UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

x
      
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
   
For the quarterly period ended: March 31, 2007
OR
¨
 
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
   
For the transition period from _______________ to _______________
 
Commission file number: 1-13759

REDWOOD TRUST, INC.
(Exact Name of Registrant as Specified in Its Charter)
 
Maryland
      
68-0329422
(State or Other Jurisdiction of
Incorporation or Organization)
 
(IRS Employer
Identification No.)
 
One Belvedere Place, Suite 300
Mill Valley, California 94941
(Address of Principal Executive Offices)(Zip Code)
Registrant’s Telephone Number, Including Area Code: (415) 389-7373

Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class:
      
Name of Exchange on
Which Registered:
Common Stock, par value $0.01 per share
 
New York Stock Exchange
 
Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x    No ¨

Indicate by check mark 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 x
Accelerated Filer ¨
Non-Accelerated Filer ¨
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨   No x

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
27,359,006 as of May 8, 2007





REDWOOD TRUST, INC.
2007 FORM 10-Q REPORT

TABLE OF CONTENTS
 
              
     
 
     
Page
PART I
Item 1.
     
Financial Statements
   
   
Consolidated Balance Sheets at March 31, 2007 (unaudited) and December 31, 2006
 
3
   
Consolidated Statements of Income for the three months ended March 31, 2007 and 2006 (unaudited)
 
4
   
Consolidated Statements of Comprehensive Income (Loss) for the three months ended March 31, 2007 and 2006 (unaudited)
 
 
5
   
Consolidated Statements of Stockholders’ Equity for the three months ended March 31, 2007 and 2006 (unaudited)
 
6
   
Consolidated Statements of Cash Flows for the three months ended March 31, 2007 and 2006 (unaudited)
 
7
   
Notes to Consolidated Financial Statements
 
8
         
Item 2.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
36
         
Item 3.
 
Quantitative and Qualitative Disclosures about Market Risk
 
67
         
Item 4.
 
Controls and Procedures
 
67
         
PART II
         
Item 2.
 
Unregistered Sales of Equity Securities and Use of Proceeds
 
68
         
Item 6.
 
Exhibits
 
68
     
Signatures
 
69

2


PART I. FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
 
March 31,
2007
 
December 31,
2006
 
(Unaudited)
           
ASSETS
             
Real estate loans
 
$
8,706,370
 
$
9,352,107
 
Real estate securities
   
3,600,462
   
3,232,767
 
Other real estate investments
   
50,057
   
 
Cash and cash equivalents
   
91,656
   
168,016
 
Total earning assets
   
12,448,545
   
12,752,890
 
Restricted cash
   
340,114
   
112,167
 
Accrued interest receivable
   
64,814
   
70,769
 
Derivative assets
   
18,424
   
26,827
 
Deferred tax asset
   
5,542
   
5,146
 
Deferred asset-backed securities issuance costs
   
41,115
   
42,468
 
Other assets
   
28,185
   
20,206
 
Total Assets
 
$
12,946,739
 
$
13,030,473
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
             
LIABILITIES
             
Redwood debt
 
$
1,879,783
 
$
1,856,208
 
Asset-backed securities issued
   
9,946,508
   
9,979,224
 
Accrued interest payable
   
51,709
   
50,590
 
Derivative liabilities
   
7,401
   
6,214
 
Accrued expenses and other liabilities
   
16,951
   
16,832
 
Dividends payable
   
20,347
   
18,715
 
Junior subordinated notes
   
100,000
   
100,000
 
Total liabilities
   
12,022,699
   
12,027,783
 
Commitments and contingencies (Note 16)
             
               
STOCKHOLDERS’ EQUITY
             
Common stock, par value $0.01 per share, 50,000,000 shares authorized;
27,129,446 and 26,733,460 issued and outstanding
   
271
   
267
 
Additional paid-in capital
   
927,648
   
903,808
 
Accumulated other comprehensive income (loss)
   
(6,183
)
 
93,158
 
Cumulative earnings
   
827,320
   
809,011
 
Cumulative distributions to stockholders
   
(825,016
)
 
(803,554
)
Total stockholders’ equity
   
924,040
   
1,002,690
 
Total Liabilities and Stockholders’ Equity
 
$
12,946,739
 
$
13,030,473
 
 
The accompanying notes are an integral part of these consolidated financial statements.
3


REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME
 
(In thousands, except share data)
 
Three Months Ended March 31,
 
(Unaudited)
 
2007
 
2006
 
             
Interest Income
             
Real estate loans                                                                                  
 
$
126,850
 
$
166,902
 
Real estate securities
   
83,458
   
56,503
 
Other real estate investments
   
2,465
   
 
Cash and cash equivalents
   
2,332
   
2,477
 
Total interest income
   
215,105
   
225,882
 
               
Interest Expense
             
Redwood debt
   
(31,094
)
 
(2,072
)
Asset-backed securities issued
   
(134,945
)
 
(178,583
)
Junior subordinated notes
   
(2,057
)
 
 
Total interest expense
   
(168,096
)
 
(180,655
)
               
Net Interest Income
   
47,009
   
45,227
 
               
Operating expenses
   
(17,782
)
 
(12,582
)
Realized gains on sales and calls, net
   
1,146
   
1,062
 
Market valuation adjustments, net
   
(10,264
)
 
(2,932
)
Net income before provision for income taxes
   
20,109
   
30,775
 
Provision for income taxes
   
(1,800
)
 
(2,760
)
               
Net Income
 
$
18,309
 
$
28,015
 
               
Basic earnings per share:
 
$
0.68
 
$
1.11
 
Diluted earnings per share:
 
$
0.66
 
$
1.09
 
               
Regular dividends declared per common share
 
$
0.75
 
$
0.70
 
Special dividends declared per common share
 
$
 
$
 
Total dividends declared per common share
 
$
0.75
 
$
0.70
 
               
Basic weighted average shares outstanding
   
26,855,681
   
25,201,525
 
Diluted weighted average shares outstanding
   
27,684,029
   
25,702,730
 
 
The accompanying notes are an integral part of these consolidated financial statements.
4

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
(In thousands)
 
Three Months Ended
March 31,
 
(Unaudited)
 
