UNITED STATES OF AMERICA
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: June 30, 2007
 
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
Incorporation or Organization)
 
(I.R.S. 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(g) 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 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  x
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 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
27,937,406 as of August 7, 2007
 



 
REDWOOD TRUST, INC.
2007 FORM 10-Q REPORT
 
TABLE OF CONTENTS
 
   
Page
     
PART I
   
Item 1.
     
Financial Statements
     
 
   
Consolidated Balance Sheets at June 30, 2007 (unaudited) and December 31, 2006
 
1
   
Consolidated Statements of Income for the three and six months ended June 30, 2007 and 2006 (unaudited)
 
2
   
Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2007 and 2006 (unaudited)
 
3
Consolidated Statements of Stockholders’ Equity for the six months ended June 30, 2007 and 2006 (unaudited)
4
 
Consolidated Statements of Cash Flows for the six months ended June 30, 2007 and 2006 (unaudited)
 
5
 
Notes to Consolidated Financial Statements
 
6
Item 2.
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
43
Item 3.
 
Quantitative and Qualitative Disclosures about Market Risk
 
83
Item 4.
Controls and Procedures
83
         
PART II
   
Item 2.
 
Unregistered Sales of Equity Securities and Use of Proceeds
 
84
Item 4.
Voting Results
   
Item 6.
Exhibits
84
Signatures
85
 

 
PART I. FINANCIAL INFORMATION
 
ITEM 1. FINANCIAL STATEMENTS
 
REDWOOD TRUST, INC. AND SUBSIDIARIES
 
CONSOLIDATED BALANCE SHEETS
 
(In thousands, except share data)
 
June 30,
2007
 
December 31,
2006
 
(Unaudited)
     
ASSETS
           
Real estate loans
 
$
8,377,474
 
$
9,352,107
 
Real estate securities
   
3,725,772
   
3,232,767
 
Other real estate investments
   
34,168
   
 
Non-real estate investments
   
80,000
   
 
Cash and cash equivalents
   
82,626
   
168,016
 
Total earning assets
   
12,300,040
   
12,752,890
 
Restricted cash
   
206,664
   
112,167
 
Accrued interest receivable
   
57,337
   
70,769
 
Derivative assets
   
40,713
   
26,827
 
Deferred tax asset
   
4,660
   
5,146
 
Deferred asset-backed securities issuance costs
   
48,532
   
42,468
 
Other assets
   
23,369
   
20,206
 
Total Assets
 
$
12,681,315
 
$
13,030,473
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
             
LIABILITIES
             
Redwood debt
 
$
848,662
 
$
1,856,208
 
Asset-backed securities issued
   
10,675,469
   
9,979,224
 
Accrued interest payable
   
48,473
   
50,590
 
Derivative liabilities
   
6,250
   
6,214
 
Accrued expenses and other liabilities
   
55,515
   
16,832
 
Dividends payable
   
20,862
   
18,715
 
Subordinated notes
   
150,000
   
100,000
 
Total liabilities
   
11,805,231
   
12,027,783
 
Commitments and contingencies (Note 17)
             
               
STOCKHOLDERS’ EQUITY
             
Common stock, par value $0.01 per share, 50,000,000 shares authorized; 27,816,200 and 26,733,460 issued and outstanding
   
279
   
267
 
Additional paid-in capital
   
964,944
   
903,808
 
Accumulated other comprehensive income (loss)
   
(80,913
)
 
93,158
 
Cumulative earnings
   
838,736
   
809,011
 
Cumulative distributions to stockholders
   
(846,962
)
 
(803,554
)
Total stockholders’ equity
   
876,084
   
1,002,690
 
Total Liabilities and Stockholders’ Equity
 
$
12,681,315
 
$
13,030,473
 
 
The accompanying notes are an integral part of these consolidated financial statements.
 
