carrying   Fair   Carrying   Fair
    Value   Value   Value   Value
                 
Assets
                               
Real estate loans held-for-investment
  $ 10,491,014     $ 10,412,445     $ 13,934,484     $ 13,855,709  
Real estate securities available-for-sale
  $ 2,661,250     $ 2,661,250     $ 2,418,917     $ 2,418,917  
Interest rate agreements
  $ 53,573     $ 53,573     $ 31,220     $ 31,220  
Cash and cash equivalents
  $ 106,491     $ 106,491     $ 175,885     $ 175,885  
Restricted cash
  $ 86,227     $ 86,227     $ 72,421     $ 72,421  
Accrued interest receivable
  $ 66,798     $ 66,798     $ 76,469     $ 76,469  
 
Liabilities
                               
Redwood debt
  $ 529,383     $ 529,383     $ 169,707     $ 169,707  
ABS issued
  $ 11,897,988     $ 11,866,302     $ 15,585,277     $ 15,519,383  
Interest rate agreements
  $ 4,203     $ 4,203     $ 507     $ 507  
Accrued interest payable
  $ 46,927     $ 46,927     $ 41,027     $ 41,027  
Commitments to purchase
  $ 3,636     $ 3,636     $     $  
Methodologies we use to estimate fair market values for various asset types are described below.
•  Real estate loans
  •  Residential loan and HELOC fair values are determined by available market quotes and discounted cash flow analyses and are confirmed by third party/dealer pricing indications.
 
  •  Commercial loan fair values are determined by appraisals on underlying collateral and discounted cash flow analyses.
•  Real estate securities
  •  Real estate securities fair values are determined by discounted cash flow analyses and other valuation techniques using market pricing assumptions confirmed by third party dealer/pricing indications.
•  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 derivative 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 approximate carrying values.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
•  Accrued interest receivable and payable
  •  Includes interest due and receivable on assets and due and payable on our liabilities. Due to the short-term nature of when these interest payments will be received or paid, fair values approximate carrying values.
•  Redwood debt
  •  All Redwood debt is adjustable and matures within one year; fair values approximate carrying values.
•  ABS issued
  •  Fair values are determined by discounted cash flow analyses and other valuation techniques confirmed by third party/dealer pricing indications.
•  Commitments to purchase
  •  Fair values are determined by discounted cash flow analyses and other valuation techniques confirmed by third party/dealer pricing indications.
NOTE 10. STOCKHOLDERS’ EQUITY
Stock Option Plan
In March 2006, we amended the previously amended 2002 Redwood Trust, Inc. Incentive Stock Plan (Incentive Plan, or IP) for executive officers, employees, and non-employee directors. This amendment was approved by our stockholders in May 2006. The IP 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 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 IP. The IP 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. In addition, this latest amendment incorporated the addition of performance units as a type of award under the Plan, which may be awarded to officers, directors, and employees of Redwood or any of its subsidiaries, and other persons expected to provide significant services to Redwood or any of its subsidiaries. Performance units are intended to be used for annual cash bonus payments granted to Executive Committee members who are named executive officers (the Chief Executive Officer and other four most highly compensated officers) in an amount not to exceed $5 million per grantee per year, so as to qualify as performance-based compensation under the Code. As of June 30, 2006 and December 31, 2005, 849,895 and 315,866 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 both June 30, 2006 and December 31, 2005, 551,697 ISOs had been granted. The exercise price for ISOs granted under the IP 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 cash or stock DERs. Cash DERs per applicable option are cash payments made that are equal to the per share dividends paid on common stock to our shareholders. In 2005 and earlier, prior to our adoption of FAS 123R on January 1, 2006, we expensed the cash DERs to be paid on options granted prior to January 1, 2003. These expenses were included in operating expenses in our Consolidated Statements of Income for the years 2005 and earlier. For the three and six months ended June 30, 2005, we accrued cash DER expenses of $1.8 million and $3.5 million, respectively, relating to these options. For 2005 and earlier years, stock options granted between January 1, 2003 and December 31, 2005 that provided for cash DERs were accounted for under the provisions of FAS 123; thus, there are no DER expenses associated with these options as future DERs were included in the valuation of the stock options at the grant date. For the three and six months ended June 30, 2005, we accrued stock option expenses of $0.3 million and $0.7 million, respectively. With the adoption of FAS 123R on January 1, 2006, the grant date fair value of all remaining unvested stock options is expensed on the Consolidated Statements of Income over the remaining vesting period of each option. For the three and six months ended June 30, 2006, stock option expense of $0.5 million and $1.1 million, respectively, was recorded on our Consolidated Statements of Income. As of June 30, 2006, there was $2.4 million of unrecognized compensation cost related to nonvested stock options. These costs will be expensed over a weighted-average period of 1.2 years. As of June 30, 2006 and December 31, 2005, there were 1,394,191 and 1,491,403 unexercised options with cash DERs, respectively. Options with cash DERs are participating securities under EITF 03-6 and were determined to be antidilutive in all reported periods.
Stock DERs represented shares of stock that were issuable when the holders exercised the underlying stock options, the amount of which was based on prior dividends paid per share on common stock and the market value of the stock on the various dividend payable dates. In November 2005, all options with stock DERs were converted to options with cash DERs to comply with Internal Revenue Code Section 409A deferred compensation rules. At June 30, 2006 and December 31, 2005, there were no unexercised options with stock DERs. For the three and six months ended June 30, 2005, an expense of $10,000 and income of $59,000, respectively, was recorded related to stock options with stock DERs for awards that were considered variable awards under APB 25.
Redwood has also granted stock options with no DERs. As of June 30, 2006 and December 31, 2005, there were 113,035 and 57,009 of unexercised options with no DERs, respectively.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
A summary of the stock option activity during the three and six months ended June 30, 2006 and 2005 is presented below. Note 2 provides a discussion on the assumptions used to value stock options at grant date.
Stock Option Activity
                                     
    Three Months Ended June 30,
     
    2006   2005
         
        Weighted Average       Weighted Average
    Shares   Exercise Price   Shares   Exercise Price
                 
Stock Options Outstanding
                               
Outstanding options at beginning of period
    1,507,957     $ 33.19       1,612,435     $ 31.88  
   
Options granted
                1,601     $ 52.20  
   
Options exercised
    (350 )   $ 24.50       (6,905 )   $ 28.67  
   
Options forfeited
    (381 )   $ 43.13       (10,392 )   $ 47.13  
 
Stock dividend equivalent rights earned
                5,301        
                         
 
Outstanding options at end of period
    1,507,226     $ 33.19       1,602,040     $ 31.71  
                         
Options exercisable at period-end
    1,287,156               1,160,054          
Weighted average fair value of options granted during the period
  $             $ 4.17          
                                     