2007
 
2006
 
             
Net Income
 
$
18,309
 
$
28,015
 
Other Comprehensive (Loss) Income:
             
Net unrealized loss on available-for-sale securities
   
(92,685
)
 
(8,058
)
Reclassification adjustment for net (gains) losses included in net income
   
(113
)
 
1,997
 
Unrealized (losses) gains on cash flow hedges, net
   
(6,138
)
 
14,187
 
Reclassification of net realized cash flow hedge (gains) to interest expense on asset-backed securities issued and realized gains on sales and calls
   
(405
)
 
(266
)
Total Other Comprehensive (Loss) Income
   
(99,341
)
 
7,860
 
Comprehensive (Loss) Income
 
$
(81,032
)
$
35,875
 
 
The accompanying notes are an integral part of these consolidated financial statements.
5

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

For the Three Months Ended March 31, 2007
 
(In thousands, except share data)
(Unaudited)
 
Common Stock
 
Additional
Paid-In
 
Other Comprehensive
 
Cumulative
 
Cumulative Distributions
to
     
 
 
Shares
 
Amount
 
Capital
 
 Income
 
Earnings
 
Stockholders
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2006
   
26,733,460
 
$
267
 
$
903,808
 
$
93,158
 
$
809,011
 
$
(803,554
)
$
1,002,690
 
Net income
   
   
   
   
   
18,309
   
   
18,309
 
Net unrealized loss/reclassification on assets AFS
   
   
   
   
(92,798
)
 
   
   
(92,798
)
Net unrealized loss/reclassification on interest rate agreements
   
   
   
   
(6,543
)
 
   
   
(6,543
)
                                             
Issuance of common stock:
                                           
Secondary offerings
   
   
   
   
   
   
   
 
Dividend reinvestment & stock purchase plans
   
330,315
   
3
   
18,659
   
   
   
   
18,662
 
Employee option & stock purchase plan
   
65,671
   
1
   
64
   
   
   
   
65
 
Non-cash equity award compensation
   
   
   
5,117
   
   
   
   
5,117
 
                                             
Common dividends declared
   
   
   
   
   
   
(21,462
)
 
(21,462
)
March 31, 2007
   
27,129,446
 
$
271
 
$
927,648
 
$
(6,183
)
$
827,320
 
$
(825,016
)
$
924,040
 

For the Three Months Ended March 31, 2006
 
(In thousands, except share data)
(Unaudited)
 
Common Stock
 
Additional
Paid-In
 
Other Comprehensive
  Cumulative  
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
   
   
   
   
   
28,015
   
   
28,015
 
Net unrealized loss/reclassification on assets AFS
   
   
   
   
(6,061
)
 
   
   
(6,061
)
Net unrealized gain/reclassification on interest rate agreements
   
   
   
   
13,921
   
   
   
13,921
 
                                             
Issuance of common stock:
                                           
Secondary offerings
   
   
   
   
   
   
   
 
Dividend reinvestment & stock purchase plans
   
209,653
   
2
   
8,697
   
   
   
   
8,699
 
Employee option & stock purchase plan
   
39,580
   
1
   
471
   
   
   
   
472
 
Non-cash equity award compensation
   
   
   
5,634
   
   
   
   
5,634
 
                                             
Common dividends declared
   
   
   
   
   
   
(18,307
)
 
(18,307
)
March 31, 2006
   
25,381,858
 
$
254
 
$
839,167
 
$
81,591
 
$
709,494
 
$
(663,173
)
$
967,333
 
 
The accompanying notes are an integral part of these consolidated financial statements.
6

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS
 
(In thousands)
 
Three Months Ended March 31,
 
(Unaudited)
 
2007
 
2006
 
Cash Flows From Operating Activities:
           
Net income
 
$
18,309
 
$
28,015
 
Adjustments to reconcile net income to net cash provided by operating activities:
             
Amortization of premiums, discounts, and debt issuance costs
   
(14,189
)
 
(16,104
)
Depreciation and amortization of non-financial assets
   
342
   
269
 
Provision for credit losses
   
3,829
   
176
 
Non-cash equity award compensation
   
5,117
   
5,634
 
Net recognized losses and valuation adjustments
   
9,118
   
1,870
 
Purchases of other real estate investments - trading
   
(40,818
)
 
 
Principal payments on other real estate investments - trading
   
2,284
   
 
Net change in:
             
Accrued interest receivable
   
5,955
   
3,051
 
Deferred income taxes
   
(315
)
 
518
 
Other assets
   
(4,807
)
 
(1,699
)
Accrued interest payable
   
1,119
   
2,375
 
Accrued expenses and other liabilities
   
119
   
(7,893
)
Net cash (used in) provided by operating activities
   
(13,937
)
 
16,212
 
Cash Flows From Investing Activities:
             
Purchases of real estate loans held-for-investment
   
(414,422
)
 
(52,689
)
Principal payments on real estate loans held-for-investment
   
1,042,027
   
1,928,003
 
Purchases of real estate securities available-for-sale
   
(650,124
)
 
(163,599
)
Proceeds from sales of real estate securities available-for-sale
   
120,049
   
13,634
 
Principal payments on real estate securities available-for-sale
   
70,043
   
45,083
 
Net increase in restricted cash
   
(227,947
)
 
(58,750
)
Net cash (used in) provided by investing activities
   
(60,374
)
 
1,711,682
 
Cash Flows From Financing Activities:
             
Net borrowings (repayments) on Redwood debt
   
23,575
   
(169,707
)
Proceeds from issuance of asset-backed securities
   
1,359,833
   
277,800
 
Deferred asset-backed security issuance costs
   
(5,869
)
 
(3,365
)
Repayments on asset-backed securities
   
(1,377,883
)
 
(1,911,617
)
Net purchases of interest rate agreements
   
(601
)
 
(2,463
)
Net proceeds from issuance of common stock
   
18,727
   
9,171
 
Dividends paid
   
(19,831
)
 
(18,132
)
Net cash used in financing activities
   
(2,049
)
 
(1,818,313
)
Net decrease in cash and cash equivalents
   
(76,360
)
 
(90,419
)
Cash and cash equivalents at beginning of period
   
168,016
   
175,885
 
Cash and cash equivalents at end of period
 
$
91,656
 
$
85,466
 
Supplemental Disclosure of Cash Flow Information:
             
Cash paid for interest
 
$
166,977
 
$
178,327
 
Cash paid for taxes
 
$
450
 
$
2,660
 
Non-Cash Financing Activity:
             
Dividends declared but not paid
 
$
20,347
 
$
17,767
 
 
The accompanying notes are an integral part of these consolidated financial statements.
7


REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
March 31, 2007
(Unaudited)
Note 1. Redwood Trust

Redwood Trust, Inc., together with its subsidiaries (Redwood, we, or us), invests in, finances, and manages real estate assets. We invest in residential and commercial real estate loans and in asset-backed securities backed by real estate loans. Our primary focus is credit-enhancing residential and commercial real estate loans. We credit-enhance loans by acquiring and managing the first-loss and other credit-sensitive securities that bear the bulk of the credit risk of securitized loans.

