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x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
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o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
(Exact Name of Registrant as Specified in Its Charter)
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Maryland | 68-0329422 | |
(State or Other Jurisdiction of Incorporation or Organization) |
(I.R.S. Employer Identification No.) |
(Address of Principal Executive Offices) (Zip Code)
(Registrants Telephone Number, Including Area Code)
Securities Registered Pursuant to Section 12(g) of the Act:
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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 if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes x No o
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o No x
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. 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):
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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
At June 30, 2007, the aggregate market value of the registrants common stock held by non-affiliates of the registrant was $1,345,747,756 based on the closing sale price as reported on the New York Stock Exchange.
The number of shares of the registrants Common Stock outstanding on March 4, 2008 was 32,608,498.
Portions of the registrants definitive Proxy Statement to be filed with the Securities and Exchange Commission under Regulation 14A within 120 days after the end of registrants fiscal year covered by this Annual Report are incorporated by reference into Part III.
This Annual Report on Form 10-K and the documents incorporated by reference herein contain forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements involve numerous risks and uncertainties. Our actual results may differ from our expectations, estimates, and projections and, consequently, you should not rely on these forward-looking statements as predictions of future events. Forward-looking statements are not historical in nature and can be identified by words such as anticipate, estimate, will, should, expect, believe, intend, seek, plan and similar expressions or their negative forms, or by references to strategy, plans, or intentions. These forward-looking statements are subject to risks and uncertainties, including, among other things, those described in this Annual Report on Form 10-K under the caption Risk Factors. Other risks, uncertainties, and factors that could cause actual results to differ materially from those projected are described below and may be described from time to time in reports we file with the Securities and Exchange Commission (SEC), including reports on Forms 10-Q and 8-K. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Important factors, among others, that may affect our actual results include: changes in interest rates; changes in prepayment rates; general economic conditions, particularly as they affect the price of earning assets and the credit status of borrowers; the availability of high quality assets for purchase at attractive prices; declines in home prices; increases in mortgage payment delinquencies; changes in the level of liquidity in the capital markets which may adversely affect our ability to finance our real estate asset portfolio; changes in liquidity in the market for real estate securities, the re-pricing of credit risk in the capital markets, rating agency downgrades of securities and increases in the supply of real estate securities available-for-sale, each of which may adversely affect the values of securities we own; the extent of changes in the values of securities we own and the impact of adjustments reflecting those changes on our income statement and balance sheet, including our stockholders equity; our ability to maintain the positive stockholders equity necessary to enable us to pay the dividends required to maintain our status as a real estate investment trust for tax purposes; and other factors not presently identified. This Annual Report on Form 10-K may contain statistics and other data that in some cases have been obtained from or compiled from information made available by servicers and other third-party service providers.
References herein to Redwood, the company, we, us, and our include Redwood Trust, Inc. and its consolidated subsidiaries, unless the context otherwise requires.
Redwood Trust is a financial institution with competitive advantages in the business of investing in real estate loans and securities. Since Redwood was founded in 1994, our goal has been to create a company that is more efficient than banks, thrifts, insurance companies, and other financial institutions at investing in, financing, and managing residential and commercial real estate loans and securities.
Like many financial institutions, our primary source of income is net interest income, which equals the interest income we earn from our investments in loans and securities less the interest expenses we incur from borrowed funds and other liabilities.
Some financial institutions fund their asset investments with borrowed money sourced by taking bank deposits, writing insurance policies, or issuing corporate debt. By contrast, we fund most of our investments with equity. Our investments are sourced from third party issuers of securitizations as well as the two securitization programs we sponsor, Sequoia and Acacia. Sequoia primarily acquires prime residential mortgage loans and creates and issues securities backed by these loans (ABS). Acacia is a collateralized debt obligation (CDO) program that acquires diverse residential and commercial mortgage-backed securities and creates and issues CDO ABS. Most of the securities created and sold by these entities earn the highest credit
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rating of AAA, so the interest expense paid out is relatively low compared to lower rated securities. Our investment in the securities we acquire from these entities generally earn the difference in the yield on the securitized assets less the interest expense payments made to the holders of the ABS securities sold. While our investments generally take the first credit losses on the underlying assets, our losses are limited to our investment in each entity.
As a long-term trend, we believe advances in securitization technology have enabled securitization to become increasingly competitive as a funding source relative to corporate debt, deposits, insurance contracts, and other borrowings. With the exception of recent months when capital markets have been in the midst of a liquidity crisis, the cost of funds for ABS securities issued has continued to improve relative to the cost of other borrowings. More importantly, until recently the range of assets that could be efficiently securitized continued to broaden and the capital efficiency of securitization as a source of funding continued to improve. Once the losses inherent in existing ABS are realized and the economy begins to improve, we expect securitization opportunities will return. As global capital markets continue to develop and evolve, we expect securitization to become an even more efficient source of funding in the long-run. There are trillions of dollars of real estate loans and securities in the U.S. and the world, and the amount outstanding has been and is expected to continue to grow every year. We believe many of these assets will be financed more efficiently through securitization than through other means. In addition, we do not believe that there are sufficient deposits in the banking system to fund all the real estate and other assets that require funding, so we believe securitization is a necessary part of our financial system on an on-going basis. Since we provide capital to credit-enhance mortgage loans and securities that are securitized by others and the securitization programs we sponsor, we believe we will be able to continue to grow and diversify our business over the long-term.
We also borrow money on a collateralized and uncollateralized basis, typically at very competitive rates. We do not, however, take deposits or raise money in any other way that would subject us to consumer lending or banking regulations. Since we are not regulated as a financial institution and do not deal directly with consumers, our operating costs are far lower than other financial institutions, and we have far greater freedom to use securitization as a source of funding.
Our tax structure gives us an additional competitive advantage that cannot be easily replicated by most other financial institutions. We have structured our company for tax purposes as a real estate investment trust (REIT) because our primary business is investing in real estate assets. As a REIT, we are required to distribute 90% or more of our taxable income as dividends. By doing so, we avoid paying corporate taxes on most of the income we generate. This lowers our costs, as taxes are one of the largest costs of doing business for most financial institutions.
In terms of capital employed, our largest area of investment is real estate credit-enhancement securities. Typically, 1% to 15% of the principal value of the securities created in a securitization of real estate assets are credit-enhancement securities (CES). These securities bear most of the credit risk with respect to the underlying assets that were securitized. If the underlying loans or securities suffer a loss of principal due to default, that loss is passed on by reducing the principal value of the CES. As a result of the high level of assumed credit risks, CES carry credit ratings that are below investment-grade. Because the CES absorb most or all of the credit risk that would normally be expected to occur, they reduce the credit risk of the more senior securities, allowing them to earn investment-grade ratings and to be sold at higher prices.
We are a leading investor in CES issued from securitizations of prime-quality residential real estate loans and in 2005 and 2006 we were an increasingly important investor in CES issued from securitizations of commercial real estate loans made on income-producing properties. In recent years, we also made small investments in CES issued from securitizations of alt-a and subprime quality residential loans. In 2007, as a result of market conditions, we significantly reduced our level of acquisitions of residential and commercial CES. In total, at December 31, 2007, we owned residential, commercial, and CDO CES with a principal value of $2.5 billion and a market value of $749 million. Many of these securities are deep discount securities where our cost is far less than the principal value. Since we receive interest payments based on the principal value of a CES security, our interest income cash flow returns are strong. In addition, if credit losses are low, we will receive principal payments in excess of our cost basis, thus generating additional investment returns.
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Conversely, larger than expected credit losses could rapidly reduce the principal value of our CES, causing our investment returns from CES to suffer.
At December 31, 2007, our CES were first in line to absorb credit losses from $250 billion of residential real estate loans and securities and $62 billion of commercial real estate loans and securities that underlie the securitizations from which our CES investments were issued. However, our potential losses are far smaller and are limited to the purchase price of the CES in our portfolio.
With respect to these CES investments, we have a high degree of structural leverage since the principal value of our CES equals only a small percentage of the underlying asset pools. We do not, however, use a high degree of financial leverage with respect to our CES assets. We use capital (equity plus long-term subordinated debt) rather than debt to finance most of our investments in the more junior subordinated CES (the first-loss and second-loss securities, or equivalent) and we have been using capital plus securitization financing through our Acacia CDO issuance program to finance the more senior CES that are closer to investment-grade quality.
In the near term, we anticipate that our net growth in CES assets will be focused in newly originated prime-quality residential assets and on distressed prime, alt-a, and subprime residential securitizations and CDOs acquired at a substantial discount. Later in 2008, we believe acquisition opportunities in commercial real estate assets may become attractive. We expect to fund these acquisitions with equity capital.
We have begun raising third party capital through a Redwood sponsored opportunity fund that will invest in distressed asset opportunities that we see in the marketplace. Due to the accelerating pace of forced asset sale liquidations, primarily ABS CDO unwinds, we feel that opportunity investments can produce attractive risk adjusted returns for Redwood that supplement our core business initiatives. Our subprime and CDO structuring and investment expertise gives us a competitive advantage in evaluating such distressed asset opportunities. As the Redwood Opportunity Fund, LP manager, we will be entitled to management fees that could become substantial income streams in the future. We allocated $50 million of capital to the Redwood Opportunity Fund, LP during the fourth quarter, and have currently deployed $22 million of this amount into Fund eligible investments. Capital contributions to future opportunity funds will be based upon portfolio diversification, our ability to realize management fee income, and our assessment of risk adjusted returns.
In the second half of 2007, capital markets turmoil increased the cost of issuing mortgage-backed and CDO securities, so our two securitization programs (Acacia and Sequoia) cut back significantly on their purchases and creation of loans and securities. We do not currently anticipate that Acacia will complete any new CDO securitizations in 2008, although it is possible market conditions for these CDO activities could improve towards year-end. We do anticipate Sequoia will acquire loans and issue ABS in 2008, although it is possible that market conditions for these types of securitizations will not improve enough to enable Sequoia to issue any new ABS on a profitable basis.
In 2007, we also acquired AAA-rated investment-grade residential securities with the intention of funding them on an on-going basis with short-term debt. Our goal was to seed the growth of an externally-managed REIT to be managed by Redwood that would pursue this strategy. As the liquidity crisis hit the capital markets in 2007, we sold these securities at a small loss. Going forward, it appears that such an externally-managed REIT may be viable, especially to the extent that assets are largely limited to agency (FNMA and FHLMC) residential mortgage securities. We may seek to develop such a REIT in 2008 or 2009 as part of our strategy of increasing our third-party asset management business.
We buy most of our assets rather than originate them. Our primary strategy for sourcing assets is for us (or the securitization entities we sponsor) to acquire loans and securities directly from other financial institutions or from the capital markets. We do not originate or service loans. Most of the real estate securities we invest in are created by others, some are created by us, but in both cases the underlying loans have been originated by others. This role allows us to have an independent point of view on asset quality and attractiveness, as well as the flexibility to change investment strategies as markets evolve. In our experience over the years, many financial institutions that have origination operations have produced sub-optimal asset investment results. We believe this is because, in some cases, there may have been incentives to retain loans that might not be the best investment (in terms of price and/or quality) in order to maintain or boost
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origination volumes and fees. In addition, origination (especially residential loan origination) is a business that is highly cyclical, operations intensive, and increasingly fraught with lender liability. Residential origination is becoming concentrated in the hands of a few large companies that have either banking or brokerage operations as well. Rather than competing with these companies, we develop close relationships with them and help them build their businesses. They need companies like Redwood (and the securitization programs we sponsor) to buy their loans and securities and credit-enhance their securitizations.
We previously built a successful commercial real estate loan origination operation at Redwood, and we may do so again in the future. We may also build a commercial real estate loan special servicing operation. Overall, in the long-run, we intend to build an integrated and diversified commercial real estate investment and specialty finance business. It is not yet clear to us, in light of increasing stress in the commercial real estate markets and the difficult market for commercial real estate CDO financing, what the best model will be for us to pursue with respect to commercial real estate finance in the future. We are in the process of recruiting new management for this business unit. In addition, in order to segregate our commercial business and possibly to finance and brand it separately in the future, we have contributed most of our commercial real estate assets to a wholly-owned subsidiary: Tanoak Commercial Capital Corporation.
We believe our operating efficiencies allow us to remain competitive. In addition, in times like these, when there are few asset buyers and potentially many sellers, and as a result asset prices decline, we benefit competitively from our strong balance sheet, minimal use of Redwood debt, cash balances, and access to new capital. Our competitors are banks, thrifts, insurance companies, Fannie Mae, Freddie Mac, Wall Street brokerage firms, hedge funds, specialty finance companies, mortgage REITs, mortgage insurance companies, CDO securitization managers, asset management companies, foreign investors, and other financial institutions.
Our corporate structure and competitive strengths differ from most other financial institutions. With our differentiated capabilities, we interact as competitors, but also as customers and suppliers, with most of the institutions active in the vast and interconnected real estate capital markets.
We commenced operations in 1994, a period of turmoil in financial markets. This turmoil allowed us to acquire assets that produced very high returns in subsequent years. The level of competition increased dramatically through the end of 1997, at which time we generally sold assets, as the prospective risk/reward relationships for assets did not seem attractive. There were several financial dislocations in 1998, including a prepayment acceleration crisis and a liquidity crisis. This allowed us to use our excess capital to acquire assets, including our own stock, at attractive prices. The CES we acquired in 1999 2002 performed very well, allowing us to report high return on equity results and to pay special dividends of $4.75 per share in 2003 and $6.00 per share in 2004.
As the financial markets experience turmoil due to falling housing prices and rising residential loan defaults, we are and will increasingly incur increased credit losses but we are also in a good position to take advantage of the lower asset prices that have resulted. We believe competition for distressed asset acquisition opportunities will increase, however, but we also believe the magnitude and duration of extraordinary asset acquisition opportunities for the next year or two could be large relative to the supply of funds available to acquire these assets.
Through our internal risk-adjusted capital policies, we seek to maintain a strong balance sheet with a large capital base, risks that are limited and segregated, and ample liquidity.
We use capital, not debt, to fund assets such as first-loss credit-enhancement securities that carry concentrated credit risks. These assets have a high degree of structural credit risk, so we do not feel it would be prudent to employ financial leverage to acquire these assets. Our risk is limited to our investment in these securities. Since we fund these assets with capital rather than debt, high credit losses should not cause liquidity concerns.
We consolidate the assets and liabilities of Sequoia and Acacia. For these entities, our economic risk is limited to the value of any securities we may acquire as an investment from these entities. Our liquid reserves are secure with respect to these securitized assets consolidated on our balance sheet, since the assets were acquired by independent securitization entities, whose liabilities are not Redwoods obligations. Typically, we fund securities acquired from securitizations we sponsor with capital or we sell these securities to another securitization entity for re-securitization. In either case, the risk is segregated and limited.
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We have used Redwood debt to fund assets, and we may do so in the future. In the current environment, we expect to use capital (equity plus long-term subordinated debt) to fund most of our assets.
With respect to interest rate and prepayment rate risks, we seek to maintain a balance sheet that is well balanced and that can generate cash flows to fund our regular dividend in a wide variety of scenarios. We believe we have achieved this the net present value of our projected cash flows does not vary materially with respect to scenarios incorporating changes in interest rates or prepayment rates. Scenarios incorporating different degrees of potential credit losses, however, show a wide variation in the long-term net present value of our cash flows. In the near-term (one to three years), our results may vary as a function of changes in interest rates, prepayments, credit results, markto-market asset values, and other factors.
Our primary financial goal is to distribute the highest levels of dividends per share over the next few decades as we can. We seek to do that while also remaining within our risk tolerance levels and while increasing the inherent value of the company by building competitive advantages, diversifying risks and opportunities, developing internal capabilities, maintaining our culture, keeping operations highly efficient, and increasing book value per share over time.
As a REIT, we are required to distribute to our shareholders as dividends at least 90% of our REIT profits as calculated for tax purposes. We distribute our profits as a regular quarterly dividend and also, in some years, in a year-end special dividend. The regular dividend rate for 2007 was $0.75 per share per quarter and the special dividend was $2.00 per share. Total dividends for 2007 were $5.00 per share.
We expect the regular dividend to be $0.75 per share per quarter for 2008, maintaining the same rate as in 2007. We set the regular dividend at a rate low enough so that we believe there is a relatively small chance that we would need to reduce it in the next few years. Whether we pay a special dividend or not in 2008 will depend primarily on how much REIT taxable income we generate during the year. We expect our total annual dividend payout amounts (regular plus special) will vary from year to year.
Profitable growth is our mission. In a manner consistent with our goal of distributing dividends per share in attractive amounts over time, our mission is to grow to become a larger company in terms of capital employed and market capitalization. We are targeting growth by building real estate investment, financing, and management operations with competitive advantages. Over the long term, growth should bring several advantages, including book value accretion and a diversified income stream.
We plan to grow organically as markets grow and as we gain long-term market share, rather than simply growing for growths sake or through short-term acquisition of market share, which would be irresponsible and inconsistent with our long-term goal of distributing attractive dividends per share. But we do not expect growth to be linear, because in cyclical markets growth is not always the appropriate short-term strategy.
Our website can be found at www.redwoodtrust.com. We make available, free of charge on or through our website, access to our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after those materials are filed with, or furnished to, the SEC. We also make available, free of charge, access to our Code of Ethics, Corporate Governance Standards, Audit Committee Charter, Compensation Committee Charter, and Governance and Nominating Committee Charter.
Our Chief Executive Officer and Chief Financial Officer have executed certifications dated March 4, 2008, as required by Sections 302 and 906 of the Sarbanes-Oxley Act of 2002, and we have included those certifications as exhibits to our Annual Report on Form 10-K for the year ended December 31, 2007. In addition, our Chief Executive Officer certified to the New York Stock Exchange (NYSE) on June 11, 2007 that he is unaware of any violations by Redwood Trust, Inc. of the NYSEs corporate governance listing standards in effect as of that date.
As of December 31, 2007, Redwood employed 99 people.
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The following is a summary of the risk factors that we believe are most relevant to our business. These are factors which, individually or in the aggregate, we think could cause our actual results to differ significantly from anticipated or historical results. In addition to understanding the key risks described below, investors should understand that it is not possible to predict or identify all risk factors, and consequently, the following is not a complete discussion of all potential risks or uncertainties. We undertake no obligation to update forward-looking statements, whether as a result of new information, future events, or otherwise. Investors are advised, however, to consult any further disclosure we make in our reports on Forms 10-Q and 8-K filed with the SEC.
We assume credit risk with respect to residential and commercial real estate loans primarily through the ownership of credit-enhancement securities (CES) backed by residential and commercial real estate loans, collateralized debt obligation (CDO) CES backed by residential and commercial securities, and through residential and commercial real estate loans. Residential and commercial CES have below investment-grade credit ratings and, correspondingly, a high degree of credit risk with respect to the residential and commercial real estate loans within the securitizations that issued these securities. We also assume credit risk through the residential, commercial, and CDO investment grade securities (which we refer to collectively as IGS) we own.
Credit losses on residential real estate loans can occur for many reasons, including: poor origination practices; fraud; faulty appraisals; documentation errors; poor underwriting; legal errors; poor servicing practices; weak economic conditions; increases in payments required to be made by borrowers; declines in the value of homes; earthquakes and other natural events; over-leveraging of the borrower; changes in legal protections for lenders; and personal events affecting borrowers, such as reduction in income, job loss, divorce or health problems. If the U.S. economy or the housing market continue to weaken, our credit losses could increase beyond levels that we originally anticipated or anticipate.
Rising interest rates may increase the credit risks associated with residential real estate loans. The interest rate is adjustable for most of the loans securitized by securitization entities we have sponsored and for a portion of the loans underlying residential and CDO CES we have acquired from securitizations sponsored by others. Accordingly, when short-term interest rates rise, required monthly payments from homeowners will rise under the terms of these adjustable-rate mortgages, and this may increase borrowers delinquencies and defaults.