    Six Months Ended June 30,
     
    2006   2005
         
        Weighted Average       Weighted Average
    Shares   Exercise Price   Shares   Exercise Price
                 
Stock Options Activity
                               
Outstanding options at beginning of period
    1,548,412     $ 32.60       1,624,465     $ 31.77  
   
Options granted
    33,871     $ 41.09       3,601     $ 51.70  
   
Options exercised
    (73,641 )   $ 24.13       (22,545 )   $ 18.91  
   
Options forfeited
    (1,416 )   $ 41.16       (13,359 )   $ 43.64  
 
Stock dividend equivalent rights earned
                9,878        
                         
 
Outstanding options at end of period
    1,507,226     $ 33.19       1,602,040     $ 31.71  
                         
Options exercisable at period-end
    1,287,156               1,160,054          
Weighted average fair value of options granted during the period
  $ 3.41             $ 10.84          

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
The following table summarizes information about stock options outstanding at June 30, 2006.
Stock Option Exercise Prices as of June 30, 2006
                                         
    Options Outstanding   Options Exercisable
         
        Weighted Average        
        Remaining        
    Number   Contractual Life   Weighted Average   Number   Weighted Average
Range of Exercise Prices   Outstanding   in Years   Exercise Price   Exercisable   Exercise Price
                     
$10 to $20
    351,783       3.18     $ 12.75       351,783     $ 12.75  
$20 to $30
    388,709       4.20     $ 24.17       348,533     $ 23.84  
$30 to $40
    266,460       0.90     $ 37.49       266,335     $ 37.49  
$40 to $50
    130,931       2.81     $ 44.37       130,756     $ 44.38  
$50 to $60
    368,542       7.64     $ 55.08       188,948     $ 54.81  
$60 to $63
    801       6.12     $ 62.54       801     $ 62.54  
                               
$10 to $63
    1,507,226       4.10     $ 33.19       1,287,156     $ 30.29  
                               
Restricted Stock
As of June 30, 2006 and December 31, 2005, 18,186 and 21,038 shares, respectively, of restricted stock were outstanding. For both the three and six months ended June 30, 2006, 247 shares of restricted stock were granted. No restrictions lapsed during the three months ended June 30, 2006 and 2005. During the six months ended June 30, 2006 and 2005, restrictions on 972 and 1,750 shares lapsed, respectively. Restrictions on the remaining shares of outstanding restricted stock lapse through July 1, 2010. The cost of these grants is amortized over the vesting term using an accelerated method in accordance with FASB Interpretation No. 28 Accounting for Stock Appreciation Rights and Other Variable Stock Options or Award Plans (FIN 28), and FAS 123R. Amortization expense of restricted stock awards totaled $76,000 and $150,000, respectively, for the three and six months ended June 30, 2006, respectively. Amortization expense of restricted stock awards totaled $21,000 and $39,000 for three and six months ended June 30, 2005, respectively. As of June 30, 2006, there was $0.5 million of unrecognized compensation cost related to nonvested restricted stock. This cost will be recognized over a weighted average period of 1.2 years.
Restricted Stock Outstanding
                                 
    Three Months Ended June 30,
     
    2005   2006
         
        Weighted Average       Weighted Average
        Grant Date       Grant Date
    Units   Fair Value   Units   Fair Value
                 
Restricted stock outstanding at the beginning of period
    18,070     $ 45.65       3,831     $ 56.83  
Restricted stock granted
    247       40.49              
Stock for which restrictions lapsed
                       
Restricted stock forfeited
    (131 )     46.98       (215 )     58.23  
                         
Restricted stock outstanding at end of period
    18,186     $ 45.57       3,616     $ 56.75  
                         

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Restricted Stock Outstanding
                                 
    Three Months Ended June 30,
     
    2005   2006
         
        Weighted Average       Weighted Average
        Grant Date Fair       Grant Date Fair
    Units   Value   Units   Value
                 
Restricted stock outstanding at the beginning of period
    21,038     $ 45.96       5,912     $ 45.47  
Restricted stock granted
    247       40.49              
Stock for which restrictions lapsed
    (972 )     53.74       (1,750 )     18.62  
Restricted stock forfeited
    (2,127 )     45.15       (546 )     56.86  
                         
Restricted stock outstanding at end of period
    18,186     $ 45.57       3,616     $ 56.75  
                         
Deferred Stock Units
The IP allows for the granting of Deferred Stock Units (DSUs) through the 2002 Redwood Trust, Inc., Executive Deferred Compensation Plan (EDCP). These are discussed below.
Executive Deferred Compensation Plan
In May 2002, our Board of Directors approved the 2002 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 six months ended June 30, 2006, deferrals of $0.6 million and $1.9 million, respectively, were made under the EDCP. For the three and six months ended June 30, 2005, deferrals of $0.4 million and $0.7 million, respectively, were made under the EDCP. The EDCP allows for the investment of deferrals in either an interest crediting account or DSUs. 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 six months ended June 30, 2006, accrued interest of $0.2 million and $0.5 million was credited to participants, respectively. For the three and six months ended June 30, 2005, accrued interest credited totaled $0.4 million and $0.7 million, respectively. During the three and six months ended June 30, 2006, DSUs valued at $20,000 and $261,000 were purchased with amounts previously deferred, respectively. Withdrawals made from the EDCP during both the three and six months ended June 30, 2006 totaled $1.9 million.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
The following table provides detail on changes in participants’ accounts in the EDCP for the three and six months ended June 30, 2006 and 2005.
EDCP Activity
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Cash accounts transfer in of participants’ payroll deductions from the EDCP
  $ 558     $ 396     $ 1,924     $ 703  
Accrued interest earned in EDCP
    208       351       504       694  
Participant withdrawals
    (1,879 )     (225 )     (2,120 )     (225 )
                         
Net change in participants’ equity
  $ (1,113 )   $ 522     $ 308     $ 1,172  
                         
Balance at beginning of period
  $ 8,426     $ 5,578     $ 7,005     $ 4,928  
Balance at end of period
  $ 7,313     $ 6,100     $ 7,313     $ 6,100  
The following table provides detail on the financial position of the EDCP at June 30, 2006 and December 31, 2005.
Net Assets Available for EDCP Participant Benefits
(In thousands)
                 
    June 30, 2006   December 31, 2005
         
Cash Accounts
               
Participants’ deferrals
  $ 4,783     $ 4,064  
Accrued interest credited
    2,530       2,941  
             