We seek to invest in assets that have the potential to generate high long-term cash flow returns to help support our goal of distributing an attractive level of dividends per share to shareholders over time. For tax purposes, we are structured as a real estate investment trust (REIT).

Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. Our executive offices are located 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 at March 31, 2007 and December 31, 2006 and for the three months ended March 31, 2007 and 2006. 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, 2006. The results for the three months ended March 31, 2007 are not necessarily indicative of the expected results for the year ended December 31, 2007. Certain amounts for prior years have been reclassified to conform to the March 31, 2007 presentation.

These consolidated financial statements include the accounts of Redwood Trust, Inc. (Redwood Trust) and its direct and indirect wholly-owned subsidiaries (collectively, Redwood). All inter-company balances and transactions have been eliminated in consolidation. A number of Redwood Trust’s subsidiaries are qualifying REIT subsidiaries and the remainder are taxable subsidiaries. References to the Redwood REIT mean Redwood Trust and its qualifying REIT subsidiaries, excluding taxable subsidiaries.

We currently operate two securitization programs. Our Sequoia program is used for the securitization of residential mortgage loans. References to Sequoia refer collectively to all the Sequoia securitization entities. Our Acacia program involves the resecuritization of mortgage-backed securities and other types of financial assets through the issuance of collateralized debt obligations (CDOs). References to Acacia refer collectively to all of the Acacia CDO issuing entities.

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), we treat the securitizations we sponsor as financings, 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. Accordingly, the underlying loans and securities owned by these securitization entities are shown on our consolidated balance sheets under real estate loans, real estate securities, and the asset-back securities (ABS) issued to third parties are shown on our consolidated balance sheets under 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 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 and the associated income and expense are not shown separately on our consolidated statements of income.
 
8

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS

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. These include fair market 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.

Real Estate Loans

Residential and Commercial Real Estate Loans: Held-for-Investment

Real estate loans include residential and commercial real estate loans. Currently, all our real estate loans are held-for-investment as we 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.

Coupon interest is recognized as revenue when earned and deemed collectible. We accrue interest on loans until they are more than 90 days past due at which point they are placed on nonaccrual status. Purchase discounts and premiums related to real estate loans are amortized into interest income over their estimated lives to generate an effective yield, considering the actual and future estimated prepayments of the loans pursuant to the provisions discussed below. Gains or losses on the sale of real estate loans are based on the specific identification method.

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.

We may exercise our right to call ABS issued by entities sponsored by us and may subsequently sell the underlying loans to third parties. For balance sheet purposes, we reclassify held-for-investment loans to held-for-sale loans once we determine which loans will be sold to third parties. In our consolidated statements of cash flows, sales of loans are reported as sales of loans held-for-investment as the acquisition of loans were reported as purchases of loans held-for-investment.

Residential and Commercial Real Estate Loans: Held-for-Sale

Residential and commercial real estate loans that we are marketing for sale are classified as real estate loans held-for-sale. These are carried at the lower of cost or fair market value on a loan-by-loan basis. Any market valuation adjustments on these loans are recognized in valuation adjustments net, in our consolidated statements of income.

Real Estate Loans - Reserve for Credit Losses

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. See Note 7 for a discussion of the levels of reserves for credit losses.

9

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
 
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), and Statement of Financial Accounting Standards No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures (FAS 118) in setting credit reserves for our real estate loans.

The following factors are considered and applied in such determinations:

 
·
Ongoing analyses 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;

 
·
Ongoing evaluations of fair market values of collateral using current appraisals and other valuations; and

 
·
Discounted cash flow analyses.

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.

We do not maintain a loan repurchase reserve, as any risk of loss due to loan repurchases (i.e., due to breach of representations) would normally be covered by recourse to the companies from whom we acquired the loans.

Real Estate Securities

Real estate securities include residential, commercial, and CDO securities. Real estate securities are classified as available-for-sale (AFS) and are carried at their estimated fair market values. Cumulative unrealized gains and losses are reported as a component of accumulated other comprehensive income (loss) in our consolidated statements of stockholders’ equity. Upon sale this accumulated other comprehensive income (loss) is reclassified into earnings on the specific identification method.

Coupon interest is recognized as revenue when earned and deemed collectible. Purchase discounts and premiums related to the securities are amortized into interest income over their estimated lives to generate an effective yield, considering the actual and future estimated prepayments of the securities pursuant to the provisions discussed below. Gains or losses on the sale of securities are based on the specific identification method.

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. Actual maturities of AFS securities are generally shorter than stated contractual maturities. All of our stated maturities are greater than ten years. Actual maturities of the AFS securities are affected by the contractual lives of the underlying mortgages, periodic payments of principal, and prepayments of principal. 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, and the change could be material.

10

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
 
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 market valuation adjustments, net in our consolidated statements of income. For real estate securities subject to Emerging Issues Task Force of the Financial Accounting Standards Board 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments (EITF 03-1), we assess whether a drop in fair market value below the cost of the real estate security should be deemed as other-than-temporary impairment. If we have the ability and intent to hold a real estate security for a reasonable period of time sufficient for a forecasted recovery of fair market value up to (or beyond) the cost of the investment, we do not deem that unrealized loss an other-than-temporary impairment.

In the footnotes to the consolidated financial statements, we disclose information on our real estate securities portfolio based on the underlying residential, commercial, and CDO assets. We also provide a further breakdown of these securities by investment-grade securities (IGS, those rated BBB to AAA) and credit-enhancement securities (CES, those rated non-rated to BB, also referred to as first-loss, second-loss, and third-loss securities) based on their current credit rating.