1

 

REDWOOD TRUST, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF INCOME
 
   
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
(In thousands, except share data)
 
2007
 
2006
 
2007
 
2006
 
(Unaudited)
                 
Interest Income
                 
Real estate loans
 
$
119,576
 
$
154,972
 
$
246,427
 
$
321,875
 
Real estate securities
   
95,193
   
60,395
   
178,651
   
116,897
 
Other real estate investments
   
669
   
   
3,134
   
 
Non-real estate investments
   
464
   
   
464
   
 
Cash and cash equivalents
   
3,756
   
2,871
   
6,088
   
5,348
 
Total interest income
   
219,658
   
218,238
   
434,764
   
444,120
 
                           
Interest Expense
                         
Redwood debt
   
(22,700
)
 
(1,822
)
 
(53,794
)
 
(3,894
)
Asset-backed securities issued
   
(140,541
)
 
(171,697
)
 
(275,487
)
 
(350,280
)
Subordinated notes
   
(2,516
)
 
   
(4,572
)
 
 
Total interest expense
   
(165,757
)
 
(173,519
)
 
(333,853
)
 
(354,174
)
                           
Net Interest Income
   
53,901
   
44,719
   
100,911
   
89,946
 
                           
Operating expenses
   
(12,772
)
 
(16,037
)
 
(30,554
)
 
(28,619
)
Realized gains on sales and calls, net
   
2,738
   
8,988
   
3,884
   
10,050
 
Market valuation adjustments, net
   
(29,430
)
 
(2,995
)
 
(39,694
)
 
(5,927
)
Net income before provision for income taxes
   
14,437
   
34,675
   
34,547
   
65,450
 
Provision for income taxes
   
(3,021
)
 
(3,265
)
 
(4,822
)
 
(6,025
)
                           
Net Income
 
$
11,416
 
$
31,410
 
$
29,725
 
$
59,425
 
                           
Basic earnings per share:
 
$
0.42
 
$
1.23
 
$
1.10
 
$
2.34
 
Diluted earnings per share:
 
$
0.41
 
$
1.20
 
$
1.06
 
$
2.29
 
                           
Regular dividends declared per common share
 
$
0.75
 
$
0.70
 
$
1.50
 
$
1.40
 
Special dividends declared per common share
 
$
 
$
 
$
 
$
 
Total dividends declared per common share
 
$
0.75
 
$
0.70
 
$
1.50
 
$
1.40
 
                           
Basic weighted average shares outstanding
   
27,405,284
   
25,496,552
   
27,132,001
   
25,349,853
 
Diluted weighted average shares outstanding
   
28,164,944
   
26,108,975
   
27,917,502
   
25,909,923
 
 
The accompanying notes are an integral part of these consolidated financial statements.
 
2

 
 
REDWOOD TRUST, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
 
   
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
(In thousands)
 
2007
 
2006
 
2007
 
2006
 
(Unaudited)
                 
Net Income
 
$
11,416
 
$
31,410
 
$
29,725
 
$
59,425
 
Other Comprehensive (Loss) Income:
                         
Net unrealized (losses) gains on available-for-sale securities
   
(101,745
)
 
6,679
   
(194,430
)
 
(1,380
)
Reclassification adjustment for net (gains) losses included in net income
   
7,058
   
(1,342
)
 
6,945
   
656
 
Unrealized (losses) gains on cash flow hedges, net
   
19,952
   
10,128
   
13,814
   
24,315
 
Reclassification of net realized cash flow hedge losses (gains) to interest expense on asset-backed securities issued and realized gains on sales and calls
   
5
   
(6,119
)
 
(400
)
 
(6,385
)
Total Other Comprehensive (Loss) Income
   
(74,730
)
 
9,346
   
(174,071
)
 
17,206
 
Comprehensive (Loss) Income
 
$
(63,314
)
$
40,756
 
$
(144,346
)
$
76,631
 
 
The accompanying notes are an integral part of these consolidated financial statements.