Net assets available for participants’ benefit
  $ 7,313     $ 7,005  
             
Deferred Stock Units
For the three and six months ended June 30, 2006, 12,721 and 85,716 DSUs, respectively, were granted through deferrals under the IP, which represented values of $0.6 million and $3.6 million at the time of the grants, respectively. For the three and six months ended June 30, 2005, 21,773 and 34,564 DSUs, respectively, were granted through deferrals under the IP, which represented values of $1.1 million and $1.9 million at the time of the grants, respectively. For both the three and six months ended June 30, 2006 11,471 DSUs were distributed out of the EDCP and converted to common stock. There were no forfeitures of DSUs during the six months ended June 30, 2006. For both the three and six months ended June 30, 2005, 1,889 DSUs were forfeited. As of June 30, 2006 and December 31, 2005, 492,371 and 418,126 of DSUs were outstanding, respectively. As of June 30, 2006 and December 31, 2005, the number of vested DSUs in the EDCP was 135,628 and 44,981, respectively. Restrictions on the remaining shares of outstanding DSUs lapse through July 1, 2010. As of June 30, 2006, there was $11.3 million of unrecognized compensation cost related to nonvested DSUs. This cost will be recognized over a weighted-average period of 1.1 years. Amortization expense of DSUs totaled $2.4 million and $4.5 million during the three and six months ended June 30, 2006, respectively. Amortization expense of DSUs totaled $0.6 million and $0.8 million for the three and six months ended June 30, 2005, respectively.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
The tables below provide summaries of the balance and activities of the DSUs in the EDCP.
Deferred Stock Units
(In thousands)
                 
    June 30, 2006   December 31, 2005
         
Value of DSUs at grant
  $ 22,656     $ 19,199  
Participant forfeitures
    (110 )     (110 )
Participant distributions
    (347 )      
Change in value at period end since date of grant
    1,843       (1,837 )
             
Value of DSUs at end of period
  $ 24,042     $ 17,252  
             
Deferred Stock Units Activity
(In thousands, except unit amounts)
                                                 
    Three Months Ended June 30,
     
    2006   2005
         
        Weighted       Weighted
        Average       Average
        Fair   Grant Date       Fair   Grant Date
    Units   Value   Fair Value   Units   Value   Fair Value
                         
Balance at beginning of period
    491,121     $ 21,275     $ 45.00       104,952     $ 5,371     $ 51.33  
Transfer in of DSUs (value of grants)
    12,721       556       43.71       21,773       1,136       52.17  
Distribution of DSUs
    (11,471 )     (347 )     30.27                    
Change in valuation during period
          2,558                   45        
Participant forfeitures
                      (1,889 )     (110 )     58.23  
                                     
Net change during period
    1,250       2,767             19,884       1,071        
                                     
Balance at end of period
    492,371     $ 24,042     $ 45.31       124,836     $ 6,442     $ 51.37  
                                     

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Deferred Stock Units Activity
(In thousands, except unit amounts)
                                                 
    Six Months Ended June 30,
     
    2006   2005
         
        Weighted       Weighted
        Average       Average
        Fair   Grant Date       Fair   Grant Date
    Units   Value   Fair Value   Units   Value   Fair Value
                         
Balance at beginning of period
    418,126     $ 17,252     $ 45.65       92,161     $ 5,722     $ 50.52  
Transfer in of DSUs (value of grants)
    85,716       3,568       41.26       34,564       1,867       54.02  
Distribution of DSUs
    (11,471 )     (347 )     30.27                    
Change in valuation during period
          3,569                   (1,037 )      
Participant forfeitures
                      (1,889 )     (110 )     58.23  
                                     
Net change during period
    74,245       6,790             32,675       720        
                                     
Balance at end of period
    492,371     $ 24,042     $ 45.31       124,836     $ 6,442     $ 51.37  
                                     
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 that 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 June 30, 2006, 29,075 shares have been purchased. For the three and six months ended June 30, 2006, employees acquired an aggregate of 2,754 and 5,460 shares of common stock, respectively, at an average purchase price of $35.10 and $35.09 per share, respectively. For the three and six months ended June 30, 2005, employees acquired an aggregate of 1,207 and 2,501 shares of common stock, respectively, at an average purchase price of $43.84 and $43.67 per share, respectively. As of June 30, 2006 and December 31, 2005, there remained a negligible amount of uninvested employee contributions in the ESPP.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
Employee Stock Purchase Plan Activity
(In thousands)
                                 
    Three Months   Six Months
    Ended   Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Transfer in of participants’ payroll deductions from the ESPP
  $ 97     $ 53     $ 184     $ 109  
Cost of common stock issued to participants under ESPP
    (97 )     (53 )     (192 )     (109 )
                         
Net change in participants’ equity
  $     $     $ (8 )   $  
                         
Balance at beginning of period
  $ 5           $ 13     $  
Balance at end of period
  $ 5     $     $ 5     $  
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 June 30, 2006 and December 31, 2005, 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 six months ended June 30, 2006, we issued 275,448 and 485,101 shares of common stock, respectively, through our Direct Stock Purchase and Dividend Reinvestment Plan (DSPP) for net proceeds of $11.8 million and $20.5 million, respectively. For the three and six months ended June 30, 2005 124,801 and 469,556 shares were issued through our DSPP for total proceeds of $6.3 million and $25.6 million, respectively.
Equity Offerings
For the three and six months ended June 30, 2006 and 2005, we did not undertake any equity offerings.
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 June 30, 2006 and December 31, 2005, we reported net accumulated other comprehensive income of $90.9 million and $73.7 million, respectively. Changes in this account reflect increases or decreases in the fair value of our earning assets and 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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
The following table provides a summary of the components of accumulated other comprehensive income as of June 30, 2006 and December 31, 2005.
Accumulated Other Comprehensive Income
(In thousands)
                 
    June 30, 2006   December 31, 2005
         
Net unrealized gains on real estate securities
  $ 55,818     $ 56,542  
Net unrealized gains on interest rate agreements accounted for as cash flow hedges
    35,119       17,189  
             
Total accumulated other comprehensive income
  $ 90,937     $ 73,731  
             
NOTE 11. COMMITMENTS AND CONTINGENCIES
As of June 30, 2006, we were obligated under non-cancelable operating leases with expiration dates through 2013 for $5.2 million. The majority of the future lease payments are related to the ten-year operating lease for our executive offices, which expires in 2013. The total lease payments to be made over the ten-year period, including certain free-rent periods, are being recognized as office rent expense on straight-line basis over the ten-year period. Leasehold improvements for our executive offices are amortized into expense over the ten-year lease term. The unamortized leasehold improvement balance at June 30, 2006 was $1.9 million.
Future Lease Commitments by Year
(In thousands)
         
    June 30, 2006
     
2006 (last six months)
  $ 453  
2007
    751  
2008
    688  
2009
    703  
2010
    703  
2011 and thereafter
    1,951  
       