Other Real Estate Investments

Other real estate investments include interest-only certificates (IOs), net interest margin securities (NIMs), and residual securities (residuals). At the conclusion of the first quarter of 2007, we classified these investments as trading securities. With the adoption of Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Investments, (FAS 155) IOs, NIMs and residuals may contain embedded derivatives which would require bifurcation and separate valuation through the income statement. We have elected to treat these investments as trading securities under FAS 115 rather than bifurcate the embedded derivative component. Trading securities are reported on our consolidated balance sheet at their estimated fair market values with changes in fair market values reported through our consolidated statements of income through market valuation adjustments.

Total income recognized in current period earnings on these investments equals coupon interest earned plus the change in fair market value. Interest income is equal to the instruments’ yield based on market expectations.

Cash and Cash Equivalents

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

Derivative Financial Instruments

All derivative financial instruments are reported at fair market value on our consolidated balance sheets. 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. Whether changes in the fair market value of these instruments are reported through our income statement depends on the type of derivative it is and the accounting treatment chosen. See Note 6 for a discussion on the value of our derivative financial instruments.

We currently enter into interest rate agreements to help manage some of our interest rate risks. We report our interest rate agreements at fair market value. 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. Net purchases and proceeds from interest rate agreements are classified within cash flows from financing activities within the consolidated statement of cash flows together with the items the interest rate agreements hedge.

11

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
 
We designate an interest rate agreement as (1) a hedge of the fair market 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).

In a cash flow hedge, the effective portion of the change in the fair market value of the hedging derivative is recorded in accumulated other comprehensive income (loss) and is subsequently reclassified into earnings when the hedging relationship is terminated. The ineffective portion of the cash flow hedge is recognized immediately in earnings. We use the dollar-offset method to determine the amount of ineffectiveness, and 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 will discontinue hedge accounting when (1) we determine that the derivative is no longer expected to be effective in offsetting changes in the fair market 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.

As of each period end, we may also have outstanding commitments to purchase real estate 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 and changes in fair market value of the purchase commitments are recorded through valuation adjustments in the consolidated statements of income.

Beginning in the first quarter of 2007, we entered into credit default swap agreements. A credit default swap is an agreement to provide (receive) credit event protection based on a financial index or specific security in exchange for receiving (paying) a fixed rate fee or premium over the term of the contract. Under FAS 133, credit default swaps are accounted for as trading instruments.

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 or the redemption of outstanding ABS issued.

Accrued Interest Receivable

Accrued interest receivable represents interest that is due and payable to us. This is generally received within the next month.

12

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
 
Deferred Tax Assets

Income recognition for GAAP and tax differ in material respects. As a result, we may recognize taxable income in periods prior to recognizing the income for GAAP. When this occurs, we pay the tax liability and establish a deferred tax asset for GAAP. When the income is then realized under GAAP in future periods, the deferred tax asset is recognized as an expense. Our deferred tax assets are generated by differences in GAAP and tax income at our taxable subsidiaries.

Deferred Asset-Backed Securities Issuance Costs

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 real estate owned (REO), fixed assets, purchased interest, principal receivable, and other prepaid expenses. REO is reported at the lower of cost or fair market value.

Redwood Debt

Redwood debt is currently all short-term debt collateralized by loans and securities. We report this debt at its unpaid principal balance.

Asset-Backed Securities Issued

The majority of the liabilities reported on our consolidated balance sheets represent ABS issued by bankruptcy-remote securitization entities sponsored by Redwood. These ABS issued are carried at their unpaid principal balances net of any unamortized discount or premium. Our exposure to loss from consolidated securitization entities (such as Sequoia and Acacia) is limited (except, in some circumstances, for limited loan repurchase obligations) to our net investment in securities we have acquired from these entities. 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.

Junior Subordinated Notes

Junior subordinated notes (trust preferred securities) are unsecured debt, requiring quarterly interest payments at a floating rate equal to LIBOR plus a spread until they are redeemed in whole, or mature at a future date. These notes contain an earlier optional redemption date without penalty.

Earnings per Share

Basic earnings per share are computed by dividing net income by the weighted average number of common shares outstanding during the period. Diluted earnings per share are 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 earnings per share computations.

13

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
 
Basic and Diluted Earnings per Share
 
(In thousands, except share data)
 
Three Months Ended March 31,
 
   
2007
 
2006
 
Denominators:
             
Denominator for basic earnings per share is equal to the weighted average number of common shares outstanding during the period
   
26,855,681
   
25,201,525
 
Adjustments for diluted earnings per share are:
             
Net effect of dilutive stock options
   
828,348
   
501,205
 
Denominator for diluted earnings per share
   
27,684,029
   
25,702,730
 
               
Basic Earnings Per Share
 
$
0.68
 
$
1.11
 
               
Diluted Earnings Per Share
 
$
0.66
 
$
1.09
 
 
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 for the three months ended March 31, 2007 and 2006. There were no other participating securities, as defined by EITF 03-6, during for the three months ended March 31, 2007 and 2006. For the three months ended March 31, 2007 and 2006, the number of outstanding stock options that were antidilutive totaled 61,042, and 466,755, respectively.

Other Comprehensive Income (Loss)

Current period net unrealized gains and losses on real estate securities available-for-sale, and interest rate agreements classified as cash flow hedges are reported as components of other comprehensive income (loss) on our consolidated statements of comprehensive income (loss). Net unrealized gains and losses on securities and interest rate agreements held by our taxable subsidiaries that are reported in other comprehensive income (loss) are adjusted for the effects of tax and may create deferred tax assets or liabilities.

Stock-Based Compensation

As of March 31, 2007 and December 31, 2006, 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 15.

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 market 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 unvested equity awards (stock options, restricted stock, and deferred stock units). At March 31, 2007, the unamortized costs totaled $17.7 million and will be expensed over the next six years, over half of which will be recognized over the next twelve months.

The Black-Scholes option-pricing model was used in determining fair market values of option grants accounted for under FAS 123R. The model requires the use of inputs such as strike price, and assumptions such as expected life, risk free rate of return, and stock price volatility. Options are generally granted over the course of the calendar year. The stock price volatility assumption is based on the historical volatility of our common stock. 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%. The following table describes the weighted average of assumptions used for calculating the value of options granted for the three months ended March 31, 2007 and 2006.