3

 

REDWOOD TRUST, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
 
For the Six Months Ended June 30, 2007
 
               
Accumulated
             
               
Other
     
Cumulative
     
           
Additional
 
Comprehensive
     
Distributions
     
(In thousands, except   
Common Stock
 
Paid-In
 
Income
 
Cumulative
 
to
     
share data)
 
Shares
 
Amount
 
Capital
 
 (Loss)
 
Earnings
 
Stockholders
 
Total
 
(Unaudited)
                             
December 31, 2006
   
26,733,460
 
$
267
 
$
903,808
 
$
93,158
 
$
809,011
 
$
(803,554
)
$
1,002,690
 
Net income
   
   
   
   
   
29,725
   
   
29,725
 
Net unrealized gain/reclassification on assets AFS
   
   
   
   
(187,485
)
 
   
   
(187,485
)
Net unrealized gain/reclassification on interest rate agreements
   
   
   
   
13,414
   
   
   
13,414
 
Issuance of common stock:
                                           
Dividend reinvestment & stock purchase plans
   
1,004,165
   
10
   
52,054
   
   
   
   
52,064
 
Employee option & stock purchase plan
   
78,575
   
2
   
330
   
   
   
   
332
 
Non-cash equity award compensation
   
   
   
8,752
   
   
   
   
8,752
 
Common dividends declared
   
   
   
   
   
   
(43,408
)
 
(43,408
)
June 30, 2007
   
27,816,200
 
$
279
 
$
964,944
 
$
(80,913
)
$
838,736
 
$
(846,962
)
$
876,084
 
 
 
 
For the Six Months Ended June 30, 2006

               
Accumulated
             
               
Other
     
Cumulative
     
           
Additional
 
Comprehensive
     
Distributions
     
(In thousands, except  
Common Stock
 
Paid-In
 
Income
 
Cumulative
 
to
     
share data)
 
Shares
 
Amount
 
Capital
 
 (Loss)
 
Earnings
 
Stockholders
 
Total
 
(Unaudited)
                             
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 plan
   
52,257
   
1
   
387
   
   
   
   
388
 
Non-cash equity award compensation
   
(2,430
)
 
   
8,647
   
   
   
   
8,647
 
Common dividends declared
   
   
   
   
   
   
(36,862
)
 
(36,862
)
June 30, 2006
   
25,667,553
 
$
257
 
$
853,896
 
$
90,937
 
$
740,904
 
$
(681,728
)
$
1,004,266
 
 
The accompanying notes are an integral part of these consolidated financial statements.
 
4

 

REDWOOD TRUST, INC. AND SUBSIDIARIES
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
 

   
Six Months Ended
June 30,
 
(In thousands)
 
2007
 
2006
 
(Unaudited)
         
Cash Flows From Operating Activities:
         
Net income
 
$
29,725
 
$
59,425
 
Adjustments to reconcile net income to net cash provided by operating activities:
             
Amortization of premiums, discounts, and debt issuance costs
   
(32,749
)
 
(31,080
)
Depreciation and amortization of non-financial assets
   
830
   
545
 
Provision for credit losses
   
6,329
   
(2,330
)
Non-cash equity award compensation
   
8,752
   
8,647
 
Net recognized losses (gains) and valuation adjustments
   
35,810
   
(4,123
)
Purchases of other real estate investments - trading
   
(40,818
)
 
 
Purchases of non-real estate investments - trading
   
(80,000
)
 
 
Principal payments on other real estate investments - trading
   
7,431
   
 
Net change in:
             
Accrued interest receivable
   
13,432
   
9,671
 
Deferred income taxes
   
568
   
281
 
Other assets
   
4,111
   
(683
)
Accrued interest payable
   
(2,117
)
 
5,900
 
Accrued expenses and other liabilities
   
38,683
   
937
 
Net cash (used in) provided by operating activities
   
(10,013
)
 
47,190
 
Cash Flows From Investing Activities:
             
Purchases of real estate loans held-for-investment
   
(1,091,496
)
 
(325,316
)
Proceeds from sales of real estate loans held-for-investment
   
2,191
   
8,408
 
Principal payments on real estate loans held-for-investment
   
2,025,662
   
3,733,573
 
Purchases of real estate securities available-for-sale
   
(1,011,181
)
 
(496,822
)
Proceeds from sales of real estate securities available-for-sale
   
175,559
   
176,432
 
Principal payments on real estate securities available-for-sale
   
160,737
   
101,803
 
Proceeds from sales of other real estate investments - trading
   
2,237
   
 
Net increase in restricted cash
   
(94,497
)
 
(13,806
)
Net cash provided by investing activities
   
169,212
   
3,184,272
 
Cash Flows From Financing Activities:
             
Net (repayments) borrowings on Redwood debt
   
(1,007,546
)
 