Total
  $ 5,249  
       
As of June 30, 2006, there were no pending legal proceedings to which we were a party or to which any of our properties were subject.
The table below shows our commitments to purchase loans and securities as of June 30, 2006. The loan purchase commitments represent derivative instruments under FAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (FAS 149). See Note 9 for the fair value of those commitments.
Commitments to Purchase
(In thousands)
         
    June 30, 2006
     
Real estate loans
  $ 850,000  
Real estate securities
    70,361  
       
Total
  $ 920,361  
       

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REDWOOD TRUST, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS — (Continued)
In November 2005, we entered into an agreement to purchase certain certificates in a commercial mortgage loan securitization to be issued by a securitization entity to be formed at a later date. We anticipate that this will require us to purchase up to 50% of any BB+ and lower grade certificates issued by this entity, on between $150 million to $200 million of loan collateral, pursuant to the underwriting criteria set forth in the agreement. As of June 30, 2006, there were approximately $68 million of commercial mortgage loans originated, but not yet securitized under this agreement. Additionally, we may be required to purchase at least 50% of a third party’s junior participation interest in this securitization, under certain circumstances (primarily where underlying loan collateral is required to be repurchased due to poor loan performance). As of June 30, 2006, we have not been required to purchase any junior participation interest; all loans funded to date are performing as expected. At June 30, 2006, we estimate the value of this commitment to be negligible.
NOTE 12. RECENT DEVELOPMENTS
In July 2006, we purchased or committed to purchase $142 million residential real estate loans, $15 million residential loan CES ($3 million to be funded with equity and $12 million on behalf of Acacia), and $26 million other real estate loan securities (all on behalf of Acacia).
In July 2006, we sold residential loan CES with a principal value of $16 million. We will recognize GAAP gains on these sales of $2 million. In July 2006, we sold other commercial and residential real estate securities with a principal value of $13 million. We will recognize GAAP losses on these sales of $0.3 million. No securities were called in July 2006.
In July 2006, we committed to issue Acacia ABS (Acacia 10) for $500 million. In addition to selling a majority of the investment-grade ABS, we sold a portion of the equity securities. The collateral in Acacia 10 consists of a greater amount of BB-rated and B-rated assets than we had included in prior Acacia entities.
On July 31, 2006, we entered into a lease for additional office space at our principal executive offices. The initial term of the lease begins January 1, 2008 and expires May 31, 2018. The rent commitment over the initial lease term for the new premises is $9.9 million. Prior to January 1, 2008 we will lease the new premises from another tenant of our landlord.
In July 2006, we issued 224,766 shares of common stock through our DSPP for net proceeds of $11 million.

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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, 2005 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, 10-Q, 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 or 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
Our primary source of revenue is interest income paid to us from the loans and securities we own, which in turn consists of the monthly loan payments made by homeowners and commercial property owners on their real estate loans. Our primary product focus is credit-enhancing real estate loans that are high quality. “High quality” means real estate loans that typically have features such as lower loan-to-value ratios, borrowers with strong credit histories, and other indications of creditworthiness relative to the range of loans within U.S. real estate markets as a whole. We currently sponsor the securitization through our Sequoia program of all the residential real estate loans we acquire. We also sponsor the re-securitization through our Acacia CDO (collateralized debt obligation) program of investment-grade (and, to a lesser degree, non-investment grade) real estate securities. We seek to invest in assets that have the potential to provide for high cash flow returns over a long period of time to help support our goal of maintaining steady dividends over time.
We declared regular quarterly dividends of $0.70 per share in each of the first and second quarters of 2006. We intend to declare and distribute the remainder of our 2005 REIT taxable income as regular quarterly dividends by September 2006. We expect to permanently retain approximately 10% of the ordinary real estate investment trust (REIT) taxable income we earn during 2006 and to retain the after-tax profits earned in our taxable subsidiaries. We also plan to defer the distribution of a portion of our 2006 income, so that it will be distributed by September 2007. These are similar actions to those we have taken in recent years. With these actions, and in order to meet our distribution requirements, we expect to declare a special dividend in the fourth quarter of 2006. This special dividend is likely to be below the $3.00 per share special dividend paid in December 2005, unless we decide to sell a significant amount of appreciated assets in the second half of 2006.
Our reported GAAP net income was $31 million ($1.20 per share) for the second quarter of 2006, a decrease from the GAAP net income of $41 million ($1.62 per share) earned in the second quarter of 2005. For the first six months of 2006, our GAAP net income was $59 million ($2.29 per share), a

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decrease from the GAAP net income of $101 million ($4.04 per share) earned during the first six months of 2005. Our GAAP return on equity was 13% for the second quarter of 2006 and 12% for the first six months of 2006, compared to 17% for the second quarter of 2005 and 22% for the first six months of 2005.
Net interest income decreased in the 2006 periods from the 2005 periods. This was largely driven by lower interest income from our Sequoia program as a result of a reduced balance of IO securities. Net interest income has also been hampered by relatively higher levels of unutilized cash. Operating expenses increased as we further professionalize our finance and information staff, increase our capability to pursue new business and opportunities, and increased due diligence expenses relating to acquisitions. (We reclassified due diligence expenses from a reduction in net interest income to an operating expense beginning this quarter and historical numbers presented have been adjusted accordingly.) Net recognized gains in the second quarter of 2006 increased from the second quarter of 2005. However, for the first six-month period, net gains decreased in 2006 as compared to 2005. In the first six months of 2006, we generated gains from selling assets acquired as a result of calling Acacia CDO 2. Gains from calls of residential credit-enhancement securities were not a major factor in the first six months of 2006 but were significant in the corresponding period of 2005. Provisions for taxes were lower in the 2006 periods from 2005 periods.
Table 1     Net Income
(In thousands, except share data)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Total interest income
  $ 218,238     $ 248,505     $ 444,120     $ 486,427  
Total interest expense
    (173,519 )     (195,125 )     (354,174 )     (371,022 )
                         
Net interest income
    44,719       53,380       89,946       115,405  
Operating expenses
    (16,037 )     (11,456 )     (28,619 )     (23,254 )
Net recognized gains and valuation adjustments
    5,993       3,045       4,123       18,057  
Provision for income taxes
    (3,265 )     (4,054 )     (6,025 )     (8,731 )
                         
Net income
  $ 31,410     $ 40,915     $ 59,425     $ 101,477  
                         
Diluted common shares
    26,108,975       25,196,286       25,909,923       25,109,390  
Net income per share
  $ 1.20     $ 1.62     $ 2.29     $ 4.04  
Better than expected credit results on the loans we credit-enhance has been the primary driver of our continued strong earnings results. For the residential real estate loans we credit-enhance, delinquencies remain at historically low levels and annual credit losses continue to be less than one basis point (0.01%) of the current balance of these loans. Credit results for the commercial real estate loans we credit-enhance have also been excellent.
Prepayment rates (CPR) for residential ARM loans owned by Sequoia entities increased from an average of 39% in the second quarter of 2005 to 48% in the second quarter of 2006. Faster prepayments on ARMs have been caused primarily by the flatter yield curve. Borrowers are more inclined to refinance out of ARMs and into hybrid or fixed rate loans when the effective interest rates on ARMs are not significantly lower than these alternatives. Additionally, new forms of adjustable-rate mortgages (negative amortization, “option ARMs”, and Moving Treasury Average (MTA) ARMs) represent an increased share of the ARM market. Faster prepayment rates for our consolidated ARM loans had a negative impact on our net interest income in the first half of 2006. However, in the long term we believe we may benefit from faster residential loan prepayments on ARM loans due to our significant investment in discount-priced residential credit enhancement securities (CES) with these loans in their underlying pools.