Credit losses on commercial real estate loans can occur for many of the reasons noted above for residential real estate loans. Losses on commercial real estate loans can also occur for other reasons including decreases in the net operating income from the underlying property, which could be adversely affected by a weakened U.S. economy. Moreover, many commercial real estate loans are not fully amortizing and, therefore, the borrowers ability to repay the principal when due may depend upon the ability of the borrower to refinance or sell the property at maturity. Additional risks associated with commercial real estate loans are discussed below.
The IGS we hold also have credit-related risks. These assets initially received investment-grade ratings, but these initial ratings do not ensure that these securities will be free from credit losses, especially in a housing or economic downturn.
We attempt to manage these risks by periodically evaluating our investments for impairment indicators and establishing reserves for credit and other risks based upon our assessment of these risks. However, the amount of capital and cash reserves that we hold to help us manage credit and other risks may prove to be insufficient to protect us from earnings volatility, reductions or suspensions in regular dividends, and liquidity issues. If these increased credit losses are greater than we anticipated and we need to increase our credit reserves or in the event that assets which have declined in value are deemed to be other-than-temporarily
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impaired, our GAAP earnings might be reduced. Increased credit losses may also adversely affect our cash flows, dividend distribution requirements and payments, asset fair values, access to short-term borrowings, and our ability to securitize assets.
Our residential and commercial CES have concentrated risks with respect to residential and commercial real estate loans, respectively. In general, losses on an asset securing a residential or commercial real estate loan included in a securitization will be borne first by the owner of the property (i.e., the owner will first lose the equity invested in the property) and, thereafter, by a cash reserve fund or letter of credit, if any, then by the first-loss CES holder, and then by holders of more senior CES. In the event the losses incurred upon default on the loan exceed any equity support, reserve fund, letter of credit, and classes of securities junior to those in which we invest (if any), we will not be able to recover all of our principal investment in the securities we hold. In addition, if the underlying properties have been overvalued by the originating appraiser or if the values subsequently decline and, as a result, less collateral is available to satisfy interest and principal payments due on the related ABS, then the first-loss securities may suffer a total loss of principal, followed by losses on the second-loss and then third-loss securities (or other residential and commercial CES or residential and commercial IGS) in which we invest (or have an indirect interest), which have effectively become the first-loss position behind the more senior securities.
For certain types of loans underlying our CES, the loan rate or borrower payment rate may increase over time, increasing the potential for default. For example, a portion of the securities we acquire, or have an indirect interest in through our investment in the Acacia entities we sponsor (sometimes collectively referred to as Acacia), are backed by residential real estate loans that have negative amortization features. The rate at which interest accrues on these loans may change more frequently or to a greater extent than payment adjustments on an adjustable-rate loan, and adjustments of monthly payments may be subject to limitations or may be limited by the borrowers option to pay less than the full accrual rate. As a result, the amount of interest accruing on the remaining principal balance of the loans at the applicable adjustable mortgage loan rate may exceed the amount of the monthly payment. This is particularly a risk in a rising interest rate environment. Negative amortization occurs when the resulting excess is added to the unpaid principal balance of the related adjustable mortgage loan. For certain loans that have a negative amortization feature, the required monthly payment is increased after a specified number of months or after a maximum amount of negative amortization has occurred in order to amortize fully the loan by the end of its original term. Other negative amortizing loans limit the amount by which the monthly payment can be increased, which results in a larger final payment at maturity. As a result, negatively amortizing loans have performance characteristics similar to those of balloon loans. Negative amortization may result in increases in delinquencies, loan loss severity, and loan defaults, which may, in turn, result in payment delays and credit losses on our investments. Other types of loans to which we are exposed, such as hybrid loans and teaser-rate adjustable-rate loans, may also have greater credit risk than more traditional mortgage loans.
The commercial real estate assets we own or in which we have an indirect interest through our investment in Acacia entities may be subject to significant credit and other risks, including environmental and legal risks. The net operating income and fair values of commercial real estate properties may fluctuate with economic cycles and as a result of other factors, so that debt service coverage may be unstable. The value of the property may not support the value of the loan if there is a default. Commercial real estate loans are particularly sensitive to changes in the local economy, so even minor local adverse economic events may adversely affect the performance of commercial real estate assets. Many commercial real estate loans are not fully amortizing and, therefore, the timely recovery of principal is dependent on the borrowers ability to refinance or sell the property at maturity.
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The prices of commercial CES are more sensitive to adverse economic downturns or individual issuer developments than more highly rated real estate securities. A projection of an economic downturn, for example, could cause a decline in the price of commercial CES because of increasing concerns regarding the ability of obligors of loans underlying ABS to continue to make principal and interest payments.
For some types of loans in which we have had an economic interest in the past and may again in the future, the commercial real estate is in transition, such as a former office building that is in the process of being converted into condominiums. These loans entail higher risks than traditional commercial property loans made against stabilized properties. Initial debt service coverage ratios, loan-to-value ratios, and other indicators of credit quality for these loans may not meet standard market criteria for stabilized commercial real estate loans. The underlying properties may not transition or stabilize as expected. The personal guarantees and forms of cross-collateralization that are secured in connection with some of these loans may not be effective. In addition, we own some mezzanine loans that are not secured by a direct lien on the underlying property.
Our commercial loans are illiquid; if we choose to sell them, we may not be able to do so in a timely manner or for a satisfactory price. Financing these loans may be difficult, and may become more difficult if credit quality deteriorates.
Mezzanine loans, distressed assets, and loan participations have concentrated credit, servicing, and other risks. We have in the past directly originated some of our commercial loans and participated in the origination of others, and may do so again in the future. This may expose us to credit, legal, and other risks that may be greater than is usually present with acquired loans.
We may incur losses on commercial real estate loans and securities for reasons not necessarily related to an adverse change in the performance of the property. This includes bankruptcy by the owner of the property, issues regarding the form of ownership of the property, poor property management, origination errors, inaccurate appraisals, fraud, and non-timely actions by special servicers. We review the underlying loan files prior to acquiring residential and commercial CES but our review may not uncover these or other issues at that time. By the time these problems become apparent, we may have little or no recourse to the issuer of the securities and we may incur losses as a result.
The timing of credit losses can be a material factor in our economic returns from residential and commercial loans and securities. If unanticipated losses occur within the first few years after a loan is originated or a securitization is completed, those losses could have a greater negative impact on our investment returns than unanticipated losses on more mature loans or securities. In addition, higher levels of delinquencies and cumulative credit losses within a securitized loan pool can delay our receipt of the principal and interest that is due to us under the terms of the securities backed by that pool. This would also lower our economic returns.
The timing of credit losses could be affected by new legislation or legal actions that allow for the modification of loans. It is difficult to anticipate what, if any, changes to underlying loans would be allowed and to determine the impact on these changes to ultimate credit losses or changes in interest income on our investments.
We actively manage the risks associated with acquiring, holding, and disposing of real estate loans and securities. No amount of risk management or mitigation, however, can change the variable nature of the cash flows, fair values of, and financial results generated by these loans and securities. Changes in the credit performance or the prepayments on these real estate loans and the loans underlying these securities and changes in interest rates impact the cash flows on these securities, and the impact could be significant for our securities with concentrated risks. Changes in cash flows lead to changes in our return and also to potential variability in reported income. The revenue recognized on most of our assets is based on an estimate of the yield over the remaining life of the asset. Thus, changes in our estimates of expected cash flow from an asset will result in changes in our reported earnings on that asset. We may be forced to recognize adverse changes
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in expected future cash flows as a current expense, further adding to earnings volatility. For other assets and some liabilities, our revenue and income is affected by changes in the fair value of our assets and liabilities, which may further accentuate our earnings volatility.
For other assets, our revenue and income, if any, are based on changes in the fair value of the asset. As market conditions, liquidity, perceptions, supply and demand, and the fundamentals of each asset change, the fair values can vary widely, causing volatility in our reported earnings. Fair values for illiquid assets can be difficult to ascertain accurately, which may also lead to volatility and uncertainty of earnings.
Fair values for our assets, liabilities, and hedges can be volatile. The fair values can change rapidly and significantly and changes can result from changes in interest rates, perceived risk, supply and demand, projected cash flows and prepayments and credit performance.
A decrease in fair value may not necessarily be the result of a deterioration in future cash flows. For GAAP purposes, we mark-to-market some, but not all, of our consolidated assets and liabilities through our consolidated balance sheet. In addition, valuation adjustments on certain assets and many of our derivatives are reflected in our consolidated statement of income. As a result, assets that are funded with certain liabilities and interest-rate matched with certain liabilities and hedges may have differing mark-to-market treatment than the liability or hedge. If we sell an asset that has not been marked to market through our consolidated statement of income at a reduced market price relative to its basis, our reported earnings will be reduced.
A decrease in the fair value of the securities we own may result in a reduction in our book value due to the accounting standards we are required to apply, and could result in a negative book value. Reporting a low or negative book value could have adverse effects even if that the book value is not indicative of the actual value of our net investments in assets and securitization entities. The adverse effects include the inability to meet or agree upon covenants with counterparties or to enter into derivative contracts, and a reduction in the market price of our stock.
Effective January 1, 2008, we adopted a new accounting standard, Financial Accounting Standards Board Statement No. 159 The Fair Value Option for Financial Assets and Financial (FAS 159), which allows us to MTM both the consolidated assets and liabilities of Acacia. FAS 159 provides for a one-time cumulative-effect adjustment to retained earnings on the balance sheet on January 1, 2008 for the unrealized gains or losses on Acacia assets and liabilities at that time. We expect the adoption of FAS 159 will reduce the magnitude of the disparity that existed between the value of Acacia under GAAP presentation and the economic value of Acacia at December 31, 2007. Even following the adoption of FAS 159, however, there will likely be significant differences between the value of Acacia under GAAP presentation and the economic value of Acacia. Discrepancies arise as a result of market dynamics and the limitations of the measurement techniques required by FAS 159. In addition to affecting our GAAP balance sheet, the adoption of FAS 159 with respect to the Acacia assets and liabilities will also affect our income statements, as we will be required to record any net changes in the fair value those assets and liabilities in any given period. Fair values for illiquid assets can be difficult to ascertain accurately, which may lead to volatility and uncertainty of earnings. Moreover, on January 1, 2008, the fair values of the Acacia liabilities used for GAAP purposes were, in our view, depressed relative to the paired collateral asset values. If the fair values of these liabilities were to increase, these changes would appear on our GAAP income statements as negative MTM adjustments.
Changes in interest rates, the interrelationships between various interest rates, and interest rate volatility could have negative effects on our earnings, the fair value of our assets and liabilities, loan prepayment rates, and our access to liquidity. Changes in interest rates can also harm the credit performance of our assets. We seek to hedge some but not all interest rate risks. Our hedging may not work effectively, or we may change our hedging strategies or the degree or type of interest rate risk we assume.
A portion of our equity-funded assets have adjustable-rate coupons. The cash flows we receive from these assets may vary as a function of interest rates, as do the GAAP earnings generated by these assets. We also
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own debt-funded loans and securities which we hold as inventory prior to sale to a securitization entity or as a longer term investment. We fund these assets with equity and with floating rate debt. To the extent these assets have fixed or hybrid interest rates (or are adjustable with an adjustment period longer than our short-term debt), an interest rate mismatch exists and we will earn less (and fair values may decline) if interest rates rise. We usually, but not always, seek to mitigate interest rate mismatches for these assets with a hedging program using interest rate swaps and futures.
Interest rate changes have diverse and sometimes unpredictable effects on the prepayment rates of real estate loans. Changes in prepayment rates can lower the returns we earn from our assets, diminish or delay our cash flows, reduce the fair value of our assets, and decrease our liquidity.
Except with respect to our adjustable-rate assets, higher interest rates generally reduce the fair value of most of our assets. This may affect our earnings results, reduce our ability to re-securitize or sell our assets, or reduce our liquidity. Higher interest rates could reduce the ability of borrowers to make interest payments or to refinance their loans. Higher interest rates could reduce property values and increased credit losses could result. Higher interest rates could reduce mortgage originations, thus reducing our opportunities to acquire new assets, and possibly driving asset acquisition prices higher.
When short-term interest rates are high relative to long-term interest rates, an increase in adjustable-rate residential loan prepayments may occur, which would likely reduce our returns from owning adjustable-rate residential whole loans.
If short-term interest rates fall, our premium amortization expense will increase on loans acquired by Sequoia prior to July 2004, which are reported on our consolidated balance sheet. Due to the GAAP principle applied to these adjustable-rate loans, the amortization expense for the current period is a function of actual and projected prepayments and the current LIBOR interest rate. During a period of rapidly falling rates, the effect that the interest rate has on the amortized amount becomes the more significant factor and will increase the amount amortized thereby decreasing our reported income for that period, all other factors being equal.
Rating agencies rate debt securities based upon their assessment of the safety of the receipt of principal and interest payments. Rating agencies do not consider the risks of fluctuations in fair value or other factors that may influence the value of debt securities and, therefore, the assigned credit rating may not fully reflect the true risks of an investment in securities. Also, rating agencies may fail to make timely adjustments to initial credit ratings based on recently available data or changes in economic outlook or may otherwise fail to make changes in credit ratings in response to subsequent events, so that our investments may be better or worse than the ratings indicate. We try to reduce the impact of the risk that a credit rating may not accurately reflect the risks associated with a particular debt security by not relying solely on credit ratings as the indicator of the quality of an investment. We make our acquisition decisions after factoring in other information. However, our assessment of the quality of an investment may also prove to be inaccurate and we may incur credit losses in excess of our initial expectations.
Credit rating agencies may change their methods of evaluating credit risk and determining ratings on securities backed by real estate loans and securities. These changes may occur quickly and often. The markets ability to understand and absorb these changes, and the impact to the securitization market in general, are difficult to predict. Such changes will have an impact on the amount securities that will be available to us either by the level of securitization and the various sizes of the investment-grade and non-investment-grade securities that are created in the future.
Some of the securities held by us through our Acacia entities as well some of the securities held by us at Redwood are insured by bond insurers such as Ambac Financial Group Inc., MBIA Inc, and Financial Guaranty Insurance Co., which are commonly known as the monoline insurers. These monoline insurers historically have had AAA credit ratings and this credit rating has been passed on to any bonds that they
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insure. The high number of credit downgrades and other market events in the second half of 2007 revealed that these monoline insurers have greater credit risk exposure than previously realized and the credit ratings of a number of these insurers have been downgraded as a result. Any decline in the credit rating of a monoline insurer generally results in a corresponding decline in the credit ratings of the securities insured by that insurer.
Downgrades on securities could have an adverse effect on the value of some of our investments and our cash flows from those investments, particularly our equity investments in Acacia. The underlying documents of each Acacia securitization entity state that certain average rating levels must be met, and if not met on the securities held by the entity, then cash that would otherwise be distributed to the equity holders or the lower-rated debt holders, would instead be distributed to the more senior debt holders. Our investment in Acacia is primarily in the equity in the securitization entities, and the vast number of downgrades that rating agencies reported in late 2007 and early 2008 are likely to cause some of the Acacia entities to fail this average rating test, which will, in turn, adversely affect our cash flows on our investments in those entities.
Some of the loans held by our Sequoia securitization entities, or in which we have an indirect interest through securities we hold through Acacia or at Redwood, are insured in part by mortgage insurers. Mortgage insurance protects the lender or other holder of a loan, up to a specified amount, in the event the borrower defaults on the loan. Relatively few of the mortgages we hold through Sequoia are insured in this manner, as mortgage insurance generally is required only when the principal amount of the loan at the time of origination is greater than 80% of the value of the property (loan-to-value), and the loan-to-value for most of the loans we hold through Sequoia are below this 80% threshold. Nonetheless, any inability of the mortgage insurers to pay in full the insured portion of the loans that we hold would adversely affect the value of those loans, which could increase our credit risk, reduce our cash flows, or otherwise adversely affect our business.
We have a concentration of residential and commercial real estate loans secured by property in California. In addition, a significant number of residential and commercial real estate loans that underlie the securities we own are secured by property in California. We have made efforts to mitigate the risks associated with geographic concentration. We have residential credit risk in all states and we do not have more than 1% of our residential loans in any one zip code. We also have commercial credit risk in most states. Nonetheless, we still have a significantly higher exposure in California and any event that adversely affected the California real estate market could have a disproportionately adverse effect on our business.
A decline in the economy or difficulties in the real estate markets are likely to cause a decline in the value of residential and commercial properties. This, in turn, will increase the risk of delinquency, default, and foreclosure on real estate loans underlying our securities. This may then adversely affect our credit loss experience and other aspects of our business, including our ability to securitize real estate loans and securities.
The occurrence of a natural disaster (such as an earthquake, tornado, hurricane, or a flood) may cause a sudden decrease in the value of real estate and would likely reduce the value of the properties collateralizing the mortgage loans we own or those underlying the securities we own. Since certain natural disasters may not typically be covered by the standard hazard insurance policies maintained by borrowers, the borrowers may have to pay for repairs due to the disasters. Borrowers may not repair their property or may stop paying their mortgage loans under those circumstances, especially if the property is damaged. This would likely cause foreclosures to increase and lead to higher credit losses on our loans or on the pool of mortgage loans underlying the securities in which we provide credit-enhancement.
The Acacia entities we sponsor own investment-grade and non-investment-grade securities (typically rated AAA through B, and in a second-loss position or better, or otherwise effectively more senior in the credit structure as compared to a first-loss residential CES or equivalent) issued by residential and commercial real
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estate loan securitization entities. Acacia also owns CDO securitiescreated and issued by others and these securities usually have concentrated risks with respect to residential and commercial real estate. Acacias securities are reported as part of our consolidated securities portfolio on our consolidated balance sheets. Generally, we do not control or influence the underwriting, servicing, management, or loss mitigation efforts with respect to the underlying assets in these securities. Some of the securities Acacia owns are backed by subprime loans and alt-a loans that have substantially higher risk characteristics than prime-quality loans. These lower-quality loans can be expected to have higher rates of delinquency and loss, and losses to Acacia (and thus Redwood as owner of the Acacia CDO equity securities) could occur. Some of the assets Acacia has acquired are investment-grade and non-investment-grade residential loan securities from the Sequoia securitization entities we have sponsored. Although we may have a limited degree of control or influence over the selection and management of the loans underlying Sequoia securitizations, we believe the possibility of loss on these assets remains approximately the same as it is for securities issued from securitizations of equivalent-quality loans that we did not sponsor. If the pools of residential loans underlying any of these securitizations were to experience poor credit results, Acacias securities could have their credit ratings down-graded, could suffer declines in fair value, or could experience principal losses. If any of these events occurs, it would likely reduce our long-term returns and near-term cash flows from the Acacia CDO equity securities we have acquired, and may also reduce our ability to sponsor Acacia transactions in the future. We may securitize first-loss residential and commercial CES in Acacia in the future, which would add to the risks we undertake in our Acacia program.