359,676
 
Proceeds from issuance of asset-backed securities
   
3,332,925
   
288,709
 
Deferred asset-backed security issuance costs
   
(19,147
)
 
(3,383
)
Repayments on asset-backed securities
   
(2,609,157
)
 
(3,934,557
)
Proceeds from issuance of subordinated notes
   
50,000
   
 
Net (purchases) proceeds from interest rate agreements
   
(2,798
)
 
4,297
 
Net proceeds from issuance of common stock
   
52,396
   
20,890
 
Dividends paid
   
(41,262
)
 
(36,488
)
Net cash used in financing activities
   
(244,589
)
 
(3,300,856
)
Net decrease in cash and cash equivalents
   
(85,390
)
 
(69,394
)
Cash and cash equivalents at beginning of period
   
168,016
   
175,885
 
Cash and cash equivalents at end of period
 
$
82,626
 
$
106,491
 
Supplemental Disclosure of Cash Flow Information:
             
Cash paid for interest
 
$
335,970
 
$
348,274
 
Cash paid for taxes
 
$
8,480
 
$
4,099
 
Non-Cash Financing Activity:
             
Dividends declared but not paid
 
$
20,862
 
$
17,967
 
 
The accompanying notes are an integral part of these consolidated financial statements.

5

 
 
REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 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 June 30, 2007 and December 31, 2006 and for the three and six months ended June 30, 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 six months ended June 30, 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 June 30, 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.
 
6


REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 2. Summary of Significant Accounting Policies - (continued)
 
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. 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.
 
7


REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 2. Summary of Significant Accounting Policies - (continued)
 
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 8 for a discussion of the reserves for credit losses.
 
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.
 
8


REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 2. Summary of Significant Accounting Policies - (continued)
 
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.
 
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 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.
 
9


REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 2. Summary of Significant Accounting Policies - (continued)
 
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.
 
Non-Real Estate Investments
 
Non-real estate investments represents a guaranteed investment contract (GIC) entered into by an Acacia securitization entity that we consolidate for financial statements purposes. We have classified this investment as a trading security that is recorded on our consolidated balance sheets at its estimated fair market value. Management considers the GIC’s fair market value to approximate contract value, as the interest rate is variable at LIBOR minus a spread and resets on a monthly basis. Changes in fair market value are reported through our consolidated statements of income through market valuation adjustments. See Note 6 for further discussion of our non-real estate investments.
 
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 and the accounting treatment chosen.
 
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.
 
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.
 
10


REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 2. Summary of Significant Accounting Policies - (continued)
 
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.
 
See Note 7 for a further discussion of our derivative financial 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.
 
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).
 
11

 
REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 2. Summary of Significant Accounting Policies - (continued)
 
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 ABS investors. ABS obligations are payable solely from the assets of these entities and are non-recourse to Redwood.
 
Subordinated Notes
 
Subordinated notes includes subordinated notes (trust preferred securities) and subordinated notes. Both 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.
 
12

 
REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 2. Summary of Significant Accounting Policies - (continued)
 
Basic and Diluted Earnings per Share
 
   
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
(In thousands, except share data)
 
2007
 
2006
 
2007
 
2006
 
                      
Denominators:
                    
Denominator for basic earnings per share is equal to the weighted average number of common shares outstanding during the period
    27,405,284    
25,496,552
   
27,132,001
   
25,349,853
 
Adjustments for diluted earnings per share are:
                         
Net effect of dilutive stock options
    759,660    
612,423
   
785,501
   
560,070
 
Denominator for diluted earnings per share
    28,164,944    
26,108,975
   
27,917,502
   
25,909,923
 
                           
Basic Earnings Per Share:
 
$
0.42
 
$
1.23
 
$
1.10
 
$
2.34
 
                           
Diluted Earnings Per Share:
 
$
0.41
 
$
1.20
 
$
1.06
 
$
2.29
 
 
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 and six months ended June 30, 2007 and 2006. There were no other participating securities, as defined by EITF 03-6, during the three and six months ended June 30, 2007 and 2006. For the three months ended June 30, 2007 and 2006, the number of outstanding stock options that were antidilutive totaled 449,105 and 465,980 respectively. For the six months ended June 30, 2007 and 2006, the number of outstanding stock options that were antidilutive totaled 252,109, and 466,166 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 June 30, 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 16.
 