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We seek to maintain a structured balance sheet that we believe should allow us to weather potential general economic downturns and liquidity crises. We generally seek to put ourselves in a position where changes in interest rates would not be likely to materially harm our ability to meet our long-term goals or maintain our regular dividend rate. We use debt to finance loans and securities that we are accumulating as inventory for sale to securitization entities sponsored by us.
We are constraining our asset acquisitions in order to preserve excess cash balances for attractive investment opportunities in the future. Our current capital utilization plan is to invest our remaining excess capital steadily during the remainder of 2006 and throughout 2007. The impact of this excess capital balance on our net interest income is likely to dampen our earnings relative to what it might have been if we were more fully invested. We may decide to accelerate (or slow) our acquisitions (as compared to our current capital utilization plan) depending on market conditions.
Designated credit reserve on all consolidated real estate loans and securities (adjustable, fixed, and hybrid) is $611 million, or $23.80 per share outstanding, at June 30, 2006. The designated credit reserve was $445 million, or $17.34 per share, on residential real estate assets and was $166 million, or $6.46 per share, on commercial real estate assets. We will realize this $611 million credit reserve into income (for the most part, over the next seven years) to the extent it is not diminished by credit losses. This would be in addition to the coupon income and other income we earn on an ongoing basis. Faster prepayments result in our realizing this income more quickly.
Our mortgage conduit’s residential loan securitization business is in transition. In 2005 and prior years, we generated attractive levels of economic gains (as indicated by high levels of gains on sale for tax purposes) by acquiring high-quality one- and six-month LIBOR adjustable-rate residential loans from originators, selling the loans to Sequoia securitization entities, and then sponsoring Sequoia securitizations of these loans. In today’s flat to inverted yield curve environment, however, ARMs indexed to London Inter-Bank Offered Rate (LIBOR) are not an attractive option for homeowners, causing origination volume of this product to decrease dramatically. In addition, several Wall Street and other firms have entered the residential conduit business, increasing competition and reducing securitization gain-on-sale opportunities.
We are responding to these changes by broadening our residential conduit’s product line (both in terms of product type and loan quality characteristics) and by expanding our mortgage originator customer base. We are focusing on market areas and relationships where we believe we have, or can develop, a competitive advantage. We expect our residential conduit business will break even economically this year (or generate a small loss) while not absorbing much capital. Even at break-even levels, our residential conduit brings multiple benefits to our business as a whole and is an excellent source of assets for us to invest in. In the longer term, we expect our residential conduit to develop in a manner that will once again generate attractive returns for our shareholders.
In the second quarter, we acquired $273 million of residential loans for future sale to our securitization entities, and, at June 30, 2006, had commitments to acquire another $850 million of loans for settlement in the third quarter of 2006. Some of these loans were short-reset ARMs, most of them were hybrid loans, and all were high-quality loans.
We are a large and active investor in the market for residential credit-enhancement securities created by others, and we continue to allocate the greater part of our capital to these assets.
We are building our business of credit-enhancing securitized commercial real estate loans. In the first half of 2006, we acquired or committed to acquire the first-loss (controlling interest class) of two CMBS securitizations on a lead basis. In 2004 and 2005, we acquired partial interest in 14 CMBS first-loss securities in conjunction with a partner that acted as the lead buyer.
We sponsor Acacia CDO transactions and invest in the CDO equity securities we create. The market for sponsoring CDO securitizations continues to be attractive, although it has become more competitive. We expect that CDO investments will generate attractive cash flows over time. We believe that the CDO business will experience significant innovation over time and we continue to explore new ways to take

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advantage of these structures. In late 2005, we completed our first predominately commercial real estate CDO. In July 2006, we sponsored an Acacia transaction that had an asset pool with a greater amount of BB-rated and B-rated assets than we had included in the past. Also for the first time, Redwood did not acquire all of the Acacia CDO equity securities, as we are seeking to develop a broad investor base for these assets. We may also incorporate an increasing amount of synthetic assets in Acacia’s asset pools. Over the next few years, we expect our CDO sponsorship business to grow and evolve in interesting new ways and to continue to generate attractive new investments and asset management fees.
The health of the real estate industry is cyclical. The tremendous growth in residential real estate prices appears to be slowing. We believe it is probable that residential real estate fundamentals may continue to deteriorate over the next two years, causing our credit losses to increase but also reducing acquisition prices for the assets we seek to buy. As a result, our current plan, which is subject to change, is to invest our excess capital ($191 million at June 30, 2006) steadily over the next two years so that we maintain reduced risk levels while also maintaining cash to take advantage of potential opportunities to acquire cheaper assets. As our excess cash balances are drawn down over time, we may seek to issue additional equity in order to maintain excess cash for the future. We will likely modify this plan as the market environment changes. Nevertheless, as a result of this general plan of action, it is likely that we will continue to have relatively high cash balances for some time. Our strong balance sheet, including these cash balances as well as low levels of Redwood debt, will be particularly helpful in the event that real estate credit fundamentals deteriorate significantly.
In our view, the long-term outlook for our business is good. Housing price increases over the past several years have reduced our risk of credit loss in the future for our existing residential assets. For most of our residential credit risk assets, the underlying loans were originated in 2003 and 2004. Commercial property values and cash flows are increasing in many areas. 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. Over the long term, we believe it is reasonably likely that we will be able to continue to find attractive investment opportunities, as we believe that we are an efficient competitor and because our market segments are growing (as the amount of real estate loans outstanding increases and the percentage of these loans that are securitized increases).
In general, we expect per share earnings and our special dividend in 2006 to be lower than 2005 as a result of higher levels of unutilized capital, a newer portfolio on average (our seasoned assets have largely been sold or called), few gains from sales (as we are not planning a significant amount of sales at this time), fewer calls (as we have fewer callable assets), continued high premium amortization expenses on the residential loans consolidated from Sequoia trusts as these loans continue to prepay rapidly, and for other reasons. There is a high degree of quarter-to-quarter variability of earnings in our business models, and short-term earnings trends should be interpreted with care. As management, we focus on building the net present value of future cash flows and on building our ability to sustain our regular dividend rate.
RESULTS OF OPERATIONS
SECOND QUARTER AND FIRST HALF — 2006 AS COMPARED TO 2005
Acquisitions, Securitizations, Sales, and Calls
Acquisitions, securitizations, gains from sales, and calls thus far in 2006 have been at lower levels than in 2005. Acquisitions and securitizations of real estate loans decreased as the available volume of loans we typically acquire (generally LIBOR ARM residential high-quality loans) was very low and acquisition prices high relative to the value of these loans within a securitization. Acquisitions of securities have been at slightly lower levels — primarily due to a decrease in residential credit-enhancement securities we have acquired in 2006 as compared to 2005.