14

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
 
Weighted Average Assumptions used for Valuation of Options under FAS 123R Granted during period
 
   
Three Months Ended
March 31,
 
   
2007
 
 2006
 
Stock price volatility
   
25.5
%
 
25.7
%
Risk free rate of return (5 yr Treasury Rate)
   
4.58
%
 
4.75
%
Average life
   
6 years
   
5 years
 
Dividend yield
   
10.00
%
 
10.00
%

Recent Accounting Pronouncements

In February 2007, the FASB issued Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities, including an amendment of FASB Statement No. 115, (“SFAS 159”). SFAS 159 permits fair value accounting to be irrevocably elected for certain financial assets and liabilities at the time of acquisition on an individual contract basis or at a remeasurement event date. Upon adoption of SFAS 159, fair value accounting may also be elected for existing financial assets and liabilities. For those instruments for which fair value accounting is elected, changes in fair value will be recognized in earnings and fees and costs associated with origination or acquisition will be recognized as incurred rather than deferred. SFAS 159 is effective January 1, 2008, with early adoption permitted as of January 1, 2007. We have determined that we will adopt SFAS 159 concurrent with the adoption of FASB issued Statement 157, Fair Value Measurements (“SFAS 157”), on January 1, 2008, but we have not yet determined the financial impact, if any, upon adoption.

Note 3. Real Estate Loans

We acquire residential real estate loans from third party originators. A portion of these loans are sold to securitization entities sponsored by us under our Sequoia program which, in turn, issue ABS. The remainder of the loans we invest in are held and financed with Redwood debt and equity. The following tables summarize the carrying value of the residential and commercial real estate loans, as reported on our consolidated balance sheets at March 31, 2007 and December 31, 2006.

Real Estate Loans Composition
 
(In thousands)
 
March 31,
2007
 
December 31,
2006
 
Residential real estate loans
 
$
8,680,487
 
$
9,323,935
 
Commercial real estate loans
   
25,883
   
28,172
 
Total real estate loans
 
$
8,706,370
 
$
9,352,107
 

Real Estate Loans Carrying Value
 
March 31, 2007
(In thousands)
 
Residential Real Estate Loans
 
Commercial Real
Estate Loans
 
Total
 
Current face
 
$
8,582,964
 
$
38,394
 
$
8,621,358
 
Unamortized premium (discount)
   
117,477
   
(2,022
)
 
115,455
 
Discount designated as credit reserve
   
   
(8,141
)
 
(8,141
)
Amortized cost
   
8,700,441
   
28,231
   
8,728,672
 
Reserve for credit losses
   
(19,954
)
 
(2,348
)
 
(22,302
)
Carrying value
 
$
8,680,487
 
$
25,883
 
$
8,706,370
 

15


REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS

Real Estate Loans Carrying Value
 
December 31, 2006
(In thousands)
 
Residential Real Estate Loans
 
Commercial Real
Estate Loans
 
Total
 
Current face
 
$
9,212,002
 
$
38,360
 
$
9,250,362
 
Unamortized premium (discount)
   
132,052
   
(2,047
)
 
130,005
 
Discount designated as credit reserve
   
   
(8,141
)
 
(8,141
)
Amortized cost
   
9,344,054
   
28,172
   
9,372,226
 
Reserve for credit losses
   
(20,119
)
 
   
(20,119
)
Carrying value
 
$
9,323,935
 
$
28,172
 
$
9,352,107
 
 
Of the $8.6 billion of face and $117 million of unamortized premium on our residential real estate loans at March 31, 2007, $4.5 billion of face and $95 million of unamortized premium relates to residential loans acquired prior to July 1, 2004. At December 31, 2006, the residential loans acquired prior to July 1, 2004 had face and unamortized premium balances of $5.2 billion and $104 million, respectively. For these residential loans, 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. During the first quarter of 2007, 13% of these residential loans prepaid and we amortized 9% of the premium. For residential loans acquired after July 1, 2004, the face and unamortized premium was $4.1 billion and $22 million at March 31, 2007 and $4.0 billion and $28 million at December 31, 2006, respectively. For these residential loans, 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.

Residential real estate loans are either sold to securitization entities sponsored by us under our Sequoia program which, in turn, issue ABS or are held and financed with Redwood debt. The table below presents information regarding real estate loans pledged under our borrowing agreements.

Real Estate Loans Pledged and Unpledged
 
(In thousands)
 
March 31, 2007 
 
December 31, 2006
 
   
Face
Value 
 
Carrying
Value 
 
Face
Value 
 
Carrying
Value 
 
Unpledged
 
$
106,987
 
$
94,119
 
$
120,578
 
$
111,231
 
Pledged for Redwood debt:
                         
Repurchase (repo) agreements
   
900,142
   
909,230
   
978,713
   
982,629
 
Commercial paper
   
252,897
   
253,430
   
301,827
   
302,615
 
Owned by securitization entities, financed through the issuance of ABS
   
7,361,332
   
7,449,591
   
7,849,244
   
7,955,632
 
Carrying value
 
$
8,621,358
 
$
8,706,370
 
$
9,250,362
 
$
9,352,107
 

Note 4. Real Estate Securities

The real estate securities shown on our consolidated balance sheets include residential, commercial, and CDO securities acquired from securitizations sponsored by others. The table below presents the carrying value (which equals fair market value as these are available-for-sale securities (AFS)) of our securities that are included in our consolidated balance sheets as of March 31, 2007 and December 31, 2006, by type of securities, and by credit rating of investment-grade (IGS) and below investment-grade (CES).