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.
 
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%.
 
13


REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 2. Summary of Significant Accounting Policies - (continued)
 
The following table describes the weighted average of assumptions used for calculating the value of options granted for the three and six months ended June 30, 2007 and 2006.
 
Weighted Average Assumptions used for Valuation of Options under FAS 123R Granted during period
 
   
Three Months Ended
June 30,
 
 Six Months Ended
June 30,
 
   
2007
 
2006
 
 2007
 
2006
 
                    
Stock price volatility   
   
27.2
%
 
   
25.5
%
 
25.7
%
Risk free rate of return (5 yr Treasury Rate)
   
4.87
%
 
   
4.58
%
 
4.75
%
Average life
   
5 years
   
   
6 years
   
5 years
 
Dividend yield
   
10.00
%
 
   
10.00
%
 
10.00
%
 
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. At June 30, 2007, we transferred $13 million (of outstanding principal) of residential delinquent loans from held-for-investment to held-for-sale as we are actively marketing these loans for sale.
 
The following tables summarize the carrying value of the residential and commercial real estate loans, as reported on our consolidated balance sheets at June 30, 2007 and December 31, 2006.
 
Real Estate Loans Composition
 
(In thousands)
 
June 30,
2007
 
December 31,
2006
 
             
Residential real estate loans - held-for-sale                                                      
 
$
9,410
 
$
 
Residential real estate loans - held-for-investment 
   
8,342,237
   
9,323,935
 
Total residential real estate loans                                                            
   
8,351,647
   
9,323,935
 
Commercial real estate loans - held-for-investment
   
25,827
   
28,172
 
Total real estate loans
 
$
8,377,474
 
$
9,352,107
 
 
14


REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 3. Real Estate Loans - (continued)
 
Real Estate Loans Carrying Value -Held-for-Investment
 
June 30, 2007
(In thousands)
 
Residential Real
Estate Loans
 
Commercial Real
Estate Loans
 
Total
 
                  
Current face                                                                                   
 
$
8,256,759
 
$
38,311
 
$
8,295,070
 
Unamortized premium (discount)
   
101,894
   
(1,995
)
 
99,899
 
Discount designated as credit reserve
   
   
(8,141
)
 
(8,141
)
Amortized cost
   
8,358,653
   
28,175
   
8,386,828
 
Reserve for credit losses
   
(16,416
)
 
(2,348
)
 
(18,764
)
Carrying value
 
$
8,342,237
 
$
25,827
 
$
8,368,064
 
 
 
 
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 $8.3 billion of face and $102 million of unamortized premium on our residential real estate loans at June 30, 2007, $3.5 billion of face and $83 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 half of 2007, 32% of these residential loans prepaid and we amortized 20% of the premium. For residential loans acquired after July 1, 2004, the face and unamortized premium was $4.8 billion and $19 million at June 30, 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.
 
15

 
REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 3. Real Estate Loans - (continued)
 
Real Estate Loans Pledged and Unpledged
 
   
June 30,
2007
 
December 31,
2006
 
(In thousands)
 
Face
Value
 
Carrying
Value
 
Face
Value
 
Carrying
Value
 
                       
Unpledged
 
$
175,965
 
$
163,789
 
$
120,578
 
$
111,231
 
Pledged for Redwood debt:
                         
Repurchase (repo) agreements
   
506,932
   
506,576
   
978,713
   
982,629
 
Commercial paper
   
204,825
   
207,135
   
301,827
   
302,615
 
Owned by securitization entities, financed through
the issuance of ABS
   
7,419,895
   
7,499,974
   
7,849,244
   
7,955,632
 
Carrying value
 
$
8,307,617
 
$
8,377,474
 
$
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 June 30, 2007 and December 31, 2006, by type of securities, and by credit rating of investment-grade (IGS) and below investment-grade (CES).
 