Despite our efforts to manage credit risk, there are many aspects of credit risk that we cannot control. Our quality control and loss mitigation operations may not be successful in limiting future delinquencies, defaults, and losses. Our underwriting reviews may not be effective. The securitizations in which we have invested may not receive funds that we believe are due from mortgage insurance companies and other counterparties. Loan servicing companies may not cooperate with our loss mitigation efforts, or those efforts may be ineffective. Service providers to securitizations, such as trustees, bond insurance providers, and custodians, may not perform in a manner that promotes our interests. The value of the homes collateralizing residential loans may decline. The value of the commercial properties collateralizing commercial loans may decline. The frequency of default and the loss severity on loans upon default may be greater than we anticipate. Interest-only loans, negative amortization loans, adjustable-rate loans, loans with balances over $1 million, reduced documentation loans, subprime loans, alt-a loans, second lien loans, loans in certain locations, and loans that are partially collateralized by non-real estate assets may have increased risks and severity of loss. As loans become real estate owned, we bear the risk of not being able to sell the property and recovering our investment. Changes in consumer behavior, bankruptcy laws, tax laws, regulation on the mortgage industry, and other laws may exacerbate loan losses. Future changes in rules that would enable loans owned by a securitization entity to be modified may not be beneficial to our interests if the modifications reduce the interest we earn and increase the eventual severity of a loss. In some states and circumstances, the securitizations in which we invest have recourse as owner of the loan against the borrowers other assets and income in the event of loan default; however, in most cases, the value of the underlying property will be the sole effective source of funds for any recoveries. Other changes or actions by judges or legislators regarding mortgage loans and contracts including the voiding of certain portions of these agreements may reduce our earnings, impair our ability to mitigate losses, or increase the probability and severity of losses. The expansion of our loss mitigation efforts as we grow our portfolio will increase our operating costs and the expanded loss mitigation efforts may not reduce our future credit losses.
We could incur substantial losses and our business operations could be disrupted if we are unable to effectively identify, manage, monitor, and mitigate operations risks, credit risks, interest rate risks, prepayment risks, liquidity risks, and other market risks related to our business, assets, and liabilities. We actively manage our risks but our risk management policies, procedures, and techniques many not be sufficient to mitigate the risks we have identified or to identify additional risks to which we are subject or may be subject in the future.
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Our loans and loans underlying securities are serviced by third-party service providers. These arrangements allow us to increase the volume of the loans we purchase and securitize without incurring the expenses associated with servicing operations. Should a servicer experience financial difficulties, it may not be able to perform these obligations. Servicers who have sought bankruptcy protection may, due to application of provisions of bankruptcy law, not be required to advance those amounts. Even if a servicer were able to advance amounts in respect of delinquent loans, its obligation to make the advances may be limited to the extent that is does not expect to recover the advances due to the deteriorating credit of the delinquent loans. In addition, as with any external service provider, we are subject to the risks associated with inadequate or untimely services for other reasons. Servicers may not advance funds to us that would ordinarily be due because of errors, miscalculations or other reasons. Many borrowers require notices and reminders to keep their loans current and to prevent delinquencies and foreclosures, which our servicers may fail to provide. A substantial increase in our delinquency rate that results from improper servicing or loan performance in general may result in credit losses and could harm our ability to securitize our real estate loans in the future.
We have invested in and intend to continue invest in a variety of real estate and non-real estate related assets that may not be closely related to our current core business. Additionally, we may enter various securitization, service, and other operating businesses that may not be closely related to our current business. Any of these actions may expose us to new, different, or increased investment, operational, financial, or management risks. We have made investments in CDO debt and equity securities issued by CDO securitizations other than Acacia that own various types of assets, generally real estate related. These CDOs (as well as the Acacia entities) have invested in manufactured housing securities, subprime residential securities, and other residential securities backed by lower-quality borrowers. They also own a variety of commercial real estate loans and securities, corporate debt issued by REITs that own commercial real estate properties, and other assets that have diverse credit risks. We may invest in CDO equity securities issued by CDOs that own trust preferred securities issued by financial institutions or other types of non-real estate assets. We may invest directly or indirectly in real property. We may invest in non-real estate ABS or corporate debt or equity. We have invested in diverse types of IO securities from residential and commercial securitizations sponsored by us or by others. The higher credit and prepayment risks associated with these types of investments may increase our exposure to losses. We may invest in non-U.S. assets that may expose us to currency risks (which we may choose not to hedge) and different types of credit, prepayment, hedging, interest rate, liquidity, legal, and other risks.
We believe the assets we acquire have the potential to generate attractive economic returns and GAAP yields, but acquiring assets in an uncertain economic environment poses risks. Potential cash flow and mark-to-market returns from new asset acquisitions could be negative, including both new assets that are backed by newly-originated loans, as well as new assets that are backed by more seasoned assets that may experience higher than expected levels of delinquency and default.
In order to maintain our portfolio size and our earnings, we reinvest in new earning assets a portion of the cash flows we receive from principal, interest, calls, and sales. We receive monthly payments from most of our assets, consisting of principal and interest. In addition, occasionally some of our residential loan CES are called (effectively sold). Principal payments and calls reduce the size of our current portfolio and generate cash for us. We also sell assets from time to time as part of our portfolio management and capital recycling strategies.
If the assets we acquire in the future earn lower GAAP yields than the assets we currently own, our reported earnings per share will likely decline over time as the older assets pay down, are called, or are sold. Under the effective yield method of accounting that we use for GAAP accounting purposes for some of our assets, we recognize yields on assets based on our assumptions regarding future cash flows. A portion of the
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cash flows we receive that exceeds the anticipated cash flows reduces our basis in these assets. As a result of these various factors, our basis for GAAP amortization purposes for many of our current assets is lower than their current fair values. Assets with a lower GAAP basis generate higher GAAP yields, yields that are not necessarily available on newly acquired assets. Business conditions, including credit results, prepayment patterns, and interest rate trends in the future are unlikely to be as favorable as they have been for the last few years.
To reinvest proceeds from principal repayments and deploy new capital that we may raise in the future, we must acquire new assets. If the availability of new assets is limited, we may not be able to acquire assets that will generate attractive returns. Generally, asset supply can be reduced if originations of a particular product are reduced, if there are few sales in the secondary market of seasoned product from existing portfolios, or if assets we believe have a favorable risk/reward ratio are not be available for purchase or if there is little or no demand for AAA-rated securities.
We do not originate loans and rely on the origination market to supply the types of loans we wish to credit-enhance. At times, due to heightened credit concerns, strengthened underwriting standards, or concerns about economic growth or housing values, the volume of originations may decrease significantly. In late 2007, the volume of subprime and alt-a loan originations was significantly lower than in recent years, and the volume may not return to previous levels in the foreseeable future. The future volume of prime loan originations may also be at a relatively low level. This reduced volume may make it difficult for us to compete and acquire loans.
The supply of new securitized assets available for purchase could be reduced if the economics or form of the securitization become unattractive. A key factor in the economics of securitization is a highly liquid market for AAA-rated securities. The events in late 2007 revealed that the liquidity of this market may be disrupted at times. Fears about credit quality and the changes in credit rating agencies analyses have dampened the demand for IGS backed by real estate loans and securities, and investor demand for these securities may not reach previous levels in the foreseeable future. Without a robust market for AAA-rated securities, the supply of real estate CES could be significantly diminished. In addition, the risks associated with the acquisition of loans for the purpose of securitization may increase significantly and we may choose not to acquire any loans during these periods.
As a REIT we are required to distribute at least 90% of our REIT taxable income. Thus, we do not generally have the ability to retain earnings and we rely on our ability to raise capital to grow. We may raise capital through the issuance of new shares of our common stock, either through our direct stock purchase and dividend reinvestment plan or through secondary offerings. We may also raise capital by issuing other types of securities, such as preferred stock or convertible subordinated notes, or by taking on long-term debt.
We may not be able to raise capital at times when we see opportunities to employ capital. Many of the same factors that would make investments in real estate loans and securities attractive, such as the availability of assets from distressed owners who need to liquidate and thus may accept reduced prices, and uncertainty about credit risk, housing, and the economy, may make it difficult for us to convince new investors to provide us with additional capital. There may be other reasons we are not able to raise capital and, as a result, may not be able to finance a growth in our portfolios. Our plan is to grow and we build our infrastructure accordingly. If we are unable to raise capital and expand our portfolios, our operating expenses may increase significantly relative to our capital base.
The residential, commercial, and CDO CES we acquire are generally less liquid that the residential, commercial, and CDO IGS we acquire. In turbulent markets, it is likely that the liquidity of the lower-rated securities, and some of the higher-rated securities that we hold, may become even less liquid. As a result, we may not be able to sell certain assets at desirable times or at attractive prices and incur significant losses upon sale of the assets.
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As a result of the limited liquidity of the types of securities we acquire and our securitization entities issue, there may be little trading information available to verify the values at which we report these assets and liabilities on our financial statements. This makes the estimates of fair value reflected in our financial statements more speculative, and our reported earnings and book values may not reflect the values we ultimately realize from our portfolio.
We need cash to meet our interest expense payments, working capital, minimum REIT dividend distribution requirements, and other needs. We may also need cash to repay our recourse short-term borrowings in the event the fair values of our assets that serve as collateral for that debt decline, the terms of short-term debt become less attractive, or for other reasons.
Our sources of cash flow may not be sufficient to satisfy these needs. Cash flows from principal repayments could be reduced if prepayments slow or if credit quality deteriorates. Cashflows on our investments in CDOs (including investments in Acacia) may also be disrupted due to credit rating agencies downgrading securities owned by the securitization entity if certain average rating tests are not satisfied. For some of our assets, cash flows are locked-out and we receive less than our pro-rata share of principal payment cash flows in the early years of the investment. For some loans, borrowers have the option to make payments that are less than the fully amortized amount. Operating cash flows could be reduced if earnings are reduced, if discount amortization income significantly exceeds premium amortization expense, or for other reasons. Our minimum dividend distribution requirements could become large relative to our cash flows if our income as calculated for tax purposes significantly exceeds our net cash flows. This could occur due to taxable income (including amortization income and interest income on negative amortizing loans) exceeding cash flows received. In the event that our liquidity needs exceed our access to liquidity, we may need to sell assets at an inopportune time, thus reducing our earnings. In an adverse cash flow situation, we may not be able to sell assets effectively, and our REIT status or our solvency could be threatened.
We have invested in IGS and residential whole loans that we have financed with various types of short-term debt. By incurring this leverage we can generate attractive returns on our equity invested in these assets. However, as a result of the leverage, we could incur significant losses if our borrowing costs increase relative to the earnings on our assets and hedges. These financing facilities may also force us to sell assets under adverse market conditions to meet the lenders margin calls in the event of a decrease in the fair values of the assets pledged as collateral. To the extent we do not have sufficient cash or other assets to post the margin calls, we could be forced to sell the assets. Liquidation of the collateral could create negative tax consequences and raise REIT qualification issues.
Although we typically seek a variety of financing facilities and counterparties, there can be no assurance that we will be able to renew those facilities when they mature. The failure to renew facilities could force us to sell assets in adverse market conditions. Liquidity in debt markets, including repo and commercial paper, can be withdrawn suddenly, making it difficult or expensive to renew short-term borrowings as they mature.
The economic returns we expect to earn from most of the residential real estate securities we or Acacia own and loans we or Sequoia own are affected by the rate of prepayment of the underlying residential real estate loans. Prepayments are unpredictable and adverse changes in the rate of prepayment could reduce our cash flows, earnings, and dividends. Adverse changes in cash flows would likely reduce an assets fair value, which could reduce our ability borrowed against that asset and may cause a market valuation adjustment for GAAP purposes, which could reduce our reported earnings. While we estimate prepayment rates to determine the effective yield of our assets and valuations, these estimates are not precise, and prepayment rates do not necessarily change in a predictable manner as a function of interest rate changes. Prepayment rates can change rapidly. As a result, changes can cause volatility in our financial results, affect our ability to securitize assets, affect our ability to fund acquisitions, and have other negative impacts on our ability to grow and generate earnings.
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We own a number of securities, the returns from which are strongly affected by prepayments rates. These securities include interest-only securities (IOs) that we acquire from third parties and from our Sequoia entities. Faster prepayments than we anticipated on the underlying loans backing these IOs will have an adverse effect on our returns on these investments.
We are subject to significant competition in seeking investments. Our competitors include other mortgage REITS, the Federal National Mortgage Association, referred to as Fannie Mae, the Federal Home Loan Mortgage Corporation, referred to as Freddie Mac, financial institutions, securities dealers, insurance companies, investment funds and other investors. In addition, other companies may be formed that will compete with us for investments or otherwise pursue investment strategies similar to ours. Some of our competitors have greater resources than us and we may not be able to compete successfully for investments. Furthermore, competition for investments may lead to a decrease in the returns available from the investments which may further limit our ability to generate desired returns.
Recent legislation may lead to increased competition. Until recently, Fannie Mae and Freddie Mac have been statutorily prohibited from purchasing loans in excess of $417,000. On February 7, 2008, Congress passed an economic stimulus package that includes provisions that increase the size of the loans these entities may purchase to up to $729,750 for loans originated between July 31, 2007, and December 31, 2008. Congress may decide to extend this window past December 31, 2008 or may otherwise increase the size of loans that these entities may acquire. Any such change would allow Fannie Mae and Freddie Mac to continue to compete against us in a market in which they had not been allowed to compete previously. The status of Fannie Mae and Freddie Mac as government-sponsored enterprises, combined with their size and other factors, make them significant competitors. If the size of the loans that Fannie Mae and Freddie Mac may acquire were to increase permanently, our business could be adversely affected.
We sponsor securitization entities which issue asset-backed securities. Through our Sequoia securitization entities, we issue ABS that are backed by mortgage loans held by the Sequoia entities. Through our Acacia securitization entities, we issue ABS that are backed by securities held by the Acacia entities. As a result of declining property values, increasing defaults and other factors, the cash flows from the loans held by the Sequoia entities and the securities held by the Acacia entities may be insufficient to repay in full the ABS issued. We are not directly liable for any of the ABS issued by these entities. Nonetheless, third parties who hold the ABS issued by these entities may try to hold us liable for any losses they experience. Defending a lawsuit can consume significant resources and may divert managements attention from our ordinary operations.
We attempt to hedge certain interest rate risks (and, to a lesser extent, prepayment risks) by balancing the characteristics of our assets with respect to those risks and entering into various interest rate agreements. The number and scope of the interest rate agreements we utilize may vary significantly over time. We generally attempt to enter into interest rate hedges that provide an appropriate and efficient method for hedging the desired risk.
Hedging against interest rate risks using interest rate agreements and other instruments usually has the effect over time of lowering long-term earnings. To the extent that we hedge, it is usually to protect us from some of the effects of short-term interest rate volatility, to lower short-term earnings volatility, to stabilize liability costs or fair values, to stabilize our economic returns from or meet rating agency requirements with respect to a securitization, or to stabilize the future cost of anticipated ABS issuance by a securitization entity. Hedging may not achieve its desired goals. Pipeline hedging for loan purchase commitments may not be effective due to loan fallout or other reasons. Using interest rate agreements as a hedge may increase short-term earnings volatility, especially if we do not elect to hedge the accounting treatment for our hedges (i.e., our hedges are accounted for as trading instruments). Reductions in fair values of interest rate
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agreements may not be offset by increases in fair values of the assets or liabilities being hedged. Conversely, increases in fair values of interest rate agreements may not fully offset declines in fair values of assets or liabilities being hedged. Changes in fair values of interest rate agreements may require us to pledge significant amounts of collateral or cash.
We also may hedge by taking short, forward, or long positions in U.S. Treasuries, mortgage securities, or other cash instruments. We intend to take both long and short positions in credit derivative transactions linked to real estate assets. These derivatives may have additional risks to us, such as special liquidity, basis risks, and counterparty risks
Our quarterly earnings may be subject to fluctuations from period to period as a result of the accounting treatment for certain interest rate agreements or for assets or liabilities that do not necessarily match those used for interest rate agreements, or as a result of our failure to meet the requirements to obtain desired hedge accounting treatment for certain interest rate agreements.
We invest in synthetic securities including credit default swaps that reference other real estate securities. These investments may present risks in excess of those resulting from the referenced securities. An investment in a synthetic security is a contractual relationship with a counterparty and not an acquisition of the referenced security. In a synthetic investment, we have no right directly to enforce compliance with the terms of the referenced security, and we have no voting or other consensual rights of ownership with respect to the referenced security. In the event of insolvency of a counterparty, we will be treated as a general creditor of the counterparty and will have no claim of title with respect to the referenced security.
The market for many synthetic securities, including credit default swaps referencing real estate securities, has only existed for a few years and is not liquid. Many of these credit default swaps incorporate pay as you go credit events which have been introduced into the market fairly recently. The terms of credit default swaps are still evolving and may change significantly which could make it more difficult to assign such an instrument or determine the loss pursuant the underlying agreement. For example, in a credit default swap, the party wishing to buy protection will pay a premium. When interest rates change, the spreads change, or the prevailing credit premiums on credit default swaps change, the amount of the termination payment due could change by a substantial amount. In an illiquid market, the determination of this change could be difficult to ascertain and, as a result, we may not achieve the desired benefit of entering into this contractual relationship.
To date, we have entered into a limited number of synthetic securities agreements. We may over time increase our exposure to these investments as the market for them grows and during times when acquiring other real estate loans and securities may be difficult. We may find credit default swaps and other forms of synthetic securities to be a more efficient method of providing credit-enhancement on specific pools of real estate loans. We will attempt to manage the risks associated with these investments including counterparty risks, but our efforts may prove to be insufficient in enabling us to generate the returns anticipated.
We enter into derivative contracts that could require us to make cash payments in certain circumstances. These potential payments would be contingent liabilities and may not appear on our balance sheet. Our ability to satisfy these contingent liabilities depends on the liquidity of our assets and our access to capital and cash. The need to fund these contingent liabilities could adversely impact our financial condition.
We have credit risks that are generally related to the counterparties with which we do business. There is a risk that the counterparty will fail to perform under its contractual arrangement with us. Counterparties may seek to eliminate credit exposure by entering into back-to-back hedging transactions, and the ability of a counterparty to settle a synthetic transaction may be dependent on whether the counterparties to the back-to-back transactions perform their delivery obligations. Those risks of non performance may differ
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materially from the risks entailed in exchange-traded transactions, which generally are backed by clearing organization guarantees, daily mark-to-market and settlement of positions, and segregations and minimum capital requirements applicable to intermediaries. Transactions entered into directly between parties generally do not benefit from those protections, and expose the parties to the risk of counterparty default. Furthermore, there may be practical and timing problems associated with enforcing our rights to assets in the case of an insolvency of a counterparty.
In the event a counterparty to our short-term borrowings becomes insolvent, we may fail to recover the full value of our pledged collateral, thus reducing our earnings and liquidity. In the event a counterparty to our interest rate agreements, credit default swaps, or other derivatives becomes insolvent or interprets our agreements with it in a manner unfavorable to us, our ability to realize benefits from the hedge transaction may be diminished, any cash or collateral we pledged to the counterparty may be unrecoverable and we may be forced to unwind these agreements at a loss. In the event that one of our servicers becomes insolvent or fails to perform, loan delinquencies and credit losses may increase and we may not receive the funds to which we are entitled. We attempt to diversify our counterparty exposure and (except with respect to loan representations and warranties) limit our counterparty exposure to strong companies with investment-grade credit ratings; however, we are not always able to do so. Our counterparty risk management strategy may prove ineffective and, accordingly, our earnings could be adversely affected.
We currently manage and receive a fee for managing the assets in Acacia. We anticipate expanding asset management initiatives in 2008 with the expected launch of Redwood Opportunity Fund, LP, and we may expand into more areas in the future. New asset management activities may increase our exposure to litigation, fiduciary responsibilities, conflicts of interest arising from Redwoods investment activities and the activities of the entities we manage, and other risks. We believe we can manage these risks effectively, but there can be no assurance that we will do so.
As we expand our asset management business, we will incur additional costs to establish new funds, limited partnerships, and other investment vehicles. Our efforts to raise capital for these ventures may not succeed, or the capital we raise may not be sufficient to offset the initial and ongoing costs of these ventures.
We are exploring the asset management business outside of the United States. To the extent we enter into commitments that will be paid with foreign currency, we will be exposed to foreign exchange risks. We may decide not to hedge or to otherwise manage this risk and the risk may become more significant over time.