16

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
Securities (AFS) — Underlying Collateral Characteristics
 
March 31, 2007
(In thousands)
 
CES
 
IGS
 
Total AFS
Securities
 
 
             
Residential securities:
                   
Prime
 
$
571,149
 
$
789,492
 
$
1,360,641
 
Alt-a
   
171,987
   
765,840
   
937,827
 
Subprime
   
9,141
   
470,518
   
479,659
 
Total residential securities
   
752,277
   
2,025,850
   
2,778,127
 
Commercial securities
   
435,382
   
116,494
   
551,876
 
CDO securities
   
16,152
   
254,307
   
270,459
 
Total securities
 
$
1,203,811
 
$
2,396,651
 
$
3,600,462
 
 
December 31, 2006
(In thousands)
 
CES
 
IGS
 
Total AFS
Securities
 
 
               
Residential securities:
                   
Prime
 
$
555,369
 
$
723,247
 
$
1,278,616
 
Alt-a
   
156,859
   
455,550
   
612,409
 
Subprime
   
9,303
   
518,453
   
527,756
 
Total residential securities
   
721,531
   
1,697,250
   
2,418,781
 
Commercial securities
   
448,060
   
119,613
   
567,673
 
CDO securities
   
21,964
   
224,349
   
246,313
 
Total securities
 
$
1,191,555
 
$
2,041,212
 
$
3,232,767
 

The table below presents the components comprising the carrying value of available-for-sale IGS reported on our consolidated balance sheets at March 31, 2007 and December 31, 2006.

Investment-Grade Securities (AFS)
 
March 31, 2007
(In thousands)
 
Residential
 
Commercial
 
CDO
 
Total IGS
 
                                                                                        
                 
Current face
 
$
2,094,494
 
$
121,737
 
$
263,237
 
$
2,479,468
 
Unamortized discount, net
   
(19,617
)
 
(3,172
)
 
(945
)
 
(23,734
)
Amortized cost
   
2,074,877
   
118,565
   
262,292
   
2,455,734
 
Gross unrealized gains
   
5,376
   
211
   
1,440
   
7,027
 
Gross unrealized losses
   
(54,403
)
 
(2,282
)
 
(9,425
)
 
(66,110
)
Carrying value
 
$
2,025,850
 
$
116,494
 
$
254,307
 
$
2,396,651
 
 
December 31, 2006
(In thousands)
 
Residential
 
Commercial
 
CDO
 
Total IGS
 
                       
Current face
 
$
1,708,607
 
$
122,869
 
$
222,413
 
$
2,053,889
 
Unamortized discount, net
   
(16,382
)
 
(3,367
)
 
(238
)
 
(19,987
)
Amortized cost
   
1,692,225
   
119,502
   
222,175
   
2,033,902
 
Gross unrealized gains
   
14,622
   
980
   
2,638
   
18,240
 
Gross unrealized losses
   
(9,597
)
 
(869
)
 
(464
)
 
(10,930
)
Carrying value
 
$
1,697,250
 
$
119,613
 
$
224,349
 
$
2,041,212
 

17

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS

The table below presents the components comprising the carrying value of available-for-sale CES reported on our consolidated balance sheets at March 31, 2007 and December 31, 2006.

Credit-Enhancement Securities (AFS)
 
March 31, 2007
(In thousands)
 
Residential
 
Commercial
 
CDO
 
Total CES
 
                                                                                        
                     
Current face
 
$
1,259,446
 
$
792,240
 
$
23,731
 
$
2,075,417
 
Unamortized discount, net
   
(158,669
)
 
(71,455
)
 
(7,004
)
 
(237,128
)
Discount designated as credit reserve
   
(392,763
)
 
(294,466
)
 
   
(687,229
)
Amortized cost
   
708,014
   
426,319
   
16,727
   
1,151,060
 
Gross unrealized gains
   
71,323
   
18,767
   
527
   
90,617
 
Gross unrealized losses
   
(27,060
)
 
(9,704
)
 
(1,102
)
 
(37,866
)
Carrying value
 
$
752,277
 
$
435,382
 
$
16,152
 
$
1,203,811
 

December 31, 2006
(In thousands)
 
Residential
 
Commercial
 
CDO
 
Total CES
 
                                                                                        
                     
Current face
 
$
1,180,605
 
$
793,743
 
$
28,731
 
$
2,003,079
 
Unamortized discount, net
   
(144,842
)
 
(71,424
)
 
(6,889
)
 
(223,155
)
Discount designated as credit reserve
   
(372,247
)
 
(295,340
)
 
   
(667,587
)
Amortized cost
   
663,516
   
426,979
   
21,842
   
1,112,337
 
Gross unrealized gains
   
71,134
   
23,235
   
516
   
94,885
 
Gross unrealized losses
   
(13,119
)
 
(2,154
)
 
(394
)
 
(15,667
)
Carrying value
 
$
721,531
 
$
448,060
 
$
21,964
 
$
1,191,555
 
 
At March 31, 2007, our residential CES provided credit-enhancement on $237 billion of residential real estate loans and our commercial CES provided credit-enhancement on $57 billion of commercial real estate loans. At December 31, 2006, our residential CES provided credit-enhancement on $210 billion of residential real estate loans and our commercial CES provided credit-enhancement on $58 billion of commercial real estate loans.

The amount of designated credit reserve equals the estimate of credit losses within the underlying loan pool on the CES 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 reserves. We use a variety of internal and external credit risk cash flow modeling and portfolio analytical tools to assist in our assessments. We review our assessments on each individual underlying loan pool and determine the appropriate level of credit reserve required for each security we own at least quarterly. The designated credit reserve is specific to each security. The following table presents the aggregate changes in our unamortized discount and the portion of the discount designated as credit reserve for the three months ended March 31, 2007 and 2006.

18

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
 
Changes In Unamortized Discount and Designated Credit Reserves on Residential, Commercial, and CDO CES
 
(In thousands)
Three months ended March 31, 2007
 
Residential
 
Commercial
 
CDO
 
Total
 
                                                                                        
                 
Beginning balance of unamortized discount, net
 
$
144,842
 
$
71,424
 
$
6,889
 
$
223,155
 
Amortization of discount
   
(18,892
)
 
9
   
   
(18,883
)
Calls, sales, and other
   
2,370
   
   
   
2,370
 
Re-designation between credit reserve and discount
   
22,312
   
(397
)
 
   
21,915
 
Upgrades to investment-grade securities
   
   
160
   
115
   
275
 
Purchased discount
   
8,037
   
259
   
   
8,296
 
Ending balance of unamortized discount, net
 
$
158,669
 
$
71,455
 
$
7,004
 
$
237,128
 
 
                         