Securities (AFS) — Underlying Collateral Characteristics
 
June 30, 2007
(In thousands)
 
CES
 
IGS
 
Total AFS
Securities
 
                  
Residential securities:
                
Prime                                                                                                     
 
$
569,789
 
$
869,884
 
$
1,439,673
 
Alt-a
   
172,356
   
855,555
   
1,027,911
 
Subprime
   
2,830
   
437,507
   
440,337
 
Total residential securities
   
744,975
   
2,162,946
   
2,907,921
 
Commercial securities
   
450,941
   
111,144
   
562,085
 
CDO securities
   
21,133
   
234,633
   
255,766
 
Total securities
 
$
1,217,049
 
$
2,508,723
 
$
3,725,772
 

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 June 30, 2007 and December 31, 2006.
 
16


REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 4. Real Estate Securities - (continued)
 
Investment-Grade Securities (AFS)
 
June 30, 2007
(In thousands)
 
Residential
 
Commercial
 
CDO
 
Total IGS
 
                       
Current face                                                     
 
$
2,276,704
 
$
121,131
 
$
262,881
 
$
2,660,716
 
Unamortized discount, net
   
(32,187
)
 
(3,103
)
 
(7,096
)
 
(42,386
)
Amortized cost
   
2,244,517
   
118,028
   
255,785
   
2,618,330
 
Gross unrealized gains
   
3,800
   
16
   
640
   
4,456
 
Gross unrealized losses
   
(85,371
)
 
(6,900
)
 
(21,792
)
 
(114,063
)
Carrying value
 
$
2,162,946
 
$
111,144
 
$
234,633
 
$
2,508,723
 

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
 
 
The table below presents the components comprising the carrying value of available-for-sale CES reported on our consolidated balance sheets at June 30, 2007 and December 31, 2006.
 
Credit-Enhancement Securities (AFS)
 
June 30, 2007
(In thousands)
 
Residential
 
Commercial
 
CDO
 
Total CES
 
                       
Current face                                                     
 
$
1,291,193
 
$
880,987
 
$
31,381
 
$
2,203,561
 
Unamortized discount, net
   
(125,948
)
 
(95,346
)
 
(9,955
)
 
(231,249
)
Discount designated as credit reserve
   
(453,076
)
 
(310,745
)
 
   
(763,821
)
Amortized cost
   
712,169
   
474,896
   
21,426
   
1,208,491
 
Gross unrealized gains
   
66,177
   
11,637
   
1,776
   
79,590
 
Gross unrealized losses
   
(33,371
)
 
(35,592
)
 
(2,069
)
 
(71,032
)
Carrying value
 
$
744,975
 
$
450,941
 
$
21,133
 
$
1,217,049
 

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
 
 
17


REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 4. Real Estate Securities - (continued)
 
At June 30, 2007, our residential CES provided credit-enhancement on $220 billion of residential real estate loans and our commercial CES provided credit-enhancement on $70 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 and six months ended June 30, 2007 and 2006.
 
18

REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 4. Real Estate Securities - (continued)
 
Changes In Unamortized Discount and Designated Credit Reserves on Residential, Commercial, and CDO CES
 
Three Months Ended June 30, 2007
(In thousands)
 
Residential
 
Commercial
 
CDO
 
Total
 
                    
Beginning balance of unamortized discount, net
 
$
158,669
 
$
71,455
 
$
7,004
 
$
237,128
 
Amortization of discount
    (21,065 )   (200 )      
(21,265
)
Calls, sales, and other
    12,931     766     105    
13,802
 
Re-designation between credit reserve and discount
    (21,803 )   9,877        
(11,926
)
Upgrades to investment-grade securities
               
 
Purchased discount (premium)
    (2,784 )   13,448     2,846    
13,510
 
Ending balance of unamortized discount, net
 
$
125,948
 
$
95,346
 
$
9,955
 
$
231,249
 
                           
Beginning balance of designated credit reserve
 
$
392,763
 
$
294,466
     
$
687,229
 
Realized credit losses
    (5,648 )   (42 )      
(5,690
)
Calls, sales, and other
    (2,158 )          
(2,158
)
Re-designation between credit reserve and discount
    21,803     (9,877 )      
11,926
 
Purchased discount designated as credit reserve
    46,316     26,198        
72,514
 
Ending balance of designated credit reserve
 
$
453,076
 
$
310,745
     
$
763,821
 
 
 