In order to continue our residential loan and CDO securitization operations, we will require access to short-term debt to finance inventory accumulation prior to sale to the securitization entities. This debt may be unavailable or the terms of the available debt may be unfavorable to us. We expect to pledge the inventory assets we acquire to secure the short-term debt we incur. This debt will be recourse to us and if the fair value of the collateral declines, we will be required to increase the amount of collateral pledged to secure the debt or to reduce the debt amount. Our goal is to sell the assets acquired with the proceeds from the debt to a securitization entity; however, if our ability to complete the securitization is disrupted and we are unable to extend the term of the debt incurred to finance the acquisition of the assets, we may need to sell the assets (most likely at a loss).
When we acquire assets for a securitization, we make assumptions about the cash flows that will be generated from the securitization of these assets. Widening ABS spreads, rising ABS yields, incorrect estimation of rating agency securitization requirements, poor hedging results, and other factors could result in a securitization execution that provides lower cash flows than initially assumed. This could result in a loss to us for tax purposes and reduced earnings for GAAP purposes.
Short-term borrowing arrangements used to support our securitization operations subject us to debt covenants. While these covenants have not meaningfully restricted our operations to date, as a practical
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matter, they could be restrictive or harmful to us in the future. In the event we violate debt covenants, we may incur expenses or losses, or our ability to incur additional debt may be restricted.
Our payment of commitment fees and other expenses to secure borrowing lines may not protect us from liquidity issues or losses. Variations in lenders abilities to access funds, lender confidence in us, lender collateral requirements, available borrowing rates, the acceptability and fair values of our collateral, and other factors could force us to utilize our liquidity reserves or to sell assets to fund the purchase of assets for sale to securitization entities, thus affecting our liquidity, financial soundness, and earnings.
We depend upon the issuance of mortgage backed securities by the securitization entities we sponsor as a funding source for our business. The credit rating agencies determine the amount of net investment we must make in the securitization entities to credit-enhance the securities issued by those entities. Increases in the amount of the net investment the credit agencies requires us to make could adversely affect our ability to sponsor new securitization entities. In addition, if the market for securitizations should become disrupted, the securitization entities we sponsor may be unable to issue ABS. In this event, our ability to continue to acquire loans and securities would be impaired and our earnings and ability to grow may be adversely affected.
In connection with our securitization activities, we sell the loans to the securitization entities we sponsor pursuant to agreements in which we make representations and warranties to those securitization entities with respect to the assets we transfer to them. If it turns out that because of irregularities in the underlying loans, our representations and warranties are inaccurate, we may be obligated to repurchase the loans from the securitization entities at principal value, which may exceed market value. We generally obtain representations and warranties that parallel those we provide to the securitization entities from the parties from whom we acquired the loans. As a result, we believe that we should, in most circumstances, be able to compel the original sellers of the loans to repurchase from us the loans we are obligated to repurchase from the securitization entities. However, if the representations and warranties are not parallel, or if the original seller is not in a financial position to be able to repurchase the loans, we may incur a loss upon repurchase of the loans from the securitization entity.
The manner in which we compete and the products for which we compete are affected by changing conditions which can take the form of trends or sudden changes in our industry, regulatory environment, changes in the role of government sponsored entities, credit rating agencies changes in their role or rating criteria or process, or the U.S. economy more generally. If we do not effectively respond to these changes, or if our strategies to respond to these changes are not successful, our financial condition and earnings may be adversely affected.
We manage our business based on long-term opportunities to generate cash flows. Our dividend distributions are driven by our minimum dividend distribution requirements under the REIT tax laws and our taxable income as calculated for tax purposes pursuant to the Internal Revenue Code. Our reported results for GAAP purposes may differ materially, however, from both the cash flows and our taxable income.
In determining our REIT taxable income (which drives our minimum dividend distribution requirements as a REIT), no current tax deduction is available for future credit losses that are anticipated to occur. Credit losses can only be deducted for tax purposes when they are actually realized. As a result, for tax purposes, there is no credit reserve or reduction of yield accruals based on anticipated losses, and an increase in our credit losses in the future will reduce our taxable income (and dividend distribution requirements). By
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contrast, for GAAP purposes, we are required to reflect in our results of operations assumptions about the amount and timing of credit losses in advance of when the losses are actually realized. As a result, the occurrence of these assumed losses will not directly impact our future GAAP income (although they could lead to additional provisions or credit reserve designations to provide for potential additional losses in the event we revise our assumptions).
For tax purposes, we do not mark-to-market any asset or liability. Any potential gain, loss, or impairment on an asset or liability is generally recognized for taxable income purposes only at the time of sale, call, or maturity of the asset or liability. For GAAP accounting purposes, certain assets and liabilities are marked-to-market with the changes in the fair values being reflected in the income statement in some cases. Thus, the amount and timing of any changes in the fair value of an asset or liability will likely be reported on substantially different bases when calculating GAAP and taxable income.
Accounting for compensation expense also varies for GAAP and tax calculations, especially in how equity awards (such as options and deferred stock units) are determined. For the most part, under GAAP, the total expense associated with an award is determined at the award date and is recognized over the vesting period. For tax purposes, the expense is recognized at the date of distribution or exercise. This leads to the potential that the total expense related to equity awards, as well as the timing for the recognition of the expense, could be significantly different for GAAP and tax purposes.
There are other differences in calculating taxable and GAAP income and there could be further differences as accounting principles and tax regulations change.
As a result of these differences in GAAP and tax accounting, our cumulative taxable income and our cumulative dividend distributions have been far greater than our cumulative reported GAAP income. To the extent that the credit loss assumptions we use for GAAP purposes on our existing portfolio do occur, then we would expect our future taxable income to decrease as the credit losses occur. To the extent the other-than-temporary impairments we have recognized for GAAP purposes reflect a decrease in future cash flows, then our taxable income will decrease. Our GAAP income to date includes the expense of vested equity awards that have not yet been distributed or exercised. The taxable expense we will incur on these equity awards will be dependent on the value of our common stock at future dates and this amount could be significant in any one period depending on the timing of distributions and exercises.
Taxable income consists of ordinary income and capital gains and losses. In order to recognize capital losses, we can only offset them against capital gains. There can be no assurance that we could generate capital gains to offset any capital losses we incur. Thus, in such instances, our dividend distributions would not be reduced even by the amounts of any unused capital losses.
The preparation of financial statements in conformity with GAAP requires us to make a significant number of estimates. These estimates include the fair value of certain assets and liabilities, the amount and timing of credit losses, prepayment rates, 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 recognized during the reported period. Our estimates are inherently subjective in nature and fluctuations in our reported earnings will result when actual results differ from our estimates.
Accounting rules for the various aspects of our business change from time to time. Changes in GAAP, or the accepted interpretation of these accounting principles, can affect our reported income, earnings, and stockholders equity.
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We may alter our policies, procedures, practices, product lines, leverage, risks, internal risk-adjusted capital guidelines, and other aspects of our business. We may enter into new businesses, relationships, or partnerships or pursue acquisitions of other companies or a variety of different types of assets. These changes may increase the magnitude of the risks to which we are exposed.
Our future success depends on the continued service and availability of skilled personnel, including members of our executive management team. Experienced personnel are in high demand and competition for their talents is intense. There can be no assurance that we will continue to attract and retain key personnel.
In order to analyze, acquire, and manage our securities and manage the risks associated with our business, assets, and liabilities, we rely upon computer hardware and software systems. Some of these systems are located at our office and some are maintained by third party vendors. Any significant interruption in the availability or functionality of these systems could have an adverse effect on our business.
We have taken steps to provide for the security of our systems and data. However, these security measures may not effectively prevent others from obtaining improper access to our systems data. Improper access could expose us to risks of data loss, litigation, and liabilities to third parties, and otherwise disrupt our operations.
The design and effectiveness of our disclosure controls and procedures and internal control over financial reporting may not prevent all errors, misstatements, or misrepresentations. While management continues to review the effectiveness of our disclosure controls and procedures and internal control over financial reporting, there can be no assurance that our disclosure controls and procedures or internal control over financial reporting will be effective in accomplishing all control objectives all of the time. Deficiencies, particularly material weaknesses, in internal control over financial reporting which may occur in the future could result in misstatements of our results of operations, restatements of our financial statements, a decline in our stock price, or otherwise materially and adversely affect our business, reputation, results of operation, financial condition, or liquidity.
We believe that we have met all requirements for qualification as a REIT for federal income tax purposes for all tax years since 1994 and we intend to continue to operate so as to qualify as a REIT in the future. However, many of the requirements for qualification as a REIT are highly technical and complex and require an analysis of particular facts and an application of the legal requirements to those facts in situations where there is only limited judicial and administrative guidance. Thus, no assurance can be given that the Internal Revenue Service or a court would agree with our conclusion that we have qualified as a REIT or that future changes in our factual situation or the law will allow us to remain qualified as a REIT. If we failed to qualify as a REIT for federal income tax purposes and did not meet the requirements for statutory relief, we would be subject to federal income tax at regular corporate rates on all of our income and we could possibly be disqualified as a REIT for four years thereafter. Failure to qualify as a REIT would adversely affect our dividend distributions and could adversely affect the value of our common stock.
To maintain REIT status, we must follow certain rules and meet certain tests. In doing so, our flexibility to manage our operations may be reduced. For instance:
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| If we make frequent asset sales from our REIT entities to persons deemed customers, we could be viewed as a dealer, and thus subject to 100% prohibited transaction taxes or other entity-level taxes on income from such transactions. |
| Compliance with the REIT income and asset rules may limit the type or extent of hedging that we can undertake. |
| Our ability to own non-real estate related assets and earn non-real estate related income is limited. Our ability to own equity interests in other entities is limited. If we fail to comply with these limits, we may be forced to liquidate attractive assets on short notice on unfavorable terms in order to maintain our REIT status. |
| Our ability to invest in taxable subsidiaries is limited under the REIT rules. Maintaining compliance with this limit could require us to constrain the growth of our taxable REIT affiliates in the future. |
| Meeting minimum REIT dividend distribution requirements could reduce our liquidity. Earning non-cash REIT taxable income could necessitate our selling assets, incurring debt, or raising new equity in order to fund dividend distributions. |
| Stock ownership tests may limit our ability to raise significant amounts of equity capital from one source. |
In addition, historically, our stated goal has been to not generate excess inclusion income that would be taxable as unrelated business taxable income (UBTI) to our tax-exempt stockholders. Achieving this goal has limited our flexibility in pursuing certain transactions and may continue to do so in the future. Despite our efforts to do so, we may not be able to avoid creating or distributing UBTI to our stockholders.
The requirements for maintaining REIT status or the taxation of REITs could change in a manner adverse to our operations. Rules regarding the taxation of dividends are enacted from time to time and future legislative or regulatory changes may limit the tax benefits accorded to REITs, either of which may reduce some of a REITs competitive edge relative to non-REIT corporations.
In order to expand our business, seek new opportunities, or for other business reasons, we may create new subsidiaries. Generally, these would be wholly-owned by Redwood. The creation of those subsidiaries may increase our administrative costs and expose us to other legal and reporting obligations. Some of these entities may be incorporated in states other than Maryland and some may be set up to expand into international businesses.
Some of these entities will be taxable REIT subsidiaries. Taxable REIT subsidiaries are wholly-owned subsidiaries of a REIT that pay corporate income tax on the income generated. That is, a taxable REIT subsidiary is not able to deduct its dividends paid to its parent in determining its taxable income, and any dividends paid to the parent are generally recognized as income at the parent level. Thus, we expect that income generated by our taxable REIT subsidiaries will be subject to corporate income taxes and we will retain the income at that entity.
Under the Investment Company Act of 1940, as amended, an investment company is required to register with the SEC and is subject to extensive restrictive and potentially adverse regulations relating to, among other things, operating methods, management, capital structure, dividends, and transactions with affiliates. However, companies primarily engaged in the business of acquiring mortgages and other liens on and interests in real estate (i.e., qualifying interests) are excluded from the requirements of the Investment Company Act. To qualify for the Investment Company Act exclusion, we, among other things, must maintain at least 55% of our assets in certain qualifying real estate assets (the 55% Requirement) and are also required to maintain an additional 25% in qualifying assets or other real estate-related assets (the 25% Requirement).
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If we failed to meet the 55% Requirement and the 25% Requirement, we could, among other things, be required either (i) to change the manner in which we conduct our operations to avoid being required to register as an investment company or (ii) to register as an investment company, either of which could harm us. Further, if we were deemed an unregistered investment company, we could be subject to monetary penalties and injunctive relief. We may be unable to enforce contracts with third parties and third parties could seek to obtain rescission of transactions undertaken during the period we were deemed an unregistered investment company, unless the court found that under the circumstances, enforcement (or denial of rescission) would produce a more equitable result than no enforcement (or grant of rescission) and would not be inconsistent with the Investment Company Act of 1940, as amended.
In order to maintain our qualifications as a REIT, not more than 50% in value of our outstanding capital stock may be owned, actually or constructively, by five or fewer individuals (defined in the Internal Revenue Code to include certain entities). In order to protect us against risk of losing our status as a REIT due to concentration of ownership among our stockholders, our charter generally prohibits any single stockholder, or any group of affiliated stockholders, from beneficially owning more than 9.8% of the outstanding shares of any class of our stock, unless our board of directors waives or modifies this ownership limit. This limitation may have the effect of precluding an acquisition of control of us by a third party without the consent of our board of directors. As of December 31, 2007, our board of directors has granted waivers to two parties to own shares in excess of 9.8%, each subject to terms and conditions including the execution of a voting agreement. These voting agreements apply to the shares owned in excess of 9.8% by each party and states that they shall be voted on matters in the same proportion as all other shares are voted (exclusive of the 9.8% block voted by the interested party.)
Certain other provisions contained in our charter and bylaws and in the Maryland General Corporation Law (MCGL) may have the effect of discouraging a third-party from making an acquisition proposal for us and may therefore inhibit a change in control. Our charter includes provisions granting our board of directors the authority to issue preferred stock from time to time and to establish the terms, preferences and rights of the preferred stock without the approval of our stockholders. In addition, provisions in our charter and the MCGL restrict our stockholders ability to remove directors and fill vacancies on our board of directors and restrict unsolicited share acquisitions. Our charter provides that our board of directors is divided into three classes serving staggered terms of office of three years each, and thus at least two annual meetings of stockholders, instead of one, generally would be required to effect a change in a majority of our directors. These provisions may deter offers to acquire our stock or large blocks of our stock upon terms attractive to our stockholders, thereby limiting the opportunity for stockholders to receive a premium for their shares over then-prevailing market prices.
None.
Redwood has two leases for executive and administrative offices at One Belvedere Place, Mill Valley, California 94941. One lease expires in 2013 and the second lease expires in 2018. The 2008 rent obligation for these leases is approximately $1.6 million.
At December 31, 2007, to our knowledge there were no legal proceedings to which we were a party or to which any of our properties was subject.
No matters were submitted to a vote of Redwoods stockholders during the fourth quarter of 2007.
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Redwoods common stock is listed and traded on the NYSE under the symbol RWT. As of March 4, 2008, Redwoods common stock was held by approximately 2,000 holders of record and the total number of beneficial stockholders holding stock through depository companies was approximately 30,000. As of March 4, 2008, there were 32,608,498 shares outstanding. The high and low sales prices of shares of the common stock as reported on the NYSE and the cash dividends declared on Redwoods common stock for the periods indicated below were as follows:
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Stock Prices | Common Dividends Declared | |||||||||||||||||||||||
High | Low | Record Date |
Payable Date |
Per Share |
Dividend Type |
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Year Ended December 31, 2007 |
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Fourth Quarter | $ | 37.25 | $ | 25.00 | 12/31/2007 | 1/22/2008 | $ | 0.75 | Regular | |||||||||||||||
12/26/2007 | 12/7/2007 | $ | 2.00 | Special | ||||||||||||||||||||
Third Quarter | $ | 49.57 | $ | 28.80 | 9/28/2007 | 10/22/2007 | $ | 0.75 | Regular | |||||||||||||||
Second Quarter | $ | 54.24 | $ | 47.68 | 6/29/2007 | 7/23/2007 | $ | 0.75 | Regular | |||||||||||||||
First Quarter | $ | 66.00 | $ | 50.19 | 3/30/2007 | 4/23/2007 | $ | 0.75 | Regular | |||||||||||||||
Year Ended December 31, 2006 |
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Fourth Quarter | $ | 59.75 | $ | 50.23 | 12/29/2006 | 1/22/2007 | $ | 0.70 | Regular | |||||||||||||||
11/27/2006 | 12/8/2006 | $ | 3.00 | Special | ||||||||||||||||||||
Third Quarter | $ | 51.82 | $ | 47.07 | 9/29/2006 | 10/23/2006 | $ | 0.70 | Regular | |||||||||||||||
Second Quarter | $ | 48.83 | $ | 40.36 | 6/30/2006 | 7/21/2006 | $ | 0.70 | Regular | |||||||||||||||
First Quarter | $ | 44.85 | $ | 40.98 | 3/31/2006 | 4/21/2006 | $ | 0.70 | Regular |
We intend to distribute to our stockholders at least 90% of our REIT taxable income. All dividend distributions are made with the authorization of the board of directors at its discretion and will depend on our REIT taxable earnings, financial condition, maintenance of REIT status, and such other factors as the board of directors may deem relevant from time to time.
We announced a new stock repurchase plan on November 5, 2007 for the repurchase of up to a total of 5,000,000 shares. This plan replaced all previous share repurchase plans and has no expiration date. There were no repurchases during 2007, and as of December 31, 2007, there remained 5,000,000 shares available for repurchase under this plan.
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The following graph presents a total return comparison of our common stock, over the last five years, to the S&P Composite-500 Stock Index and the National Association of Real Estate Investment Trusts, Inc. (NAREIT) Mortgage REIT index. The total returns reflect stock price appreciation and the reinvestment of dividends for our common stock and for each of the comparative indices. The information has been obtained from sources believed to be reliable; but neither its accuracy nor its completeness is guaranteed. The total return performance shown on the graph is not necessarily indicative of future performance of our common stock.
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2002 | 2003 | 2004 | 2005 | 2006 | 2007 | |||||||||||||||||||
Redwood Trust, Inc | 100.00 | 213.45 | 300.72 | 226.42 | 355.32 | 239.87 | ||||||||||||||||||
S&P Composite-500 Index | 100.00 | 128.70 | 142.70 | 149.71 | 173.35 | 182.88 | ||||||||||||||||||
NAREIT Mortgage REIT Index | 100.00 | 157.39 | 186.40 | 143.18 | 170.85 | 98.50 |
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The following selected financial data for 2007, 2006, 2005, 2004, and 2003 is qualified in its entirety by, and should be read in conjunction with, the more detailed information contained in the Consolidated Financial Statements and Notes thereto and, Managements Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Annual Report on Form 10-K. Certain amounts for prior periods have been reclassified to conform to the 2007 presentation.