Beginning balance of designated credit reserve
 
$
372,247
 
$
295,340
   
 
$
667,587
 
Realized credit losses
   
(3,805
)
 
(1,271
)
 
   
(5,076
)
Calls, sales, and other
   
(1,516
)
 
   
   
(1,516
)
Re-designation between credit reserve and discount
   
(22,312
)
 
397
   
   
(21,915
)
Purchased discount designated as credit reserve
   
48,149
   
   
   
48,149
 
Ending balance of designated credit reserve
 
$
392,763
 
$
294,466
   
 
$
687,229
 
 
(In thousands)
Three months ended March 31, 2006
 
 Residential
 
 Commercial
 
 CDO
 
 Total
 
                                                                                        
                     
Beginning balance of unamortized discount, net
 
$
121,824
 
$
28,993
 
$
8,004
 
$
158,821
 
Amortization of discount
   
(12,391
)
 
564
   
44
   
(11,783)
)
Calls, sales, and other
   
756
   
(44
)
 
   
712
 
Re-designation between credit reserve and discount
   
1,822
   
(4,429
)
 
   
(2,607
)
Upgrades to investment-grade securities
   
(6,249
)
 
   
   
(6,249
)
Purchased discount (premium)
   
2,609
   
(4,611
)
 
   
(2,002
)
Ending balance of unamortized discount, net
 
$
108,371
 
$
20,473
 
$
8,048
 
$
136,892
 
 
                         
Beginning balance of designated credit reserve
 
$
354,610
 
$
141,806
   
 
$
496,416
 
Realized credit losses
   
(2,577
)
 
(2
)
 
   
(2,579
)
Calls, sales, and other
   
(4,710
)
 
   
   
(4,710
)
Re-designation between credit reserve and discount
   
(1,822
)
 
4,429
   
   
2,607
 
Purchased discount designated as credit reserve
   
28,280
   
21,539
   
   
49,819
 
Ending balance of designated credit reserve
 
$
373,781
 
$
167,772
   
 
$
541,553
 
 
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 than previously expected), the yield over the remaining life of the security may be adjusted upwards. 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 months ended March 31, 2007 and 2006, we recognized other-than-temporary impairments of $2.4 million and $3.2 million, respectively. This includes AFS securities that were in unrealized loss positions of $0.6 million at the end of the period (and were subsequently sold in April 2007) that we did not intend to hold for a period long enough to recover the unrealized loss position. These impairments are included in valuation adjustments in our consolidated statements of income.

Gross realized gains on sales of securities were $0.7 million and $1.1 million for the three months ended March 31, 2007 and 2006, respectively. Gross realized losses on sales of securities were $1.5 million and zero for the three months ended March 31, 2007 and 2006, respectively. Gains on calls of securities were $0.8 million for the three months ended March 31, 2007. There were no gains on calls for the three months ended March 31, 2006.

19

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
 
Gross unrealized gains and losses represent the difference between the net amortized cost and the fair market value of individual securities. Gross unrealized losses represent a decline in fair market value for securities not deemed impaired for GAAP. The following tables show the gross unrealized losses, fair market values, and length of time that any real estate securities have been in a continuous unrealized loss position as of March 31, 2007 and December 31, 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.

Securities with Unrealized Losses
 
March 31, 2007
                         
(In thousands)
 
Less Than 12 Months
 
12 Months or More
 
Total
 
   
Fair Market Value
 
Unrealized Losses
 
Fair Market Value
 
Unrealized Losses
 
Fair
Market Value
 
Unrealized Losses
 
                                                          
                         
Residential
 
$
1,231,405
 
$
(56,179
)
$
497,662
 
$
(25,284
)
$
1,729,067
 
$
(81,463
)
Commercial
   
154,968
   
(7,588
)
 
155,555
   
(4,398
)
 
310,523
   
(11,986
)
CDO
   
102,607
   
(7,283
)
 
58,522
   
(3,244
)
 
161,129
   
(10,527
)
Total securities
 
$
1,488,980
 
$
(71,050
)
$
711,739
 
$
(32,926
)
$
2,200,719
 
$
(103,976
)


December 31, 2006
(In thousands)
 
Less Than 12 Months
 
12 Months or More
 
Total
 
   
Fair Market Value
 
Unrealized Losses
 
Fair Market Value
 
Unrealized Losses
 
Fair
Market Value
 
Unrealized Losses
 
                                                          
                               
Residential
 
$
495,242
 
$
(9,938
)
$
385,170
 
$
(12,778
)
$
880,412
 
$
(22,716
)
Commercial
   
111,603
   
(1,055
)
 
85,010
   
(1,968
)
 
196,613
   
(3,023
)
CDO
   
29,378
   
(257
)
 
29,543
   
(601
)
 
58,921
   
(858
)
Total real estate securities
 
$
636,223
 
$
(11,250
)
$
499,723
 
$
(15,347
)
$
1,135,946
 
$
(26,597
)
 
We fund some of the securities we acquire on a temporary basis with short-term borrowings prior to the sale to the securitization entities we sponsor. We also acquire less credit-risk sensitive assets and finance these investments with a combination of Redwood debt and equity. The table below presents information regarding our securities pledged under borrowing agreements and owned by securitization entities as of March 31, 2007 and December 31, 2006.

Securities Pledged and Unpledged
 
(In thousands)
 
March 31, 2007
 
December 31, 2006
 
           
Unpledged
 
$
513,986
 
$
463,891
 
Pledged for Redwood debt
   
708,721
   
593,070
 
Owned by securitization entities, financed through issuance of ABS
   
2,377,755
   
2,175,806
 
Carrying value
 
$
3,600,462
 
$
3,232,767
 

Note 5. Other Real Estate Investments

Other real estate investments shown on our balance sheets include IOs, NIMs and residuals. We have elected to classify these investments as “trading investments” as they contain derivatives under GAAP. These assets are carried at fair market value on our consolidated balance sheet and changes in fair market value flow through market valuation adjustments, net on the consolidated statements of income.

20

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
 
The table below presents the carrying value (which equals fair market value as these are classified as trading instruments) of these investments as of March 31, 2007. We did not have any assets classified as other real estate investments at December 31, 2006. At the conclusion of the quarter we reclassified $18 million of investments from real estate securities available for sale to other real estate investments. We recorded a negative $4 million market valuation adjustment as a result of this transfer. We recorded a negative $5 million market valuation adjustment in total for other real estate investments through the consolidated statements of income during the first three months of 2007. The other $1 million loss was the result of market valuation adjustments on other real estate investments acquired during the first quarter of 2007.
 