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In the second quarter of 2006, our residential real estate loan acquisitions totaled $273 million, and for the first six months of 2006 our residential real estate loan acquisitions totaled $325 million. These levels of acquisitions were a decrease from the $427 million acquired during the second quarter of 2005 and the $1.3 billion acquired during the first six months of 2005. As of June 30, 2006, our inventory of residential loans held for securitization was $352 million. Sequoia entities did not acquire any loans from us during the first half of 2006 and did not issue asset-backed securities (ABS) during this period. Sequoia entities issued $0.4 billion of ABS during the second quarter of 2005 to acquire $0.4 billion of residential real estate loans. Sequoia entities issued $1.1 billion ABS during the first six months of 2005 to acquire $1.1 billion of residential real estate loans. Of the ABS issued by Sequoia entities, Redwood acquired residential credit-enhancement securities totaling $1 million in the second quarter of 2005 and $2 million in the first half of 2005. Acacia acquired certain Sequoia ABS securities rated AA to BB, totaling $3 million in the second quarter of 2005 and $10 million in the first six months of 2005.
During the second quarter of 2006, we acquired $333 million securities. Of these, $97 million were residential and commercial CES and $236 million were acquired on behalf of existing or planned Acacia entities. During the first half of 2006, we acquired $497 million securities, of which $157 million were CES and $340 million were on behalf of existing or planned Acacia entities. During the second quarter of 2005, we acquired $244 million securities, of which $88 million were CES and $156 million were on behalf of existing or planned Acacia entities. During the first half of 2005, we acquired $493 million securities, of which $169 million were CES and $324 million were on behalf of existing or planned Acacia entities.
We generally intend to hold our assets as long-term investments, or sell them to our sponsored securitization entities (Sequoia and Acacia). We occasionally sell assets held as investments when we feel it is appropriate, given market conditions and outlook. Sales to third parties (i.e., other than to sponsored entities) have been lower in 2006 than in 2005. Calls have been lower as we have fewer assets that are callable during 2006 than in recent years.
In the second quarter and the first half of 2006, we sold an $8 million commercial real estate loan realizing a negligible loss for GAAP purposes. In the second quarter of 2005, we sold $15 million of residential and commercial real estate loans.
During the second quarter of 2006, we sold $163 million securities, generating GAAP gains of $2 million. For the first half of 2006, sales of securities totaled $176 million and generated GAAP gains of $3 million. For the second quarter of 2005, sales of securities totaled $3 million, generating GAAP gains of $1 million, and in the first six months of 2005 we sold $43 million of securities for gains of $8 million.
In the second quarter of 2006, $4 million principal value of our securities were called, generating GAAP gains of $1 million.
In the first half of 2006, $6 million of principal value of our securities were called, generating GAAP gains of $1 million. In the second quarter of 2005, we had calls of $9 million principal value that generated GAAP gains of $4 million, and for the first six months of 2005, we had calls of $27 million that generated GAAP gains of $12 million. At June 30, 2006, we had securities with principal value totaling $1 million that were callable.
Net Income
The reduction in our net income of $10 million from the second quarter of 2005 to 2006 resulted from a decrease in net interest income of $9 million, an increase in net gains on sales and calls net of recognized gains (losses) and valuation adjustments of $3 million, an increase in operating expenses of $5 million, and a decrease in provisions for income taxes of $1 million.
Our reduction in our net income of $42 million from the first half of 2005 to 2006 resulted from a decrease in net interest income of $26 million, a decrease in net gains on sales and calls net of recognized gains (losses) and valuation adjustments of $14 million, an increase in operating expenses of $5 million, and a decrease in provisions for income taxes of $3 million.

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Net Interest Income
Net interest income decreased to $45 million in the second quarter of 2006 compared to $53 million in the second quarter of 2005. The reduction in net interest income of $8 million resulted primarily from increased ARM prepayment rates on residential loans consolidated from Sequoia securitization entities and from an increase in the amount of unutilized capital. For the first six months of 2006 as compared to the same time period of 2005, our net interest income decreased to $90 million from $115 million. The reduction of net interest income of $25 million resulted from increased ARM prepayment rates on residential loans consolidated from Sequoia securitization entities and an increase in the amount of unutilized capital.
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 on loans.
Table 2     Interest Income and Yield
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Interest income
  $ 214,544     $ 248,786     $ 439,339     $ 486,499  
Discount amortization
    14,381       8,395       29,042       17,711  
Premium amortization
    (13,193 )     (10,203 )     (26,591 )     (18,285 )
Reversal of provision for credit losses
    2,506       1,527       2,330       502  
                         
Total interest income
  $ 218,238     $ 248,505     $ 444,120     $ 486,427  
                         
Average earning assets
  $ 13,581,710     $ 22,606,036     $ 14,401,198     $ 23,320,331  
                         
Yield as a result of:
                               
Interest income
    6.33 %     4.40 %     6.11 %     4.18 %
Discount amortization
    0.42 %     0.15 %     0.40 %     0.15 %
Premium amortization
    (0.39 )%     (0.18 )%     (0.37 )%     (0.16 )%
Credit provision expense
    0.07 %     0.03 %     0.03 %     0.00 %
                         
Yield on earning assets
    6.43 %     4.40 %     6.17 %     4.17 %
                         
For the three and six months ended June 30, 2006 as compared to the same periods in 2005, interest income decreased primarily due to a decrease in the amount of consolidated residential real estate loans. These loans have prepaid at a increasingly faster pace, and we have not acquired many new loans to replace them.
Higher short-term interest rates have served to partially offset the impact on interest income of the lower balance of assets. Most consolidated assets are adjustable rate loans tied to one- and six-month LIBOR. The rise in these rates over the past year has resulted in a significant increase in the average yield we are earning on LIBOR-indexed consolidated assets.
Increases in both the amount of securities and yields on securities have also helped to offset the amount of decline in interest income due to the decrease in loan balances.
Reported yields on our assets are affected by interest rates, prepayments, credit performance and outlook, and accounting principles. For example, we do not recognize in interest income any amounts