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(In Thousands, Except Per Share Data) | 2007 | 2006 | 2005 | 2004 | 2003 | |||||||||||||||
Selected Statement of Operations Data: |
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Interest income | $ | 855,540 | $ | 885,160 | $ | 962,197 | $ | 651,618 | $ | 330,976 | ||||||||||
Interest expense | (651,762 | ) | (701,704 | ) | (757,270 | ) | (431,421 | ) | (202,861 | ) | ||||||||||
Net interest income | 203,778 | 183,456 | 204,927 | 220,197 | 128,115 | |||||||||||||||
Operating expenses | (58,555 | ) | (55,925 | ) | (48,382 | ) | (38,692 | ) | (36,895 | ) | ||||||||||
Realized gains on sales and calls, net | 12,781 | 22,557 | 65,879 | 66,378 | 53,531 | |||||||||||||||
Market valuation adjustments, net | (1,261,449 | ) | (12,586 | ) | (5,031 | ) | (7,251 | ) | (6,855 | ) | ||||||||||
Provision for income taxes | (5,192 | ) | (9,970 | ) | (17,521 | ) | (7,997 | ) | (5,502 | ) | ||||||||||
Dividends on Class B preferred stock | | | | | (681 | ) | ||||||||||||||
Undistributed earnings allocated to Class B preferred stock | | | | | (15 | ) | ||||||||||||||
Net (loss) income available to common stockholders | $ | (1,108,637 | ) | $ | 127,532 | $ | 199,872 | $ | 232,635 | $ | 131,698 | |||||||||
Average common shares basic | 27,928,234 | 25,718,435 | 24,637,016 | 21,437,253 | 17,759,346 | |||||||||||||||
Net (loss) income per share basic | $ | (39.70 | ) | $ | 4.96 | $ | 8.11 | $ | 10.85 | $ | 7.42 | |||||||||
Average common shares diluted | 27,928,234 | 26,313,826 | 25,121,467 | 22,228,929 | 18,812,166 | |||||||||||||||
Net (loss) income per share diluted | $ | (39.70 | ) | $ | 4.85 | $ | 7.96 | $ | 10.47 | $ | 7.04 | |||||||||
Dividends declared per Class B preferred share | | | | | $ | 0.76 | ||||||||||||||
Regular dividends declared per common share | $ | 3.00 | $ | 2.80 | $ | 2.80 | $ | 2.68 | $ | 2.60 | ||||||||||
Special dividends declared per common share | $ | 2.00 | $ | 3.00 | $ | 3.00 | $ | 6.00 | $ | 4.75 | ||||||||||
Total dividends declared per common share | $ | 5.00 | $ | 5.80 | $ | 5.80 | $ | 8.68 | $ | 7.35 | ||||||||||
Selected Balance Sheet Data: |
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Earning assets | $ | 9,695,240 | $ | 12,752,890 | $ | 16,529,286 | $ | 24,572,723 | $ | 17,543,487 | ||||||||||
Total assets | $ | 9,938,472 | $ | 13,030,473 | $ | 16,776,960 | $ | 24,778,065 | $ | 17,670,386 | ||||||||||
Redwood debt | $ | 7,561 | $ | 1,856,208 | $ | 169,707 | $ | 203,281 | $ | 236,437 | ||||||||||
Asset-backed securities issued | $ | 10,329,279 | $ | 9,979,224 | $ | 15,585,277 | $ | 23,630,162 | $ | 16,826,202 | ||||||||||
Subordinated notes | $ | 150,000 | $ | 100,000 | | | | |||||||||||||
Total liabilities | $ | 10,656,751 | $ | 12,027,783 | $ | 15,842,000 | $ | 23,913,909 | $ | 17,117,058 | ||||||||||
Total stockholders (deficit) equity | $ | (718,279 | ) | $ | 1,002,690 | $ | 934,960 | $ | 864,156 | $ | 553,328 | |||||||||
Number of common shares outstanding | 32,385,073 | 26,733,460 | 25,132,625 | 24,153,576 | 19,062,983 | |||||||||||||||
Book value per common share | $ | (22.18 | ) | $ | 37.51 | $ | 37.20 | $ | 35.78 | $ | 29.03 | |||||||||
Other Selected Data: |
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Average assets | $ | 12,177,451 | $ | 14,123,151 | $ | 21,797,922 | $ | 21,559,604 | $ | 11,058,272 | ||||||||||
Average debt and ABS issued outstanding | $ | 11,322,898 | $ | 12,996,244 | $ | 20,710,057 | $ | 20,748,658 | $ | 10,489,614 | ||||||||||
Average common equity | $ | 723,807 | $ | 988,495 | $ | 970,269 | $ | 730,499 | $ | 526,808 | ||||||||||
Net income/average common equity | (153.2 | )% | 12.9 | % | 20.6 | % | 31.8 | % | 25.3 | % |
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Redwood Trust, Inc., together with its subsidiaries (Redwood, we, or us), is a financial institution focused on investing in, financing, and managing residential and commercial real estate loans and securities. We seek to invest in assets that have the potential to provide high cash flow returns over a long period of time to help support our goal of distributing attractive levels of dividends per share. For tax purposes, we are structured as a real estate investment trust (REIT).
Our primary source of income is net interest income, which equals the interest income we earn from our investments in loans and securities less the interest expenses we incur from our borrowed funds and other liabilities. We assume a range of risks in our investments and the level of assumed risk dictates the manner in which we finance our purchase of and derive income from these investments.
Our investments in residential, commercial, and collateralized debt obligation (CDO) credit-enhancement securities (CES, or below investment-grade securities) have concentrated credit risk. We finance the acquisition of most of our first-loss and equivalent CES that are directly exposed to credit losses with capital. To date, our primary credit-enhancement investment focus has been in securities backed by high-quality residential and commercial real estate loans. High-quality real estate loans are loans that typically have low loan-to-value ratios, borrowers with strong credit histories, and other indications of quality relative to the range of loans within U.S. real estate markets as a whole. Our CES investment returns depend on the amount and timing of the interest and principal collected on the loans in the pools supporting the securities. In an ideal environment, for most of our residential CES, we would experience fast loan prepayments and low credit losses which would, in turn, lead to attractive CES returns. Conversely, the return on most of our residential CES investments would be adversely affected by slow loan prepayments and high credit losses.
We also make investments in the securitization entities we sponsor Sequoia and Acacia. The Sequoia entities hold real estate loans. The Acacia entities generally hold investment-grade securities (IGS), which have less concentrated credit risk than CES, as well as some second-loss, third-loss, and equivalent securities. The income we earn on our investment in the equity of these securitization entities is based upon the spread between the yield on the assets owned by each entity and the cost of funds borrowed to fund those assets. The cost of funds is the interest paid on the asset-backed securities (ABS) issued by each of these entities. Each entity is independent of Redwood and of each other and the assets and obligations are not owned by and are not obligations of Redwood.
During 2007, the most significant factor affecting our consolidated financial statements was the extensive price decline in real estate securities that began early in the year and continued unabated through the end of the fourth quarter. This price decline caused a substantial decline in our reported GAAP book value and earnings. We believe the real economic impact on Redwood is significantly less severe than the financial reporting impact reflected in our consolidated financial statements for the year ended December 31, 2007. The primary reason for the divergence between economics and GAAP relates to the accounting treatment required for our investments in the Acacia securitization entities.
For accounting purposes, we consolidate the balance sheets and income statements of the Acacia securitization entities. In 2007, we were required, for financial statement purposes, to mark-to-market (MTM) all of the assets of Acacia to fair value, but we were not permitted to MTM paired liabilities. The GAAP accounting treatment resulted in a carrying value for our investments in Acacia of a negative $1.4 billion at December 31, 2007. On January 1, 2008, we elected to adopt a new accounting standard, SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (FAS 159), to value the assets and liabilities of the Acacia entities. This new standard significantly improved the disparity that existed between the GAAP carrying value of our Acacia investments and our estimate of the economic value of those investments. In accordance with FAS 159, we recorded a one-time, cumulative-effect adjustment to our balance sheet that increased the balance of our stockholders equity at January 1, 2008 by $1.5 billion. Our reported consolidated stockholders equity at December 31, 2007 was a negative $718 million. After giving affect to the adoption of FAS 159, our reported GAAP stockholders equity at January 1, 2008 was a positive $751 million.
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In 2007, our reported GAAP net loss was $1.1 billion ($39.70 per share) compared to GAAP net income of $128 million ($4.85 per share) in 2006. We paid $5.00 per share in dividends in 2007 (consisting of $3.00 per share in regular dividends and a $2.00 per share special dividend). Our board of directors has announced its intention to maintain the regular dividend at $0.75 per share per quarter in 2008.
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(In Thousands, Except Share Data) | 2007 | 2006 | 2005 | |||||||||
Total interest income | $ | 855,540 | $ | 885,160 | $ | 962,197 | ||||||
Total interest expense | (651,762 | ) | (701,704 | ) | (757,270 | ) | ||||||
Net interest income | 203,778 | 183,456 | 204,927 | |||||||||
Operating expenses | (58,555 | ) | (55,925 | ) | (48,382 | ) | ||||||
Realized gains on sales and calls, net | 12,781 | 22,557 | 65,879 | |||||||||
Market valuation adjustments, net | (1,261,449 | ) | (12,586 | ) | (5,031 | ) | ||||||
Provision for income taxes | (5,192 | ) | (9,970 | ) | (17,521 | ) | ||||||
Net (Loss) Income | $ | (1,108,637 | ) | $ | 127,532 | $ | 199,872 | |||||
Diluted common shares | 27,928,234 | 26,313,826 | 25,121,467 | |||||||||
Net (loss) income per share | $ | (39.70 | ) | $ | 4.85 | $ | 7.96 |
By far the largest factor in the decline in net income in 2007 was a $1.3 billion increase in negative mark-to-market valuation adjustments. Another factor negatively affecting our net income relative to the prior year was a $10 million decline in gains generated from sales and calls of assets. Operating expenses increased from $56 million in 2006 to $59 million in 2007 as a result an increase in headcount and a reorganization of our residential and commercial operations, partially offset by a decrease in bonus awards as a result of the companys GAAP results.
On the positive side, our operating results in 2007 were strong. Net interest income increased to $204 million in 2007, up from $184 million in 2006. This increase in net interest income was attributable to higher net interest income from our CES and IGS partially offset by a decline in the aggregate net interest income from our Sequoia investments caused by a reduction in the volume of loans held by the Sequoia entities in 2007 relative to 2006. Provision for income taxes decreased from $10 million in 2006 to $5 million in 2007.
Our estimated taxable income in 2007 was $5.79 per share, as compared to $6.75 per share in 2006, and our REIT taxable income in 2007 was $5.65 per share, as compared with $6.45 per share in 2006. Our REIT taxable income determines the minimum amount of dividends we must distribute in order to maintain our tax status as a REIT. Taxable income continues to run higher than GAAP income as we are not permitted to establish credit reserves or recognize MTM adjustments (impairments) for tax purposes. We amortize more of our CES discount into income for tax purposes, generally do not record impairments for tax purposes, and have a higher tax basis in these securities. Consequently, any future credit losses on our CES will have a more significant impact on taxable income and REIT taxable income compared to GAAP income. See Potential Income Tax Volatility later in this document.
The non-GAAP pro forma consolidating income statement shown below highlights the significant impact from the consolidation of Acacia securitization entities on our overall results. For the reasons described in the Mark-to-Market Adjustments Discussion below, we believe the net economic loss from our Acacia investments was significantly less than the net loss of $1.0 billion reported under GAAP.
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Year Ended December 31, 2007 | ||||||||||||||||
(In Millions) | Redwood Parent Only | Sequoia | Acacia | Redwood Consolidated | ||||||||||||
Net interest income | $ | 133 | $ | 29 | $ | 42 | $ | 204 | ||||||||
Operating expenses | (59 | ) | | | (59 | ) | ||||||||||
Realized gains on sales and calls, net | 15 | | (2 | ) | 13 | |||||||||||
Market valuation adjustments, net | (174 | ) | | (1,087 | ) | (1,261 | ) | |||||||||
Net (loss) income before provision for income taxes | (85 | ) | 29 | (1,047 | ) | (1,103 | ) | |||||||||
Provision for income taxes | (5 | ) | | | (5 | ) | ||||||||||
Net (Loss) Income | $ | (90 | ) | $ | 29 | $ | (1,047 | ) | $ | (1,108 | ) |
This is a non-GAAP presentation. In a GAAP presentation, the Redwood income column shown above would reflect the income from Sequoia and the loss from Acacia.
It is likely that we will continue to experience earnings volatility as a result of MTM adjustments in 2008. In particular, prices for real estate securities have continued to decline in the first quarter of 2008. We may also encounter further MTM adjustments from impairments on CES held at Redwood and from the consolidation of Acacia entities even after the adoption of FAS 159. These items are discussed in detail in the Mark-to-Market Adjustments Discussion that follows.
We believe that it is highly likely that the net interest income contribution from our existing Acacia investments will be lower in 2008 in comparison to 2007. Cash distributions from our Acacia investments can be disrupted based on credit rating agencies downgrades of the underlying collateral or due to deterioration in collateral performance. Our investment in each of these entities is separate and independent, thus diminished performance for one of our investments would have no effect on our investments in the other Acacia entities. We believe there is a strong likelihood that cash flows from our investments in four of the Acacia entities could be disrupted in the first or second quarter of 2008 and the cash flows from our investment in a fifth Acacia entity could be disrupted within a year. During the year ended December 31, 2007, the net interest income reported from our investments in these five entities was $21 million of the $42 million total net interest income shown in the table above.
A broad re-evaluation of residential and commercial mortgage credit risk and the subsequent reduction in market values began early in the year and continued unabated through the end of the fourth quarter of 2007 and into the first quarter of 2008. The most dramatic negative price adjustments involved residential mortgage-backed securities (RMBS) and CDO securities backed by subprime and alt-a mortgages originated in 2006 and 2007.
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The table below illustrates the additional interest rate spread that investors have required to compensate for the perceived additional credit risk of various types of RMBS and commercial mortgage-backed securities (CMBS).
We believe several converging factors led to the broad decline in capital markets pricing for RMBS, CMBS, and CDO securities which, in turn, negatively affected our operating results and caused us to incur dramatic negative mark-to-market valuation adjustments against our securities portfolio. These factors included:
| declines in residential and commercial real estate prices; |
| a rapid increase in the number of delinquent residential mortgage loans; |
| a reduced willingness of investors to acquire commercial paper or other short-term debt backed by mortgage collateral; |
| credit-rating downgrades by credit rating agencies of numerous mortgage-backed securities and of bond insurers; |
| overall contraction in market liquidity; |
| forced selling, caused by margin calls and other factors; |
| the impact of speculation in related derivatives markets; and |
| a general unwillingness of investors to acquire assets in a falling market. |
In addition, market trading activity during the second half of 2007 was unusually light. We believe that uncertainty related to future loss estimates made it difficult for willing buyers and sellers to agree on price. Correspondingly, new securitization activity was low throughout the second half of 2007 and remained at low levels into the first quarter of 2008. These changing market conditions have impacted our activities and operations in a variety of ways, while our core focus has remained consistent. Over the past few years, we have focused on establishing a foundation for growth. We have laid this foundation by diversifying our investment and financing capabilities, strengthening the Redwood team, and bolstering our systems and infrastructure. These remain top priorities for us going forward. At the same time, however, the manner in which we utilize these resources has evolved, and will continue to do so, in response to changing market conditions.
During the first half of 2007, when market conditions began to show signs of a correction, we closely monitored our acquisition decisions while continuing to acquire real estate securities, both as investments and for planned Acacia CDO entities, as well as loans for planned Sequoia entities. As market conditions became more turbulent toward the end of the second quarter and through the third quarter, we reduced our acquisition activity, focusing instead on strengthening our liquidity position and freeing up capital for deployment into higher yielding assets. During the fourth quarter, while continuing to focus on maintaining the strength of our capital base, we began to take advantage of some of the acquisition opportunities created by the current market conditions.
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The majority of our residential CES was originated during or prior to 2005, and these securities continue to perform in line with or better than our original expectations. The prime and alt-a loans backing these seasoned CES have generally exhibited strong payment histories and declining loan-to-value ratios due to principal pay-downs and home price appreciation in the earlier years of those loans. In contrast, our residential CES originated in 2006 and 2007 are performing below our original expectations. We have assessed our exposure to these vintages ($48 million or 30% of total residential CES) and believe we were adequately reserved for credit losses at December 31, 2007.
Our commercial CES portfolio continues to perform well in the face of weakening fundamentals for this asset class in general. Serious delinquencies on commercial loans underlying CES are still near industry historic lows. We expect industry default rates to increase and approach 1% during 2008. As expected with diverse CMBS collateral pools, we continue to experience isolated defaults that have not been indicative of overall performance trends to date. We believe that our credit reserves adequately provided for expected losses on all of our credit-sensitive commercial securities at December 31, 2007.
We expect that an economic stimulus package recently passed by Congress, which raises conforming limits for Freddie Mac and Fannie Mae eligible loans, will have a modest positive impact on our credit-enhancement portfolio. The long-term impact, however, remains unclear.
Our excess capital position was $282 million at December 31, 2007, an increase from the $183 million we had at the end of 2006. Our sources of capital during the year were $185 million from stock issuance, $50 million from the issuance of subordinated notes, $216 million from portfolio cash flows in excess of our operating costs, and $276 million from asset sales to third parties and our securitization entities. During the year, we used $485 million of capital for new investments and $143 million of capital for dividend payments.
Our year-end liquidity position remained strong at $297 million. Redwood debt (short-term debt not included in capital) was $8 million at the end of the year. We continue to have no liquidity issues or need to sell assets and, using our excess capital, have commenced investing in new long-term assets.
Although we intend to be cautious in deploying our capital in 2008, we believe there may be extraordinary opportunities in 2008 to make new investments with long-term earnings potential at attractive prices. Price levels for many real estate assets are now at historic lows, providing a substantial cushion against future losses. We have begun to see compelling long-term value in many new and seasoned assets, in spite of the price volatility that we and other market participants will continue to experience over the near term.
We deployed a significant amount of capital during the fourth quarter of 2007 ($123 million), and we believe our rate of capital deployment could increase in 2008. The velocity of forced liquidations of seasoned assets at attractive prices by many financial institutions is increasing, and we expect new opportunities to arise to credit-enhance new loans originated to much higher-quality standards. We expect to continue financing these types of credit-sensitive investments with capital, either on our own or with third-party capital sourced through opportunity funds or other asset management vehicles. Given the opportunities in front of us, we will likely seek to raise additional Redwood capital in 2008, assuming capital can be raised in a manner that is accretive to earnings given our planned capital uses.
We expect that over the next two to three years, we will likely experience delinquencies and credit losses that will increase materially on a percentage basis in comparison to the low levels we experienced over the last few years. We believe we have established appropriate reserves for these increased losses, however, and we expect most of our assets to produce healthy economic returns even with the increased losses that we currently anticipate. That being said, we do not know how long or how severe this credit cycle will be, and our current expectations about the level of future losses could be overly optimistic.
Overall, we believe the most appropriate expectation over the next few years is that credit losses will escalate and likely reduce the amount of our special dividends. In a severe case a case that we are not expecting despite current market turmoil taxable income alone may be less than our regular dividend for some period of time.
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On the positive side for Redwood, the real estate and capital markets excesses of the past continue to get wrung out of the system, which we believe will make for a positive longer-run future for us. Real estate is beginning to return to sound fundamentals, competition has been reduced, and there are some prospects for new forms of credit-enhancement to arise in the future where we could be competitive. Additionally, asset prices continue to fall, and assets are beginning to change hands after several months during which there was little market activity, so our search for new acquisition opportunities is becoming more interesting.
After a painful year for our industry, we believe we have emerged from 2007 as one of the companies best positioned to capitalize on the opportunities that lay ahead. The strength of our balance sheet allowed us to weather the current liquidity crisis and build for the future. Overall, we believe the long-term outlook for Redwood is favorable, although the near and medium-term will likely remain difficult. As a survivor and a leader, we will have an opportunity to define the new operating models in our space in the future.
The rules regarding mark-to-market (MTM) accounting are complex and may not clearly reflect the underlying economics. This accounting and economic discussion is intended to provide investors with a better understanding of the impact of MTM adjustments on our reported financial results.
MTM adjustments can result from changes in fair values caused either by a change in expected cash flows (i.e. increased credit loss estimates reducing expected cash flows), or a change in market discount rates (i.e., the market requires a greater risk premium and/or interest rates rise), or a combination of both.