 
Three Months Ended June 30, 2006
(In thousands)
 
Residential
 
Commercial
 
CDO
 
Total
 
                    
Beginning balance of unamortized discount, net
 
$
108,371
 
$
20,473
 
$
8,048
 
$
136,892
 
Amortization of discount
    (11,684 )   257        
(11,427
)
Calls, sales, and other
    (813 )   1,835     (70 )  
952
 
Re-designation between credit reserve and discount
    20,828     (884 )      
19,944
 
Upgrades to investment-grade securities
               
 
Purchased discount
        6,503        
6,503
 
Ending balance of unamortized discount, net
 
$
116,702
 
$
28,184
 
$
7,978
 
$
152,864
 
                           
Beginning balance of designated credit reserve
 
$
373,781
 
$
167,772
     
$
541,553
 
Realized credit losses
    (1,041 )   138        
(903
)
Calls, sales, and other
    (192 )          
(192
)
Re-designation between credit reserve and discount
    (20,828 )   884        
(19,944
)
Purchased discount designated as credit reserve
    73,858     23,340        
97,198
 
Ending balance of designated credit reserve
 
$
425,578
 
$
192,134
     
$
617,712
 
 
19


REDWOOD TRUST, INC. AND SUBSIDIARIES
 
NOTES TO FINANCIAL STATEMENTS
June 30, 2007
(Unaudited)
 
Note 4. Real Estate Securities - (continued)
 
Changes In Unamortized Discount and Designated Credit Reserves on Residential, Commercial, and CDO CES
 
Six Months Ended June 30, 2007
(In thousands)
 
Residential
 
Commercial
 
CDO
 
Total
 
                       
Beginning balance of unamortized discount, net
 
$
144,842
 
$
71,424
 
$
6,889
 
$
223,155
 
Amortization of discount
   
(39,957
)
 
(191
)
 
   
(40,148
)
Calls, sales, and other
   
15,301
   
766
   
105
   
16,172
 
Re-designation between credit reserve and discount
   
509
   
9,480
   
   
9,989
 
Upgrades to investment-grade securities
   
   
160
   
115
   
275
 
Purchased discount
   
5,253
   
13,707
   
2,846
   
21,806
 
Ending balance of unamortized discount, net
 
$
125,948
 
$
95,346
 
$
9,955
 
$
231,249
 
                           
Beginning balance of designated credit reserve
 
$
372,247
 
$
295,340
   
 
$
667,587
 
Realized credit losses
   
(9,453
)
 
(1,313
)
 
   
(10,766
)
Calls, sales, and other
   
(3,674
)
 
   
   
(3,674
)
Re-designation between credit reserve and discount
   
(509
)
 
(9,480
)
 
   
(9,989
)
Purchased discount designated as credit reserve
   
94,465
   
26,198
   
   
120,663
 
Ending balance of designated credit reserve
 
$
453,076
 
$
310,745
   
 
$
763,821
 


Six Months Ended June 30, 2006
(In thousands)
 
Residential
 
Commercial
 
CDO
 
Total
 
                       
Beginning balance of unamortized discount, net
 
$
121,824
 
$
28,993
 
$
8,004
 
$
158,821
 
Amortization of discount
   
(24,075
)
 
821
   
   
(23,254
)
Calls, sales, and other
   
(57
)
 
1,209
   
(26
)
 
1,126
 
Re-designation between credit reserve and discount
   
22,650
   
(5,313
)
 
   
17,337
 
Upgrades to investment-grade securities
   
(6,249
)
 
   
   
(6,249
)
Purchased discount
   
2,609
   
2,474
   
   
5,083
 
Ending balance of unamortized discount, net
 
$
116,702
 
$
28,184
 
$
7,978
 
$
152,864
 
                           
Beginning balance of designated credit reserve
 
$
354,610
 
$
141,806
   
 
$
496,416
 
Realized credit losses
   
(3,618
)
 
136
   
   
(3,482
)
Calls, sales, and other
   
(4,903
)
 
   
   
(4,903
)
Re-designation between credit reserve and discount
   
(22,650
)
 
5,313
   
   
(17,337
)
Purchased discount designated as credit reserve
   
102,139
   
44,879