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negatively amortized on loans collateralizing first-loss and second-loss securities. Another example is the credit provision expense that effects the yield reported on loans held-for-investment. In the second quarter of 2006 we reversed $2.5 million of credit reserve as a result of prepayments and other factors. This reversal helped to increase reported yield in the second quarter.
Table 3     Interest Income and Yield
(In thousands)
                                                                 
    Three Months Ended June 30, 2006   Three Months Ended June 30, 2005
         
        Percent of           Percent of    
        Total           Total    
    Interest   Interest   Average       Interest   Interest   Average    
    Income   Income   Balance   Yield   Income   Income   Balance   Yield
                                 
Real estate loans, net of provision for credit losses
  $ 154,972       71.01 %   $ 10,832,187       5.72 %   $ 207,471       83.49 %   $ 20,357,699       4.08 %
Real estate securities
    60,395       27.67 %     2,502,926       9.65 %     40,230       16.19 %     2,123,630       7.58 %
Cash and cash equivalents
    2,871       1.32 %     246,597       4.66 %     804       0.32 %     124,707       2.58 %
                                                 
Total interest income
  $ 218,238       100.00 %   $ 13,581,710       6.43 %   $ 248,505       100.00 %   $ 22,606,036       4.40 %
                                                 
                                                                 
    Six Months Ended June 30, 2006   Six Months Ended June 30, 2005
         
        Percent of           Percent of    
        Total           Total    
    Interest   Interest   Average       Interest   Interest   Average    
    Income   Income   Balance   Yield   Income   Income   Balance   Yield
                                 
Real estate loans, net of provision for credit losses
  $ 321,875       72.48 %   $ 11,710,861       5.50 %   $ 406,759       83.63 %   $ 21,165,225       3.84 %
Real estate securities
    116,897       26.32 %     2,445,031       9.56 %     78,284       16.09 %     2,030,409       7.71 %
Cash and cash equivalents
    5,348       1.20 %     245,306       4.36 %     1,384       0.28 %     124,697       2.22 %
                                                 
Total interest income
  $ 444,120       100.00 %   $ 14,401,198       6.17 %   $ 486,427       100.00 %   $ 23,320,331       4.17 %
                                                 
The table below details how our interest income changed by portfolio as a result of changes in consolidated asset balances (“volume”) and yield (“rate”) for the three and six months ended June 30, 2006 as compared to the three and six months ended June 30, 2005.
Table 4     Volume and Rate Changes for Interest Income
(In thousands)
                                                 
    Change in Interest Income   Change in Interest Income
    Three Months Ended   Six Months Ended
    June 30, 2006 Versus June 30, 2005   June 30, 2006 Versus June 30, 2005
         
        Total       Total
    Volume   Rate   Change   Volume   Rate   Change
                         
Real estate loans, net of provisions for credit losses
  $ (97,077 )   $ 44,578     $ (52,499 )   $ (181,697 )   $ 96,813     $ (84,884 )
Estate securities
    7,185       12,980       20,165       15,986       22,627       38,613  
Cash and cash equivalents
    786       1,281       2,067       1,339       2,625       3,964  
                                     
Total interest income
  $ (89,106 )   $ 58,839     $ (30,267 )   $ (164,372 )   $ 122,065     $ (42,307 )
                                     
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.

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A discussion of the changes in total income, average balances, and yields for each of our loans and securities is provided below.
Table 5     Consolidated Real Estate Loans — Interest Income and Yield
(In thousands)
                                 
    Three Months Ended June 30,   Six Months Ended June 30,
         
    2006   2005   2006   2005
                 
Interest income
  $ 164,513     $ 215,800     $ 343,574     $ 423,786  
Net premium amortization expense
    (12,047 )     (9,856 )     (24,029 )     (17,529 )
Reversal of (provision for) credit losses
    2,506       1,527       2,330       502  
                         
Total interest income
  $ 154,972     $ 207,471     $ 321,875     $ 406,759  
                         
Average consolidated real estate loans
  $ 10,832,187     $ 20,357,699     $ 11,710,861     $ 21,165,225  
                         
Yields as a result of:
                               
Interest income
    6.07 %     4.24 %     5.87 %     4.01 %
Net premium amortization expense
    (0.44 )%     (0.19 )%     (0.41 )%     (0.17 )%
Credit provision expense
    0.09 %     0.03 %     0.04 %     0.00 %
                         
Yield
    5.72 %     4.08 %     5.50 %     3.84 %
                         
Interest income on real estate loans decreased in the 2006 periods from the 2005 periods primarily as a result of lower balance of real estate loans as our portfolio prepaid and acquisitions of new real estate loans were at a slow pace. Offsetting this decrease in consolidated balances was the effect of higher short-term interest rates. Almost all these loans have coupon rates that adjust monthly or every six months based on the one- or six-month LIBOR interest rate. Thus, yields on these real estate loans increased as short-term interest rates rose.
Higher premium amortization expenses (as a percentage of current loan balances) in the second quarter of 2006 were caused primarily by increasing prepayment speeds on the residential real estate loans. However, due to rising short-term interest rates, the amount of the premium amortization was not as great as it might otherwise have been. Specifically, the proportion of premium amortized on these loans was not as great as the proportion of principal that was repaid. As a result, our cost basis in the remaining residential real estate loans increased from prior periods. The amortization expense in future periods may increase significantly, especially during a period of falling interest rates. The increased cost basis on remaining loans could also have an impact in future periods to the extent these pools pay down to their call factors. At current prepayment speeds, we expect a number of pools to reach this factor towards the end of 2006 or early 2007. We own the call rights and would generally call the ABS issued if it benefits us economically. After calling the ABS, we may sell the loans to another Sequoia entity (and the Sequoia entity would issue new ABS) or we may sell the loans. To the extent we sell the loans, the gains would be less (or losses would be greater) since our GAAP basis is higher as a result of this amortization expense principle.