All changes in fair value for securities or derivatives accounted for as trading instruments flow through the income statement. These adjustments can be either positive or negative from period to period.
The vast majority of real estate securities held by Redwood and consolidated Acacia entities at December 31, 2007 were accounted for as available-for-sale (AFS) securities. We carry AFS securities in our GAAP balance sheet at their fair value. Positive changes in the fair value of AFS securities from period to period are always accounted for as increases to stockholders equity and do not flow through our income statement. Accounting for negative changes in the fair value of AFS securities from period to period requires a three-step process involving a combination of quantitative and judgmental evaluations. The ultimate purpose of this process is to determine whether negative MTM adjustments represent other-than-temporary (OTT) impairments, which flow through our GAAP income statement, or represent temporary impairments, which are recorded as a reduction of stockholders equity and do not flow through our income statement.
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The diagram below and the narrative discussion that follow addresses the three-step process for evaluating impairments on AFS securities.
The first step in this process is to determine whether there has been an adverse change in the underlying cash flows generated by the security. A security is considered OTT impaired even if the change in projected cash flows is small relative to the resulting MTM adjustment. It is difficult to separate with precision how much of the change in fair value is driven by changes in expected cash flows versus changes in market discount rates, but during periods of market illiquidity and uncertainty (as we encountered in late 2007), the market discount rate impact can be significant.
The second step is to determine whether we have the ability and intention to hold the security.
The third step requires us to evaluate whether an impaired security will recover in value within a reasonable period of time. This step is very subjective and proved especially difficult this quarter in light of turmoil and uncertainty in the capital markets. We needed additional time to complete this step, and thus we requested a fifteen-day extension of the filing date of our annual report on Form 10-K. Over 70% of the total OTT impairments we recorded during the fourth quarter resulted from this third step of the process.
AFS securities deemed OTT impaired for accounting purposes cannot be written back up through MTM adjustments in our income statement. This does not mean the underlying security could not recover in value. If the value of an impaired security does recover, we would recognize this benefit through higher interest yields over time. Therefore, some of our securities which were classified as OTT impaired for accounting purposes during 2007 may eventually prove to have significant economic value to us.
We believe the MTM accounting rules applicable to the preparation of our 2007 financial statements caused our stockholders equity to be significantly understated at December 31, 2007. We are required for accounting purposes to consolidate the Acacia CDO entities. As a result, the net GAAP carrying value of our investments in Acacia reflected in our financial statements is expressed as the difference between the carrying value of Acacias assets and the carrying value of Acacias liabilities (ABS issued to third parties). The MTM
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accounting rules in place at December 31, 2007, required us to MTM Acacias assets, but did not permit us to MTM Acacias liabilities, even though the assets and liabilities are directly paired (i.e., the liabilities of an Acacia entity will be repaid only from the cash flows generated by that entitys assets). Consequently, the GAAP net carrying value of our investments in Acacia entities was negative $1.4 billion at December 31, 2007, a value that is impossible (as the economic value of our investments cannot be less than zero) and significantly understates our estimate of the economic value of our Acacia investments at that time.
In our opinion, the best economic method to assess the value of our investments in Acacia is to calculate the net present value of future expected cash flows of these investments. Our December 31, 2007 estimate of the sum of future expected cash flows from our investments in Acacia securities plus management fees we anticipate receiving from those entities was $244 million. The net present value of these cash flows discounted at 45% was $46 million. We believe that $46 million is a reasonable approximation of the economic value of our investments in Acacia at December 31, 2007. If we were permitted for accounting purposes to use the valuation methodology described above, GAAP and economics would be in sync, and our financial statements and disclosures would be less complicated.
On January 1, 2008, we adopted FAS 159 and elected to fair value both the assets and liabilities of the Acacia entities. In accordance with FAS 159, we recorded a one-time, cumulative-effect adjustment to our balance sheet that decreased the carrying value of Acacia liabilities by $1.5 billion and increased stockholders equity by that amount in our January 1, 2008 balance sheet. Adoption of this new accounting standard significantly improves the substantial disparity that existed between the Acacia GAAP presentation and economics at December 31, 2007.
Discrepancies between economic and GAAP valuations of our Acacia investments will continue to occur because under FAS 159 the cash flow value of our investments is not taken into account in determining the carrying value of our investments. Instead, GAAP carrying value of our investments is derived by subtracting the fair value of Acacias liabilities from the fair value of Acacias assets. Furthermore, Acacias assets and liabilities are valued separately in their independent markets. In theory, changes in the fair values of Acacias assets and liabilities should be reasonably correlated as they are paired within the same legal structure -- ABS issued by each Acacia entity will be repaid directly and solely from the cash flows generated by the assets owned by that entity. However, at any given moment, the capital markets may use different discount rates and valuation parameters for Acacias collateral assets relative to its ABS issued to third parties. On January 1, 2008, for instance, the market values for Acacia liabilities were, in our view, depressed relative to the paired collateral asset values. As a consequence of this market condition, when we fair valued the assets and liabilities of the Acacia entities under FAS 159 at January 1, 2008, the derived net GAAP carrying value of our Acacia investments was $84 million. This result exceeded our $46 million estimate of economic value of our investments in Acacia entities based on the net present value of expected cash flows.
As a consequence of adopting FAS 159, we will be required in the future to flow through our quarterly income statements the relative changes in the fair values of Acacia assets and liabilities as measured in their independent markets. There is no way to anticipate these relative changes from quarter to quarter. As a consequence, our earnings will vary as these values fluctuate over time. In particular, if Acacia liability values increase from the low levels at December 31, 2007, all or a portion of the $38 million by which the GAAP carrying value at January 1, 2008 ($84 million) exceeded our estimate of economic value ($46 million) will flow through our income statement as negative MTM adjustments. There is no scheduled time frame when this excess may be absorbed. It could happen gradually over time, or it could happen in a single quarter.
The price declines in real estate securities in 2007 had a significant negative GAAP financial reporting impact on Redwood, as MTM adjustments to our consolidated real estate securities portfolio caused our GAAP book value and our GAAP earnings to decline significantly. As previously discussed, we believe the real economic effect of these MTM adjustments is significantly less than the impact shown under GAAP as a consequence of being required to MTM Acacia assets, but not being permitted to MTM the paired Acacia liabilities.
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The tables below detail the total MTM adjustments by the underlying collateral type for the securities.
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2007 | ||||||||||||||||||||
(In Millions) | IGS | CES | OREI & Derivatives |
Total | MTM Percent (1) |
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Residential |
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Prime | $ | (252 | ) | $ | (290 | ) | $ | 1 | $ | (541 | ) | (39.33 | )% | |||||||
Alt-a | (467 | ) | (168 | ) | (67 | ) | (702 | ) | (56.10 | )% | ||||||||||
Subprime | (192 | ) | (59 | ) | (11 | ) | (262 | ) | (52.62 | )% | ||||||||||
Residential total | (911 | ) | (517 | ) | (77 | ) | (1,505 | ) | ||||||||||||
Commercial | (20 | ) | (156 | ) | | (176 | ) | (29.19 | )% | |||||||||||
CDO | (167 | ) | (33 | ) | | (200 | ) | (61.61 | )% | |||||||||||
Interest rate agreements & other derivatives | | | (44 | ) | (44 | ) | ||||||||||||||
Total Mark-to-Market Adjustments | $ | (1,098 | ) | $ | (706 | ) | $ | (121 | ) | $ | (1,925 | ) |
(1) | This percentage represents the MTMs taken as a percentage of the reported market values at the beginning of the year, or purchase price if acquired during the year. It is intended to highlight the price declines by collateral type for the year ended December 31, 2007. These price declines are for our specific portfolio and my not be indicative of price declines in the market in general. |
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December 31, 2007 | Vintage | |||||||||||||||||||
(In Millions) | 2004 & Earlier | 2005 | 2006 | 2007 | Total | |||||||||||||||
Acacia | $ | (200 | ) | $ | (315 | ) | $ | (742 | ) | $ | (339 | ) | $ | (1,596 | ) | |||||
Redwood | (65 | ) | (52 | ) | (108 | ) | (104 | ) | (329 | ) | ||||||||||
Total Mark-to-Market Adjustments | $ | (265 | ) | $ | (367 | ) | $ | (850 | ) | $ | (443 | ) | $ | (1,925 | ) |
The purpose of this pro forma presentation is to show total mark-to-market adjustments for 2007 by vintage and by the amount that affected Redwood (separate from Acacia), Acacia, and Redwood on a consolidated basis. This is a non-GAAP presentation. The totals shown above are reconciled to GAAP in Table 5 below.
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The tables below show how these MTM adjustments on securities affected Redwood (separate from Acacia), Acacia, and Redwood on a consolidated basis. They also show the MTM adjustment amounts that flowed through our income statement and balance sheet.
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2007 | ||||||||||||||||
(In Millions) | Redwood Excluding Acacia |
Sequoia | Acacia | Total | ||||||||||||
Balance Sheet Impact |
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Reduction in stockholders' equity | $ | (158 | ) | $ | | $ | (509 | ) | $ | (667 | ) | |||||
Income Statement Impact |
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Market valuation adjustments |
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Impairments on AFS securities | (144 | ) | | (1,031 | ) | (1,175 | ) | |||||||||
Changes in fair value on trading instruments | (27 | ) | | (56 | ) | (83 | ) | |||||||||
Total income statement impact | (171 | ) | | (1,087 | ) | (1,258 | ) | |||||||||
Total Mark-to-Market Adjustments | (329 | ) | | (1,596 | ) | (1,925 | ) |
The purpose of this pro forma presentation is to show the consolidating components for total mark-to-market adjustments for the year ended December 31, 2007. These mark-to-market adjustments are further detailed by the balance sheet (stockholders equity) and income statement impact. This is a non-GAAP presentation. The total stockholders equity impact of $667 million for the year ended December 31, 2007 agrees with our consolidated balance sheet for the year. The total income statement impact of $1.3 billion for the year ended December 31, 2007 agrees with our consolidated income statement for the year.
Effective January 1, 2008, we elected to adopt the new accounting standard, FAS 159, that allows us to MTM both the assets and the liabilities of Acacia. We recorded a one-time cumulative adjustment to our opening balance for 2008 to reduce the carrying value of Acacias liabilities by $1.5 billion. After giving effect to this adjustment, the net MTM impact for 2007 was negative $106 million. This impact is substantially less than the $1.6 billion reflected in our consolidated financial statements.
Negative MTM adjustments on the securities at Redwood that were reflected as a reduction of stockholders equity at December 31, 2007 (that is, gross unrealized losses that have not flowed through our income statement) were $51 million for residential CES and $43 million for commercial CES. If credit conditions continue to deteriorate in 2008, causing an adverse change in the expected cash flows from these securities, we could be required to flow through our income statement an impairment charge for a portion or for all of these negative MTM adjustments. It is important to note that those impairment charges would not impact our book value as the MTM adjustments were already deducted from stockholders equity at December 31, 2007, but they would reduce our GAAP earnings in 2008.
The fair values we use in our mark-to-market process reflect what we believe we would realize if we chose to sell our securities or would have to pay if we chose to buy back our asset-backed securities (ABS) issued (liabilities). Establishing fair values is inherently subjective and is dependent upon many market-based inputs, including observable trades, information on offered inventories, bid lists, and indications of value obtained from dealers. Valuations are especially difficult for more illiquid securities, such as the securities we own and our ABS issued, and when there is limited trading visibility, as was the case in recent months. For these reasons, we expect market valuations to continue to be highly volatile.
Fair values for the securities we own and our ABS issued are dependent upon a number of market-based assumptions including future interest rates, prepayment rates, discount rates, credit loss rates, and the timing of credit losses. We then use these assumptions to generate cash flow estimates and internal values for each individual security.
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We request indications of value (marks) from dealers every quarter to assist in the valuation process. For December 31, 2007, we received dealer marks on 87% of the assets and liabilities on our balance sheet and did not receive marks for the remaining 13%.
One of the factors we consider in our valuation process is our assessment of the quality of the dealer marks we receive. Dealers were overwhelmed with requests for 2007 year-end marks, and there was little observable trading information for them to rely upon. Thus, their marks were most likely generated by their own pricing models for which they did not share their inputs and we had little insight into their assumptions. Furthermore, the dealers now heavily qualify the information they send to us. The qualifications include the following:
| credit markets have been characterized by significant volatility and very limited liquidity; |
| the sharp downturn in trading levels for many securities has resulted in poor price transparency; |
| valuations have become especially dependent on assumptions used in valuation models rather than observable inputs; |
| valuations are indicative only and may not reflect the actual prices or spread levels at which the securities could be sold; and |
| valuations do not necessarily reflect the values that would be produced by other pricing models or methods. |
Our valuation process relied on our internal values to estimate the fair values of our securities at December 31, 2007. In the aggregate, our internal valuations of the securities on which we received dealer marks were $298 million, or 14%, lower than the aggregate dealer marks at December 31, 2007. Our internal valuations of our ABS issued on which we received dealer marks were $3 million, or less than 1%, lower than the aggregate dealer marks at December 31, 2007.
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Total interest income consists of the interest earned on interest-bearing assets, adjusted for amortization of discounts and premiums and provisions for loan credit losses. The table below summarizes interest income earned on the following types of interest-bearing assets consolidated on our balance sheet: real estate loans, real estate securities, other real estate investments, non-real estate investments, and cash.
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Year Ended December 31, | ||||||||||||||||||||||||||||||||
2007 | 2006 | |||||||||||||||||||||||||||||||
(Dollars in Thousands) | Interest Income | Percent of Total Interest Income | Average Amortized Cost |
Yield | Interest Income | Percent of Total Interest Income | Average Amortized Cost |
Yield | ||||||||||||||||||||||||
Real estate loans, net of provision for credit losses | $ | 467,677 | 54.67 | % | $ | 8,056,936 | 5.80 | % | $ | 608,868 | 68.78 | % | $ | 10,652,094 | 5.72 | % | ||||||||||||||||
Real estate securities | 364,023 | 42.55 | % | 3,599,396 | 10.11 | % | 265,353 | 29.98 | % | 2,612,934 | 10.15 | % | ||||||||||||||||||||
Other real estate investments | 5,762 | 0.67 | % | 33,717 | 17.09 | % | | | | | ||||||||||||||||||||||
Non-real estate investments | 2,590 | 0.30 | % | 49,752 | 5.21 | % | | | | | ||||||||||||||||||||||
Cash and cash equivalents | 15,488 | 1.81 | % | 332,856 | 4.65 | % | 10,939 | 1.24 | % | 268,340 | 4.08 | % | ||||||||||||||||||||
Total Interest Income | $ | 855,540 | 100.00 | % | $ | 12,072,658 | 7.09 | % | $ | 885,160 | 100.00 | % | $ | 13,533,368 | 6.54 | % |
The table below details how our interest income changed by portfolio as a result of changes in consolidated asset balances (volume) and yield (rate) for 2007 as compared to 2006.
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Change in Interest Income Years Ended December 31, 2007 Versus December 31, 2006 | ||||||||||||
(In Thousands) | Volume | Rate | Total Change | |||||||||
Real estate loans, net of provisions for credit losses | $ | (148,338 | ) | $ | 7,147 | $ | (141,191 | ) | ||||
Real estate securities | 100,179 | (1,509 | ) | 98,670 | ||||||||
Other real estate investments | 5,762 | | 5,762 | |||||||||
Non-real estate investments | 2,590 | | 2,590 | |||||||||
Cash and cash equivalents | 2,630 | 1,919 | 4,549 | |||||||||
Total Interest Income | $ | (37,177 | ) | $ | 7,557 | $ | (29,620 | ) |
Note: Volume change is the change in average volumes between periods multiplied by the rate earned in the earlier period. Rate change is the change in rate between periods multiplied by the average portfolio balance in the prior period. Interest income changes that resulted from changes in both rate and volume were allocated to the rate change amounts shown in the table. For investments we did not own in prior periods, the entire change was attributable to volume.
Below is a further breakdown and discussion of the year-over-year changes for interest-bearing real estate loans, real estate securities, other real estate investments, and cash.
The following tables provide detail on interest income earned on our residential and commercial real estate loan portfolios for 2007 and 2006.
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Year Ended December 31, 2007 | Yield as a Result of | |||||||||||||||||||||||||||||||
(Dollars in Thousands) | Interest Income | Net (Premium) Discount Amortization | Provision For Credit Losses | Total Interest Income | Average Amortized Cost |
Interest Income | (Premium) Discount Amortization and Credit Provision | Total Interest Income | ||||||||||||||||||||||||
Residential loans | $ | 516,848 | $ | (37,671 | ) | $ | (10,461 | ) | $ | 468,716 | $ | 8,030,563 | 6.44 | % | (0.60 | )% | 5.84 | % | ||||||||||||||
Commercial loans | 1,210 | 99 | (2,348 | ) | (1,039 | ) | 26,373 | 4.59 | % | (8.53 | )% | (3.94 | )% | |||||||||||||||||||
Total Loans | $ | 518,058 | $ | (37,572 | ) | $ | (12,809 | ) | $ | 467,677 | $ | 8,056,936 | 6.43 | % | (0.63 | )% | 5.80 | % |
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Year Ended December 31, 2006 | Yield as a Result of | |||||||||||||||||||||||||||||||
(Dollars in Thousands) | Interest Income | Net (Premium) Discount Amortization | Reversal of Provision For Credit Losses | Total Interest Income | Average Amortized Cost |
Interest Income | (Premium) Discount Amortization and Credit Provision | Total Interest Income | ||||||||||||||||||||||||
Residential loans | $ | 654,192 | $ | (48,700 | ) | $ | 394 | $ | 605,886 | $ | 10,611,827 | 6.17 | % | (0.46 | )% | 5.71 | % | |||||||||||||||
Commercial loans | 2,849 | 168 | (35 | ) | 2,982 | 40,267 | 7.08 | % | 0.33 | % | 7.41 | % | ||||||||||||||||||||
Total Loans | $ | 657,041 | $ | (48,532 | ) | $ | 359 | $ | 608,868 | $ | 10,652,094 | 6.18 | % | (0.46 | )% | 5.72 | % |
Total interest income on residential real estate loans decreased to $469 million for 2007 from $606 million for 2006. This was primarily a result of lower average balances of residential real estate loans and increased credit provisions in 2007 relative to 2006. Our residential real estate loan balance decreased to $7.2 billion at December 31, 2007 from $9.3 billion at December 31, 2006, as our loans paid down and we had a relatively low level of loan acquisitions. Of the $7.2 billion of residential loans outstanding at December 31, 2007, 68% consisted of one or six-month LIBOR adjustable-rate residential loans (LIBOR ARMs). The level of short-term interest rates and the shape of the yield curve have an impact on the prepayment performance of LIBOR ARM loans. As the yield curve flattened and short-term interest rates rose beginning in early 2004, prepayments on these loans accelerated and, until recently, have generally prepaid at relatively fast speeds. In the second half of 2007, as the yield curve steepened and short-term interest rates began to fall, prepayments on LIBOR ARM loans slowed considerably. The average constant prepayment rate (CPR) for our LIBOR ARMs was 46% in the year ended December 31, 2006, 38% in the year ended December 31, 2007, and 27% on an annualized basis in the fourth quarter of 2007.
Loan premium amortization expense was $38 million for 2007 and $49 million for 2006. On a percentage basis, loan premium amortization expense for our LIBOR ARMs continues to lag the rate of decrease in our LIBOR ARM residential loan balance. The reason for this anomaly relates to the loan premium amortization method we use for loans acquired prior to July 2004, which represented 36% of the loan balance at December 31, 2007. For these loans, the premium amortization rate is somewhat influenced by prepayments, but is also influenced by short-term interest rates. As short-term rates increase, premium amortization slows; as short-term rates decrease, premium amortization potentially accelerates in a material way. See the Potential for GAAP Earnings Volatility below for further discussion. For the remainder of the loans (those acquired after July 2004), we use a different accounting method for premium amortization, where the percentage of amortization is more closely correlated to prepayment rates regardless of changes in short-term interest rates.