Other Real Estate Investments - Trading
         
           
March 31, 2007
         
(In thousands)
 
Prime
 
Alt-a
 
Subprime
 
Total
 
Residential
                         
IOs
 
$
1,625
 
$
410
 
$
 
$
2,035
 
NIMs
   
   
11,679
   
16,937
   
28,616
 
Residuals
   
   
16,219
   
3,187
   
19,406
 
Total other real estate investments
 
$
1,625
 
$
28,308
 
$
20,124
 
$
50,057
 

As of March 31, 2007, $2.6 million of other real estate investments were owned by securitization entities, financed through the issuance of ABS. The remaining $47.5 million were funded with equity.

Note 6. Derivative Financial Instruments

Interest Rate Agreements

We report our interest rate agreements at fair market value as determined using third-party models and confirmed by Wall Street dealers. As of March 31, 2007 and December 31, 2006, the net fair market value of interest rate agreements was $11.0 million and $20.6 million, respectively. Our total unrealized gain on interest rate agreements included in accumulated other comprehensive income (loss) was $0.2 million and $7.0 million at March 31, 2007 and December 31, 2006, respectively.

The following table shows the aggregate fair market value and notional amount of our interest rate agreements as of March 31, 2007 and December 31, 2006.
 
Interest Rate Agreements 
 
(In thousands)
 
March 31, 2007
 
December 31, 2006
 
   
Fair Market
Value
 
Notional
Amount
 
Fair Market
Value
 
Notional
Amount
 
                       
Accounted for as Trading Instruments
                         
Interest rate caps purchased                                 
 
$
1,389
 
$
66,900
 
$
1,114
 
$
71,900
 
Interest rate caps sold
   
   
   
   
 
Interest rate corridors purchased
   
   
798,967
   
   
844,805
 
Interest rate swaps
   
203
   
238,831
   
242
   
131,195
 
Credit default swaps
   
(2,492
)
 
35,000
   
(6
)
 
1,000
 
Futures
   
   
   
90
   
204,000
 
Purchase commitments
   
(192
)
 
81,676
   
(168
)
 
80,964
 
Accounted for as Cash Flow Hedges
                         
Futures
   
   
   
(44
)
 
627,000
 
Interest rate swaps
   
12,115
   
1,121,884
   
19,385
   
1,279,007
 
Total Interest Rate Agreements
 
$
11,023
 
$
2,343,258
 
$
20,613
 
$
3,239,871
 
 
Our interest rate agreements had net receipts of $2.4 million for the three months ended March 31, 2007 and net receipts of $2.2 million for the three months ended March 31, 2006.

21

 
REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
 
Interest rate agreements accounted for as cash flow hedges may be terminated prior to the completion of the forecasted transactions. In these cases, provided the forecasted transaction is still likely to occur, the net gain or loss on the interest rate agreements remains in accumulated other comprehensive income (loss) and will be reclassified from accumulated other comprehensive income (loss) to our consolidated statements of income during the period the forecasted transaction occurs. We reclassified $0.7 million and $0.3 million from other comprehensive income (loss) to interest expense for the three months ended March 31, 2007 and 2006, respectively. At March 31, 2007, the maximum length of time over which we are hedging our exposure to the variability of future cash flows for forecasted transactions with cash flow hedges is ten years, and in all cases, the forecasted transactions are expected to occur within the next year.

In the case when the hedge is terminated and the forecasted transaction is not expected to occur, we immediately recognize the gain or loss through gains on sales, net in our consolidated statements of income. For the three months ended March 31, 2007, there was one such instance which resulted in a gain of $1.1 million. For the three months ended March 31, 2006, there were no such instances. The following table presents the interest income and expense for the three months ended March 31, 2007 and 2006.

Impact on Interest Income (Expense) of Our Interest Rate Agreements
 
   
Three Months Ended March 31,
 
(In thousands)
 
2007
 
2006
 
            
Net interest income on interest rate agreements                                        
 
$
2,399
 
$
2,231
 
Realized net gains (losses) due to net ineffective portion of hedges
   
(81
)
 
483
 
Realized net (losses) gains reclassified from other comprehensive income (loss)
   
(672
)
 
266
 
Total
 
$
1,646
 
$
2,980
 
 
When the interest rate agreement is accounted for as a trading instrument, changes in the fair market value of the interest rate agreement and all associated income and expenses are reported in earnings through market valuation adjustments and were negative $0.8 million and positive $0.3 million for three months ended March 31, 2007 and 2006, respectively.

Purchase Commitments

At March 31, 2007, we had commitments to purchase $82 million residential real estate loans and these commitments had an estimated fair market value of negative $0.2 million. The change in fair market value is included in market valuation adjustments on our consolidated statements of income.

We have committed to purchase commercial CES from a securitization entity to be formed in 2007 subject to adherence to representations and underwriting criteria as set forth in the agreement. At March 31, 2007, there were approximately $115 million of commercial mortgage loans originated for this future securitization. At March 31, 2007, we estimate the value of this commitment to be negligible.

Credit Default Swaps

A credit default swap is an agreement to provide (receive) credit event protection based on a financial index or specific security in exchange for receiving (paying) a fixed rate fee or premium over the term of the contract. In the first quarter of 2007, we entered into several credit default swaps with an aggregate notional amount of $35 million where we agreed to provide credit event protection in exchange for a premium. We intend to include these credit default swaps in our next Acacia CDO (scheduled to close in the second quarter of 2007) and we plan to acquire more credit default swaps in the future. These will likely increase volatility of our GAAP income.

Credit default swaps are accounted for as trading instruments, and are thus reported at fair market value with the changes in fair market values recognized through our income statements. Since the acquisition of these credit default swaps, the value has decreased $2.5 million, primarily as the result of widening spreads in these types of instruments. We currently do not believe that the probability of a credit event has substantially increased from our date of purchase through March 31, 2007. As a trading instrument, the change in fair market value is included in valuation adjustments on our consolidated statements of income.