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Table 6a     Real Estate Securities — Interest Income and Yield
(In thousands)
                                 
    Three Months Ended June 30,   Six Months Ended June 30,
         
    2006   2005   2006   2005
                 
Interest income
  $ 47,162     $ 32,182     $ 90,418     $ 61,328  
Net discount amortization income
    13,233       8,048       26,479       16,956  
                         
Total interest income
  $ 60,395     $ 40,230     $ 116,897     $ 78,284  
                         
Average earning assets
  $ 2,502,926     $ 2,123,630     $ 2,445,031     $ 2,030,409  
                         
Yield as a result of:
                               
Interest income
    7.54 %     6.06 %     7.39 %     6.04 %
Net discount amortization income
    2.11 %     1.52 %     2.17 %     1.67 %
                         
Total
    9.65 %     7.58 %     9.56 %     7.71 %
                         
Interest income recognized from our real estate securities increased in the second quarter and first half of 2006 as compared to the second quarter and first half of 2005 due to growth in our portfolio over the past year and increased average yields. Portfolio growth reflected our ability to find new assets at a pace in excess of our sales, calls, and principal prepayments. Yields increased for a variety of reasons, including continued strong credit performance, and asset sales during 2005 of lower-yielding assets.
To determine yields on real estate loan securities, we make assumptions regarding credit 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 results in yields on these assets in early periods of ownership that are lower than what we might realize over the life of the assets if future credit performance turns out to be better than the low range of our expectations. Specifically, the initial yield we book on newly acquired securities may be lower than the market mid range expectation of performance (and below our hurdle rate of 14% pre-tax and pre-overhead internal rate of return),especially for our CES. We review the actual performance of each real estate loan security and the market’s and our renewed range of expectations every quarter. We adjust the yields of assets as a result of supportable changes in market conditions and anticipated performance. In addition, to the extent we credit-enhance loans with special credit risks (e.g., negative amortization loans), we may not recognize interest income that is not paid currently. We make ongoing determinations of the likelihood that any deferred interest payments will be collectible in recognizing current period yields.
The tables below present the income and yields of the components of our securities portfolio: residential CES, commercial CES, and other securities.
Table 6b Residential Loan Credit-Enhancement Securities — Interest Income and Yield
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Interest income
  $ 17,039     $ 11,664     $ 31,632     $ 22,561  
Net discount amortization income
    12,410       7,775       25,565       16,502  
                         
Total interest income
  $ 29,449     $ 19,439     $ 57,197     $ 39,063  
                         
Average earning assets
  $ 610,046     $ 550,460     $ 585,256     $ 522,093  
                         
Interest income
    11.17 %     8.48 %     10.81 %     8.64 %
Net discount amortization income
    8.14 %     5.65 %     8.74 %     6.32 %
                         
Total
    19.31 %     14.13 %     19.55 %     14.96 %
                         

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Interest income recognized from residential loan CES increased due to growth in our portfolio over the past year and increased average yields. Portfolio growth reflected our ability to find new assets at a pace in excess of our sales, calls, and principal prepayments. Yields increased as our portfolio is beginning to season and benefit from a period of favorable prepayment rates and continued strong credit performance. In addition, asset sales during 2005 of lower-yielding assets increased our average yield for the first quarter of 2006.
Table 6c     Commercial Loan Credit-Enhancement Securities — Interest Income and Yield
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Interest income
  $ 2,739     $ 1,227     $ 5,003     $ 1,992  
Net premium amortization expense
    (1,091 )     (346 )     (2,367 )     (755 )
                         
Total interest income
  $ 1,648     $ 881     $ 2,636     $ 1,237  
                         
Average earning assets
  $ 65,190     $ 25,085     $ 61,018     $ 22,186  
                         
Yield as a result of:
                               
Interest income
    16.80 %     19.57 %     16.40 %     17.96 %
Net premium amortization expense
    (6.69 )%     (5.52 )%     (7.76 )%     (6.81 )%
                         
Total
    10.11 %     14.05 %     8.64 %     11.15 %
                         
Interest income recognized from commercial loan CES increased due to the growth in this portfolio. This increase was partially offset by lower yields on newer commercial loan CES. The yield on commercial loan CES is based on our projected cash flows over time.
The terms of our commercial CES differ from residential CES in that we generally do not receive principal on our investment until the end of the note term (typically seven to ten years). Our commercial portfolio is performing well; the fundamentals of the commercial business are strong, and we expect over time that our returns on our commercial CES investments should meet our hurdle rate of 14%. However, for GAAP purposes, our recognized yields may not approach this rate until later in the life of the investments as the accretion of the discount into income is slower in the earlier years, given the uncertainty of future events. Since most of our existing commercial CES are newer investments, the overall yield on this portfolio is currently lower than we might expect if credit performance meets or exceeds our long-term estimates.
Table 6d     Other Securities — Interest Income and Yield
(In thousands)
                                 
    Three Months Ended   Six Months Ended
    June 30,   June 30,
         
    2006   2005   2006   2005
                 
Interest income
  $ 27,384     $ 19,291     $ 53,783     $ 36,775  
Net discount amortization income
    1,914       619       3,281       1,209  
                         
Total interest income
  $ 29,298     $ 19,910     $ 57,064     $ 37,984  
                         
Average earning assets
  $ 1,827,690     $ 1,548,085     $ 1,798,757     $ 1,486,130  
                         
Yield as a result of:
                               
Interest income
    5.99 %     4.98 %     5.98 %     4.95 %
Net discount amortization expense
    0.42 %     0.16 %     0.36 %     0.16 %
                         
Total
    6.41 %     5.14 %     6.34 %     5.11 %
                         

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Total interest income increased for the securities portfolio as the total size of the portfolio grew and as yields increased. Yields increased 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.
During the course of preparing the financial statements for the period ended June 30, 2006 we discovered that accrual rates for interest income on certain securities and interest expense on certain ABS issued had been incorrectly applied and not correctly adjusted to the appropriate amount once the cash had been received or paid. The impact of this error was that on a cumulative basis we had overstated interest income by $1.3 million and understated interest expense by $0.2 million.
Also, due diligence expenses for certain securities purchased had been incorrectly capitalized and amortized. The incorrectly capitalized due diligence expenses were $0.6 million.
Under the provisions of Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20 and FASB Statement No. 3 (FAS 154), we analyzed the errors for each period affected. After carefully assessing the effect of this error on previously reported earnings and the effect of recording a total cumulative correcting adjustment of $2.1 million in the second quarter of 2006, we determined that the errors were not material to the financial statements for the six-months ended June 30, 2006 and the year ended December 31, 2006. Accordingly a cumulative correcting adjustment of $1.5 million was recorded in the second quarter of 2006 and resulted in a decrease in interest income, and an increase in interest expense in our Consolidated Statements of Income and a decrease in accrued interest receivable and an increase in accrued interest payable balances on our Consolidated Balance Sheets.
For due diligence expenses the cumulative correcting adjustment of $0.6 million was recorded and resulted in an increase in operating expenses in the Consolidated Statements of Income and a decrease in mortgage securities on the Consolidated Balance Sheets. The correction of this error did not materially affect taxable income or our dividend distribution