In 2007, we increased our provision for credit losses for residential loans by $11 million. In 2006, we reduced our provision for credit losses for residential loans by less than $1 million. As the residential loans on our consolidated balance sheet season and we do not acquire many new loans, we would expect to increase our credit reserve on a percentage basis, as we would expect our delinquencies to rise. On a percentage basis, our credit reserve increased to 0.26% of the residential loan balance at December 31, 2007 from 0.22% at December 31, 2006. Serious delinquencies (defined as those loans that are 90 days or more delinquent, in foreclosure or real estate owned) in residential loans have increased from 0.71% of the current loan balance at December 31, 2006 to 0.96% at December 31, 2007. As a percentage of original balance, serious delinquencies increased from 0.21% at December 31, 2006 to 0.24% at December 31, 2007.
39
Interest income on commercial real estate loans decreased by $4 million for 2007 compared to the previous year. The majority of the decrease related to fully reserving for an anticipated loss on a mezzanine commercial loan financing a condominium-conversion project during the first quarter of 2007. Cost over-runs and changing market conditions make it probable that we will not collect any outstanding principal or accrued interest upon completion of the project. The total charge-off for this loan was $3 million, of which $2 million related to principal (and taken through the credit provision) and $1 million to accrued interest (and taken as a reduction in interest income).
The tables below present the income and yields of the components of our real estate securities for 2007 and 2006.
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Year Ended December 31, 2007 | Yield as a Result of | |||||||||||||||||||||||||||
(Dollars in Thousands) | Interest Income | Discount (Premium) Amortization | Total Interest Income | Average Amortized Cost |
Interest Income | Discount (Premium) Amortization | Total Interest Income | |||||||||||||||||||||
IGS |
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Residential | $ | 128,398 | $ | 7,428 | $ | 135,826 | $ | 2,038,545 | 6.30 | % | 0.36 | % | 6.66 | % | ||||||||||||||
Commercial | 7,001 | 270 | 7,271 | 117,709 | 5.95 | % | 0.23 | % | 6.18 | % | ||||||||||||||||||
CDO | 17,392 | 121 | 17,513 | 245,595 | 7.08 | % | 0.05 | % | 7.13 | % | ||||||||||||||||||
Total IGS | $ | 152,791 | $ | 7,819 | $ | 160,610 | $ | 2,401,849 | 6.36 | % | 0.33 | % | 6.69 | % | ||||||||||||||
CES |
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Residential | $ | 81,414 | $ | 75,543 | $ | 156,957 | $ | 714,023 | 11.40 | % | 10.59 | % | 21.99 | % | ||||||||||||||
Commercial | 43,446 | 271 | 43,717 | 457,803 | 9.49 | % | 0.06 | % | 9.55 | % | ||||||||||||||||||
CDO | 2,872 | (133 | ) | 2,739 | 25,721 | 11.17 | % | (0.52 | )% | 10.65 | % | |||||||||||||||||
Total CES | $ | 127,732 | $ | 75,681 | $ | 203,413 | $ | 1,197,547 | 10.67 | % | 6.32 | % | 16.99 | % | ||||||||||||||
Total Real Estate Securities | $ | 280,523 | $ | 83,500 | $ | 364,023 | $ | 3,599,396 | 7.79 | % | 2.32 | % | 10.11 | % |
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Year Ended December 31, 2006 | Yield as a Result of | |||||||||||||||||||||||||||
(Dollars in Thousands) | Interest Income | Discount (Premium) Amortization | Total Interest Income | Average Amortized Cost |
Interest Income | Discount (Premium) Amortization | Total Interest Income | |||||||||||||||||||||
IGS |
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Residential | $ | 86,181 | $ | 6,874 | $ | 93,055 | $ | 1,393,736 | 6.18 | % | 0.49 | % | 6.67 | % | ||||||||||||||
Commercial | 9,436 | 263 | 9,699 | 138,425 | 6.82 | % | 0.19 | % | 7.01 | % | ||||||||||||||||||
CDO | 10,777 | 29 | 10,806 | 175,358 | 6.15 | % | 0.02 | % | 6.17 | % | ||||||||||||||||||
Total IGS | $ | 106,394 | $ | 7,166 | $ | 113,560 | $ | 1,707,519 | 6.23 | % | 0.42 | % | 6.65 | % | ||||||||||||||
CES |
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Residential | $ | 67,135 | $ | 57,404 | $ | 124,539 | $ | 597,206 | 11.24 | % | 9.61 | % | 20.85 | % | ||||||||||||||
Commercial | 26,961 | (1,561 | ) | 25,400 | 290,964 | 9.27 | % | (0.54 | )% | 8.73 | % | |||||||||||||||||
CDO | 1,854 | | 1,854 | 17,245 | 10.75 | % | | 10.75 | % | |||||||||||||||||||
Total CES | $ | 95,950 | $ | 55,843 | $ | 151,793 | $ | 905,415 | 10.60 | % | 6.17 | % | 16.77 | % | ||||||||||||||
Total Real Estate Securities | $ | 202,344 | $ | 63,009 | $ | 265,353 | $ | 2,612,934 | 7.74 % | 2.41 % | 10.15 | % |
40
Interest income from IGS increased to $161 million in 2007 as compared to $114 million in 2006, due primarily higher average balances of IGS in 2007. The majority of the IGS we acquired over the past year were residential, in part because comparably rated commercial securities traded at relatively higher prices and lower yields. The overall yield on our IGS portfolio increased during the year, reflecting increasing coupon rates on the underlying loans. The decrease in yields on commercial IGS in 2007 relative to 2006 was due to the sale of commercial IOs in 2006 owned by earlier Acacia entities.
We acquire many first-loss securities at 25% to 35% of their principal value and other, more senior, credit-enhancement securities at 50% to 100% of their principal value. Many of these securities are priced at a substantial discount to their principal value since future credit losses could reduce or eliminate the principal value of these securities. Our yields on these investments depend on how much principal and interest we eventually collect and how quickly we receive those payments. The faster we collect principal and the longer it takes to realize credit losses, the better it is for our investment returns.
Interest income from our residential CES was $157 million for 2007, a $32 million increase over 2006. This increase is the result of higher yields and higher average balances. Most of our residential CES portfolio is backed by loans originated in 2005 and earlier. The credit performance on these loans has generally been better than our initial expectations, and this has contributed to higher yields than anticipated. Faster than anticipated prepayment rates on adjustable-rate mortgages (ARMs) have also contributed to higher levels of discount amortization. ARMs represented (by market value) 44% of our residential CES portfolio at December 31, 2007 and average actual prepayment rates were in excess of 34% in 2007 compared to our initial expectations (at the time of acquisition) of 20% to 25%.
We own residential real estate securities that are backed by option ARMs that give the borrower the option of making a minimum payment that is less than the amount of interest owed for that loan period. The unpaid interest is added to the loan balance creating negative amortization (neg am). The amount of neg am interest we currently recognize or defer for GAAP purposes on option ARM securities depends on our expectation of collectability. We currently expect that accumulated neg am interest for securities rated BB and higher will be paid in full. We currently do not expect to collect the neg am interest on our unrated and B-rated securities. As a result, in both 2007 and 2006 we recognized $5 million of neg am interest on securities rated BB and higher. During each of these time periods we deferred recognition of neg am interest of $4 million on our unrated and B-rated securities backed by option ARMs. We will recognize any deferred interest on these securities only if and when cash is received. Our cumulative deferred neg am interest was $8 million at December 31, 2007, an increase from $4 million at December 31, 2006.
Interest income from our commercial CES was $44 million for 2007, an $18 million increase over 2006. This increase is primarily the result of significantly higher average balances. The average yield earned on our commercial CES portfolio for 2007 was 9.55%, an increase from 8.73% for 2006. For both 2007 and 2006, the yield was low relative to our other CES due to our credit loss assumptions. Similar to residential CES, commercial CES are acquired at a net discount. Commercial CES generally have a ten year maturity and are not expected to receive principal prepayments prior to maturity. As a result, it will take several years to further observe credit performance and re-assess our loss assumptions. A decrease in projected credit loss assumptions would result in higher yields (an increase in discount amortization) while increased loss assumptions would lead to lower yields or impairments.
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The table below presents the interest income, average balance, and yield on our other real estate investments for 2007. We did not hold other real estate investments in 2006.
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(Dollars in Thousands) | Interest Income | Average Balance | Yield as a Result of Interest Income | |||||||||
Year Ended December 31, 2007 | $ | 5,762 | $ | 33,717 | 17.09 | % |
Other real estate investments consist of residential IOs, NIMs, and residuals. In prior years, these assets were included in real estate securities. The majority of the interest income was from residuals we purchased in the first half of 2007. Since we account for these assets as trading assets, the yield should be considered in conjunction with the market valuation adjustments recognized through the income statement on these assets, as discussed further later in this document.
Interest income from cash and cash equivalents was $15 million for 2007, an increase from $11 million for 2006. Average cash balances were higher for 2007 as compared to 2006 as we had higher levels of excess capital. Yields were marginally higher for 2007 as compared to 2006.
Interest expense consists of interest incurred on consolidated ABS issued by sponsored securitization entities, Redwood debt, and Redwood subordinated notes.
The table below presents our interest expense and balances for these components for 2007 and 2006.
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Year Ended December 31, | ||||||||
(Dollars in Thousands) | 2007 | 2006 | ||||||
Interest expense on consolidated ABS issued | $ | 580,955 | $ | 671,445 | ||||
Interest expense on Redwood debt | 60,029 | 29,836 | ||||||
Interest expense on subordinated notes | 10,778 | 423 | ||||||
Total Interest Expense on Total Obligations | $ | 651,762 | $ | 701,704 | ||||
Average balance of ABS issued | $ | 10,171,192 | $ | 12,497,551 | ||||
Average balance of Redwood debt | 1,024,829 | 493,357 | ||||||
Average balance of subordinated notes | 126,877 | 5,336 | ||||||
Average Total Obligations | $ | 11,322,898 | $ | 12,996,244 | ||||
Cost of funds of ABS issued | 5.71 | % | 5.37 | % | ||||
Cost of funds of Redwood debt | 5.86 | % | 6.05 | % | ||||
Cost of funds of subordinated notes | 8.49 | % | 7.93 | % | ||||
Total Cost of Funds of Obligations | 5.76 | % | 5.40 | % |
Total consolidated interest expense decreased to $652 million in 2007 from $702 million in 2006. The primary reason relates to a decline in the average balance outstanding of ABS issued offset to some extent by higher average balances of Redwood debt and subordinated notes.
Interest expense on consolidated ABS decreased by $90 million to $581 million in 2007 from $671 million in 2006. The reduction in consolidated ABS interest expense was caused by a decline in the average balance of outstanding consolidated ABS issued as a result of prepayments of the loans within these securitization entities. Offsetting some of the decline in balances was the higher cost of funds due to an increase in short-term interest rates during the first nine months of 2007 as most of our debt and consolidated ABS issued is indexed to one, three, or six-months LIBOR. These factors are illustrated in the volume and rate change table below.
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Interest expenses on Redwood debt increased by $30 million to $60 million in 2007 from $30 million in 2006 as a result of increased use of Redwood debt primarily during the first half of 2007. The average balance of our outstanding Redwood debt increased during 2007 due to a high level of financing for the acquisition of residential real estate loans and securities prior to the securitization of these assets through Sequoia and Acacia, (including from calling some older Sequoia loan securitizations) and financing of AAA and AA-rated real estate securities during the early part of the year.
Our subordinated notes (issued in 2006 and May 2007) pay interest expense at three-month LIBOR plus 225 basis points (2.25%). The cost of funds accrued on these notes includes the amortization of deal costs.
The table below illustrates the factors for the reduction in consolidated ABS interest expense.
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Change in Interest Expense Years Ended December 31, 2007 vs. December 31, 2006 | ||||||||||||
(In Thousands) | Volume | Rate | Total Change | |||||||||
Interest expense on ABS | $ | (124,986 | ) | $ | 34,496 | $ | (90,490 | ) | ||||
Interest expense on Redwood debt | 32,141 | (1,948 | ) | 30,193 | ||||||||
Interest expense on subordinated notes | 9,635 | 720 | 10,355 | |||||||||
Total Interest Expense on Total Obligation | $ | (83,210 | ) | $ | 33,268 | $ | (49,942 | ) |
Note: Volume change is the change in average balance of obligations between periods multiplied by the rate paid in the earlier period. Rate change is the change in rate between periods multiplied by the average outstanding obligations in the current period. Interest expense changes that resulted from changes in both rate and volume were allocated to the rate change amounts shown in the table.
The table below presents the different components of our interest costs on ABS issued for 2007 and 2006. ABS issuance premiums are created when ABS are issued at prices greater than principal value, such as interest-only securities (IOs).
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Year Ended December 31, | ||||||||
(Dollars in Thousands) | 2007 | 2006 | ||||||
ABS issued interest expense | $ | 575,363 | $ | 667,061 | ||||
ABS issued issuance expense amortization | 22,009 | 25,669 | ||||||
Net ABS issued interest rate agreement income | (8,228 | ) | (12,472 | ) | ||||
Net ABS issued issuance premium income amortization | (8,189 | ) | (8,813 | ) | ||||
Total ABS Issued Interest Expense | $ | 580,955 | $ | 671,445 | ||||
Average balance of ABS issued | $ | 10,171,192 | $ | 12,497,551 | ||||
ABS issued interest expense | 5.66 | % | 5.34 | % | ||||
ABS issued issuance expense amortization | 0.21 | % | 0.21 | % | ||||
Net ABS issued interest rate agreement income | (0.08 | )% | (0.10 | )% | ||||
Net ABS issued issuance premium income amortization | (0.08 | )% | (0.07 | )% | ||||
Cost of Funds of ABS Issued | 5.71 | % | 5.38 | % |
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Components of our operating expenses for 2007 and 2006 are presented in the table below.
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Year Ended December 31, | ||||||||
(In Thousands) | 2007 | 2006 | ||||||
Fixed compensation expense | $ | 17,779 | $ | 13,871 | ||||
Variable compensation expense | 1,787 | 7,709 | ||||||
Equity compensation expense | 12,249 | 11,498 | ||||||
Severance expense | 3,720 | | ||||||
Total compensation expense | 35,535 | 33,078 | ||||||
Systems | 9,547 | 7,947 | ||||||
Due diligence | 1,080 | 4,035 | ||||||
Office costs | 5,200 | 4,278 | ||||||
Accounting and legal | 3,674 | 3,533 | ||||||
Other operating expenses | 3,519 | 3,054 | ||||||
Total Operating Expenses | $ | 58,555 | $ | 55,925 |
Total operating expenses were $59 million for 2007, an increase of $3 million from 2006. The primary reason was an increase in compensation expense, although the various components of this expense either increased and decreased from last years levels. There was severance expense as part of a realignment of residential and commercial operations in 2007 and no such expense in 2006. Fixed compensation expense includes employee salaries and related employee benefits. Our average headcount increased 20% in 2007 over 2006 levels and combined with salary increases in 2007 accounts for the 30% year over year increase in the fixed compensation. Variable compensation expense was significantly lower in 2007. Variable compensation expense includes employee bonuses which are based on the annual adjusted return on equity earned by Redwood and individual performance. The adjusted return on equity was below that required for company performance bonuses, to be earned in 2007. Equity compensation expense includes the cost of equity awards granted to employees and directors over the vesting period.
Non-compensation expenses were relatively the same in 2007 as in 2006. The ongoing office and system related costs were in line with our staffing growth. These increases were offset by a decrease in due diligence expenses as our acquisition activity was lower in 2007.
Total realized gains on sales and calls were lower for 2007 compared to 2006. The primary reason was the fact that prices on securities fell throughout 2007 and, as a result, we did not choose to exercise our call rights on eligible Acacia entities. In 2006, we called three Acacias, sold the underlying assets and recognized gains after paying back the related debt. Early in 2007, we called one Acacia and generated some gains. As prices on securities fell in the second half of 2007, the liquidity in the market also became restricted. Early in the second half of 2007, we decided to sell most of our AAA-rated securities funded with debt and did so at a loss, further contributing to the disparity in net (losses) gains on sales between 2007 and 2006.
In the second half of 2007, we acquired a few Acacia ABS at discounts relative to the issued price. Under GAAP accounting, these transactions generated a $13 million gain which was the difference between our purchase price ($16 million) and the outstanding amortized principal balance of the ABS acquired ($29 million).
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The table below provides detail of the net realized gains on sales and calls for 2007 and 2006.
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Year Ended December 31, | ||||||||
(In Thousands) | 2007 | 2006 | ||||||
Realized gains (losses) on sales of: |
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Real estate loans | $ | 678 | $ | (14 | ) | |||
Real estate securities | (6,147 | ) | 11,205 | |||||
Interest rate agreements | 439 | 8,386 | ||||||
Total (losses) gains on sales | (5,030 | ) | 19,577 | |||||
Total gains on repurchase of Acacia ABS | 12,500 | | ||||||
Total gains on calls of residential CES | 5,311 | 2,980 | ||||||
Total Realized Gains on Sales and Calls, Net | $ | 12,781 | $ | 22,557 |
Market valuation adjustments reflect those changes in fair values of assets that we recognize through our income statement. These include changes in the fair value of our trading instruments (other real estate investments, non-real estate investments, credit default swaps, and certain interest rate agreements), the write-downs of assets that are impaired under the provisions of EITF 99-20, EITF 03-01, and SAB 59 and the change in the value of our purchase commitments.
The table below provides the components of realized valuation adjustments for 2007 and 2006. Other than certain interest rate agreements, we did not have any assets accounted for as trading instruments in 2006.
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Year Ended December 31, | ||||||||
(In Thousands) | 2007 | 2006 | ||||||
Changes in fair value of trading instruments |
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Other real estate investments |
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Residuals | $ | (15,223 | ) | $ | | |||
NIMs | (9,436 | ) | | |||||
IOs | 1,050 | | ||||||
Total other real estate investments | (23,609 | ) | | |||||
Derivative financial instruments | ||||||||
Credit default swaps | (54,113 | ) | | |||||
Interest rate agreements | (4,112 | ) | (5,731 | ) | ||||
Purchase commitments | (1,119 | ) | (24 | ) | ||||
Total changes in derivative financial instruments | (59,344 | ) | (5,755 | ) | ||||
Total changes in fair value of trading instruments | (82,953 | ) | (5,755 | ) | ||||
Lower of cost or market adjustments on real estate loans | (2,978 | ) | | |||||
Other than temporary impairments | (1,175,518 | ) | (6,831 | ) | ||||
Total Market Valuation Adjustments, Net | $ | (1,261,449 | ) | $ | (12,586 | ) |
Our portfolio of other real estate investments (OREI) accounted for as trading instruments was $12 million at December 31, 2007. We did not own any OREI at December 31, 2006. Due to the implementation of a new accounting standard, Statement of Financial Accounting Standards No. 155, Accounting for Certain Hybrid Financial Investments (FAS 155) in the first quarter of 2007, we elected at the end of the first quarter to classify certain securities (IOs, NIMs, and residuals) that contain embedded derivatives as trading instruments. Under previous GAAP guidance, we had classified these securities as available-for-sale (AFS). The fair value of these OREI declined in 2007 by $24 million as spreads widened considerably as a result of the dislocation of the residential mortgage-backed securities market.
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Credit default swaps held in our Acacia securitizations are derivatives and accounted for as trading instruments. The fair value of these credit default swaps decreased $54 million in 2007 as spreads widened out and prices fell on the underlying securities that these credit default swaps referenced.
The fair values of those interest rate agreements accounted for as trading instruments decreased by $4 million during 2007. All changes in fair values, whether positive or negative, of these particular interest rate agreements are recognized through the income statement. We use interest rate agreements to manage our interest rate risks. The changes in the fair value of the hedged asset or liability may not be reported through our income statement. Consequently, our use of interest rate agreements accounted for as trading instruments, could lead to volatile reported earnings even when they are accomplishing the goal of hedging some of our interest rate risks.
We recorded negative $3 million of market valuation adjustments on our held-for-sale residential real estate loans during 2007 as these are reported on our balance sheet at the lower of cost of market (LOCOM). Once transferred from held-for-investment to held-for-sale the loans are required to be revalued quarterly and recorded at LOCOM. Write-downs to current market value once in the held-for-sale category are recorded through the income statement. We had no held-for-sale loans during 2006.
For accounting purposes, securities are deemed impaired if the fair value is below amortized cost. An assessment is then required as to whether the impairment is temporary and is reflected as unrealized losses in the balance sheet, or is other-than-temporary and realized through the income statement as market valuation adjustments. The assessment of other-than-temporary impairments requires a determination of whether there has been an adverse change in the underlying cash flows generated by a security, whether we have the intent and ability to hold the security, and whether we believe the impaired security will recover its value within a reasonable period of time. This is a highly complex and subjective evaluation.
Based on our assessment, we recorded $1.2 billion of other-than-temporary impairments through our income statement in 2007 with $1.1 billion of this amount recorded in the fourth quarter. The majority of these fourth quarter impairments (over 70%) were due to our assessment that the values of many types of securities would not recover within a reasonable period of time.
Most of our real estate securities are accounted for as AFS and are reported on our consolidated balance sheets at fair value. Many of our derivative instruments are accounted for as cash flow hedges and are also reported on our consolidated balance sheets at fair value. The differences between the value of these assets and our amortized cost are shown as a component of stockholders equity as accumulated other comprehensive (loss) income. Periodic changes in the fair value of these assets relative to amortized cost are included in other comprehensive (loss) income.
As a result of the spread widening on real estate securities that occurred during 2007, the fair value adjustments recorded on our consolidated balance sheet on AFS assets was negative $1.4 billion. The table below provides the change during 2007 and cumulative balances of unrealized gains and losses and carrying value by type of real estate securities and by IGS and CES at December 31, 2007 and 2006.
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Cumulative Unrealized (Loss) Gain |
Change in (Loss) Gain | Carrying Value | ||||||||||||||||||
(In Thousands) | December 31, 2007 | December 31, 2006 | Year Ended December 31, 2007 |
December 31, 2007 | December 31, 2006 | |||||||||||||||
Investment Grade Securities |
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Residential | $ | (240,538 | ) | $ | 5,025 | $ | (245,563 | ) | $ | 1,157,464 | $ | 1,697,250 | ||||||||
Commercial | (20,229 | ) | 111 | (20,340 | ) | 89,676 | 119,613 | |||||||||||||
CDO | (12,750 | ) | 2,174 | (14,924 | ) | 113,619 | 224,349 | |||||||||||||
Total IGS | (273,517 | ) | 7,310 | (280,827 | ) | 1,360,759 | 2,041,212 | |||||||||||||
Credit Enhancement Securities |
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Residential | (143,510 | ) | 58,015 | (201,525 | ) | 401,945 | 721,531 | |||||||||||||
Commercial | (124,948 | ) | 21,081 | (146,029 | ) | 336,835 | 448,060 | |||||||||||||
CDO | 822 | 122 | 700 | 10,541 | 21,964 | |||||||||||||||
Total CES | (267,636 | ) | 79,218 | (346,854 | ) | 749,321 | 1,191,555 | |||||||||||||
Total Real Estate Securities | $ | (541,153 | ) | $ | 86,528 | $ | (627,681 | ) | $ | 2,110,080 | $ | 3,232,767 | ||||||||
Tax effect of unrealized gains in prior periods | 343 | |||||||||||||||||||
Total Other Comprehensive (Loss) Income on Real Estate Securities | $ | (627,338 | ) |
There is no net tax effect of unrealized losses at December 31, 2007 as a result of an offsetting valuation allowance of $12 million against a deferred tax asset of $12 million, both recorded through other comprehensive (loss) income. See the discussion in Note 15 for a further explanation of deferred tax assets.
The change in the fair market valuation adjustment recorded on the balance sheet of our interest rate agreements was negative $40 million.
As a REIT, we are able to pass through substantially all of our earnings generated at our REIT to stockholders without paying income tax at the corporate level. We pay income tax on the REIT taxable income we retain and on the income we earn at our taxable subsidiaries.
Our income tax provision in 2007 was $5 million, a decrease from the $10 million income tax provision recorded in 2006, primarily due to a decline in net income, particularly at our taxable subsidiaries.
In 2007, we earned an estimated $164 million of total taxable income, or $5.79 per share. Of this amount, $161 million was earned at the REIT and $3 million was earned at our taxable subsidiaries. Total taxable income is not a measure calculated in accordance with GAAP; it is the pre-tax income calculated for tax purposes. REIT taxable income is that portion of our taxable income that we earn at Redwood Trust and its qualifying REIT subsidiaries and does not include taxable income earned in taxable subsidiaries. Estimated REIT taxable income is an important measure as it is the basis of our required dividend distributions to stockholders.
Taxable income calculations differ from GAAP income calculations in a variety of ways. The most significant differences include the timing of amortization of premium and discounts and the timing of the recognition of gains or losses on assets. The rules for both GAAP and tax accounting for loans and securities are technical and complicated and the impact of changing interest rates, actual and projected prepayment rates, and actual and projected credit losses can have a very different impact on the amount of GAAP and tax income recognized in any one period. See the discussions under Potential GAAP Earnings Volatility and Potential Tax Earnings Volatility below for further information on this topic.
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Total estimated taxable income of $164 million was less than the $175 million earned in 2006 by $11 million. This decrease was the result of an increase in credit losses on CES of $7 million, $10 million in write-offs of interest-only certificates resulting from the call of Sequoia securitizations, $4 million of losses on commercial assets, and lower gains of $2 million from sales and calls. These decreases were partially offset by lower equity compensation expenses of $8 million in 2007.
The table below reconciles GAAP income to total taxable income for 2007 and 2006.
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Year Ended December 31, | ||||||||
(In Thousands, Except Per Share Data) | 2007 | 2006 | ||||||
GAAP net (loss) income | $ | (1,108,637 | ) | $ | 127,532 | |||
Difference in taxable income calculations | ||||||||
Amortization and credit losses | 16,811 | 44,016 | ||||||
Operating expense differences | 2,695 | (8,218 | ) | |||||
Realized gains on calls and sales | (10,797 | ) | (7,952 | ) | ||||
Market valuation adjustments, net | 1,261,449 | 12,586 | ||||||
Income tax provisions | 2,874 | 7,090 | ||||||
Total differences in GAAP/tax income | 1,273,032 | 47,522 | ||||||
Taxable Income | $ | 164,395 | $ | 175,054 | ||||
Shares used for taxable EPS calculations | 28,392 | 25,934 | ||||||
Total Taxable Income Per Share | $ | 5.79 | $ | 6.75 |
Our taxable income estimates are based on a number of assumptions regarding future events. To the extent such events do not occur, or other events occur which we have not anticipated, our quarterly estimates could change and could be significantly different quarter over quarter. See the discussion in Potential Tax Income Volatility below.
Our board of directors declared regular dividends of $0.75 per share for each of the four quarters of 2007 and a 2007 special dividend of $2.00 per share. As in the past few years, we permanently retained 10% of our 2007 taxable REIT income and deferred the distribution of a portion of our taxable REIT income to shareholders into the subsequent year. At December 31, 2007, there was $49 million ($1.52 per share) of 2007 undistributed estimated REIT taxable income that we plan to distribute to our shareholders during the first two quarters of 2008.
We continue to be in compliance with all REIT tests. We generally attempt to avoid acquiring assets or structuring financings or sales at the REIT that could generate unrelated business taxable income or excess inclusion income that would be distributed to our shareholders or that would cause prohibited transaction taxes on the REIT. There can be no assurance that we will be successful in doing so.
We expect quarter-to-quarter GAAP earnings volatility for a variety of reasons, including the timing of sales and calls of assets, changes in interest rates, prepayments, credit losses, changes in fair values of assets and liabilities, and capital utilization. In addition, volatility may occur because of technical accounting issues, some of which are described below.
Our unamortized loan premium on our consolidated residential real estate loans at December 31, 2007 was $86 million. This will be expensed over the remaining life of these loans. Amortization for a significant portion of this premium balance is driven by effective yield calculations that depend on interest rates and prepayments (see Critical Accounting Policies for further details). Loan premium amortization was $38 million and $49 million in 2007 and 2006, respectively. Declines in short-term interest rates and increases in prepayments could cause a significant increase in required amortization in subsequent periods.
In addition, premium amortization expense acceleration could occur if we reclassify a portion of the underlying loans from held-for-investment to held-for-sale, as the GAAP carrying value of these loans is
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currently in excess of their fair value. This reclassification could occur as the various underlying pools of loans become callable and we decide to sell these loans, or it could occur if there is a change in accounting principles.
Currently, all of our IGS and CES are classified as AFS and are carried on our consolidated balance sheets at their estimated fair values. Cumulative unrealized gains and losses are reported as a component of accumulated other comprehensive (loss) income in our consolidated statements of stockholders equity. However, adverse changes to projected cash flows related to poor credit performance, adverse changes to prepayment speeds, or our decision to sell assets could create an other-than-temporary impairment for accounting purposes and could cause declines in fair values to be reported through our income statement as market valuation adjustments.
At December 31, 2007 we had $2.1 billion of securities on our consolidated balance sheet. Of these, $226 million were backed by subprime loans ($10 million of CES and $216 million of IGS) and $527 million were backed by option ARMs ($85 million of prime CES, $197 million of prime IGS, $67 million of alt-a CES, and $178 million alt-a IGS). In the event future credit performance on our CES securities is worse than our current projections, we would be required to report losses through our income statement. See the Financial Condition discussion later in this document for further detail on these securities.
As of January 1, 2008 we elected the fair value option under FAS 159 for the consolidated assets and liabilities of Acacia. See below for a discussion on the potential impact to GAAP earnings of this election.
Other real estate investments (IOs, NIMs, and residuals) typically contain embedded derivatives that require bifurcation and separate valuation through the income statement under FAS 155. We have elected to treat these investments as trading instruments rather than bifurcate the embedded derivative component. Trading instruments are required to be reported on our consolidated balance sheet at their estimated fair values with changes in fair values reported through our consolidated statements of income (loss) through market valuation adjustment. Marking to market the security rather than just the embedded derivative component will likely increase GAAP earnings volatility going forward. Under previous GAAP guidance, we classified these securities as AFS. We may classify other assets as trading instruments or may elect the fair value option under FAS 159 for certain of our future acquisitions (see below).
To date, we have elected two classifications for derivative instruments: trading instruments and cash flow hedges. All derivative instruments, regardless of classification, are reported on our consolidated balance sheets at fair value. Changes to the fair values of the derivatives classified as trading instruments are recognized through the consolidated statements of income (loss). For those derivatives accounted for as cash flow hedges, the changes in fair values are reported through our consolidated balance sheets with only the ineffective portions (as determined according to the accounting provisions) reported through our income statement.
We could experience significant earnings volatility from our use of derivatives. This could occur, for example, when changes in the fair values of the derivatives are reported through our income statement but changes in the fair values in the hedged assets or liabilities are not recognized in a similar manner. Earnings volatility could also occur as we expand our use of derivatives (including acquiring derivatives as investments and not just as hedging instruments).
As of January 1, 2008 we elected the fair value option for all assets, derivatives, and liabilities in Acacia and we also plan to elect the fair value option for certain new acquisitions. See the Critical Accounting Policy section for a discussion of the potential impact of this election under FAS 159.
These fair value option elections under FAS 159 could lead to further GAAP volatility as we will now mark-to-market through the income statement each quarter all of the assets and liabilities of Acacia and certain other assets and liabilities. The market value of even paired assets and liabilities may not move in tandem in any one quarter. Thus, even if the liabilities can only be paid from the cash flows of the collateral assets (as in the Acacia securitization entities), we may report significant income or loss in a period.
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Taxable income may vary from quarter to quarter based on many reasons, three of which are discussed below.
To determine taxable income we are not permitted to anticipate, or reserve for, credit losses. Taxable income can only be reduced when credit losses occur. As a consequence, we are required to accrete the entire purchase discount on CES into taxable income over their expected life. For GAAP purposes, we do anticipate credit losses and only accrete a portion of the purchase discount into income. Additionally, for GAAP we write-down these securities when they become impaired. As a result, our income recognition on CES is faster for tax as compared to GAAP, especially in the early years of owning the assets (when there are generally few credit losses). At December 31, 2007, the cumulative difference between the GAAP and tax amortized costs basis of our residential, commercial, and CDO CES was $242 million. In addition, as of December 31, 2007, we had a credit reserve of $18 million for GAAP on our residential and commercial loans, and we recorded a $3 million write-down on a commercial loan for tax. As of December 31, 2007, we had an $8 million reserve for accrued interest on securities backed by option ARMs for GAAP and no corresponding reserve on this income for tax. As we have no credit reserves for tax and a higher CES basis, any future credit losses on our CES or loans would have a more significant impact on tax earnings as compared to GAAP and may create significant taxable income volatility to the extent the level of credit losses varies during periods.
As a result of rapid prepayments, we are experiencing negative economic returns on some IOs we acquired from prior Sequoia securitizations. For tax purposes, however, we are not permitted to recognize a negative yield, so premium amortization expenses for tax have not been as high as they otherwise would have been based on the economic returns. As a result, our current tax basis of $75 million on these IOs is higher than the fair value. Many of our Sequoia securitization entities are currently callable and others will become callable over the next two years. Depending on prevailing market conditions, we may call certain securitizations, at which time the IO tax basis at that time will be written off and an ordinary loss for tax will be realized. The actual losses will depend on the tax basis at the time of any calls as the monthly cash flows received on these IOs in the interim will reduce their tax basis. At this time, we do not anticipate calling any Sequoia deals in 2008. Our taxable earnings will vary from period to period based on the exact timing of these Sequoia calls.
Compensation expense for tax varies depending on the timing of dividend equivalent rights payments, the exercise of stock options, the distribution of deferred stock units, and deferrals to and withdrawals from our executive deferred compensation plan. For the most part, for GAAP, the total expense associated with an award is determined at the award date and is recognized over the vesting period. For tax, the expense is recognized at the date of distribution or exercise. This leads to the possibility that the total expense related to equity awards could be significantly different for GAAP than for tax in addition to the differences in timing.
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Our reported GAAP net income was $128 million ($4.85 per share) for 2006. Our GAAP net income was $200 million ($7.96 per share) in 2005 and was $233 million ($10.47 per share) in 2004. Our GAAP return on equity was 13% for 2006 compared to 21% for 2005 and 32% for 2004. In 2006, we declared four regular quarterly dividends of $0.70 per share and a special dividend of $3.00 per share.
The largest factor in the decline in net income for 2006 as compared to 2005 was a $43 million drop in income from gains generated on the sale and call of assets. In 2005, we sold a significant amount of CES as part of a portfolio management strategy to reduce our level of residential credit risk and to free up capital. We also benefited from a large number of calls of securities in 2005. Another factor contributing to the decline in earnings was a decrease in net interest income of $21 million primarily due to high prepayments on adjustable-rate loans securitized under our Sequoia program. This decline was partially offset by an increase in yields from our securities portfolio (primarily residential CES). Other factors include an increase of operating expenses of $8 million and an increase in negative mark-to-market valuation adjustments of $8 million primarily related to interest rate agreements. The assets associated with these interest rate agreements generally increased in value, but those increases were not recognized in GAAP income. These items were partially offset by a decrease in the tax provision of $8 million due to a decrease in net income.
In 2006, we raised $66 million of capital through the sale of common stock via our direct stock purchase plan and we raised $100 million of capital from the sale of trust preferred securities. Additionally, we freed up $97 million of capital for investment by selling and re-securitizing a portion of our CES. We absorbed all of this capital in 2006, primarily through new investments in commercial and residential CES and investment-grade securities. At year end 2006, we had $182 million of excess capital, $7 million less than at the beginning of the year.
At 2006 year-end, we had over $2 billion of residential and commercial securities funded through our Acacia CDO program.
We owned $518 million subprime investment-grade securities at year-end 2006 and most of them were financed via Acacia CDO securitization. Over 90% of these securities were rated BBB+ or higher. We owned $44 million of 2006 subprime BBB- and BBB securities at year-end 2006.
Total interest income consists of interest earned on consolidated earning assets, adjusted for amortization of discounts and premiums and provisions for loan credit losses. The table below summarizes interest income earned on real estate loans, securities, and cash.
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Year Ended December 31, | ||||||||||||||||||||||||||||||||
2006 | 2005 | |||||||||||||||||||||||||||||||
(Dollars in Thousands) | Interest Income | Percent of Total Interest Income | Average Amortized Cost |
Yield | Interest Income | Percent of Total Interest Income | Average Amortized Cost |
Yield | ||||||||||||||||||||||||
Real estate loans, net of provision for credit losses | $ | 608,868 | 68.78 | % | $ | 10,652,094 | 5.72 | % | $ | 779,469 | 81.01 | % | $ | 18,694,028 | 4.17 | % | ||||||||||||||||
Real estate securities | 265,353 | 29.98 | % | 2,612,934 | 10.15 | % | 177,524 | 18.45 | % | 2,173,295 | 8.17 | % | ||||||||||||||||||||
Other real estate investments | | | | | | | | | ||||||||||||||||||||||||
Non-real estate investments | | | | | | | | | ||||||||||||||||||||||||
Cash and cash equivalents | 10,939 | 1.24 | % | 268,340 | 4.08 | % | 5,204 | 0.54 | % | 181,259 | 2.87 | % | ||||||||||||||||||||
Total Interest Income | $ | 885,160 | 100.00 | % | $ | 13,533,368 | 6.54 | % | $ | 962,197 | 100.00 | % | $ | 21,048,582 | 4.57 | % |
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The table below details how our interest income changed by portfolio as a result of changes in consolidated asset balances (volume) and yield (rate) for 2006 as compared to 2005.
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Change in Interest Income Years Ended December 31, 2006 Versus December 31, 2005 | ||||||||||||
(In Thousands) | Volume | Rate | Total Change | |||||||||
Real estate loans, net of provisions for credit losses | $ | (335,318 | ) | $ | 164,717 | $ | (170,601 | ) | ||||
Real estate securities | 35,912 | 51,917 | 87,829 | |||||||||
Other real estate investments | | | | |||||||||
Non-real estate investments | | | | |||||||||
Cash and cash equivalents | 2,526 | 3,209 | 5,735 | |||||||||
Total Interest Income | $ | (296,880 | ) | $ | 219,843 | $ | (77,037 | ) |
Volume change is the change in average portfolio balance between periods multiplied by the rate earned in the earlier period. Rate change is the change in rate between periods multiplied by the average portfolio balance in the prior period. Interest income changes that result from changes in both rate and volume were allocated to the rate change amounts shown in the table.
A further breakdown and discussion of the year over year changes for the real estate loan, real estate securities, and cash components of interest income follows below.
The following table provides detail on interest income earned on our residential and commercial real estate loan portfolios for 2006 and 2005.
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Year Ended December 31, 2006 | Yield as a Result of | |||||||||||||||||||||||||||||||
(Dollars in Thousands) | Interest Income | < |