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



 

FORM 10-Q



 

 
x   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended: June 30, 2008

OR

 
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period from  to 

Commission File Number 1-13759



 

REDWOOD TRUST, INC.

(Exact Name of Registrant as Specified in Its Charter)



 

 
Maryland   68-0329422
(State or Other Jurisdiction
of Incorporation or Organization)
  (I.R.S. Employer
Identification No.)

One Belvedere Place, Suite 300
Mill Valley, California 94941

(Address of Principal Executive Offices) (Zip Code)

(415) 389-7373

(Registrant’s Telephone Number, Including Area Code)



 

Securities registered pursuant to Section 12(g) of the Act:

   
  Title of Each Class:   Name of Exchange on Which Registered:
     Common Stock, par value $0.01 per share   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

   
Large Accelerated Filer x   Accelerated Filer o   Non-Accelerated Filer o

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

Indicate the number of shares outstanding of each of the issuer’s classes of stock, as of the last practicable date.

 
Common Stock, $0.01 par value per share   33,575,409 as of August 5, 2008
 

 


TABLE OF CONTENTS

REDWOOD TRUST, INC.
  
2008 FORM 10-Q REPORT
  
TABLE OF CONTENTS

 
  Page
PART I
 

Item 1.

Financial Statements

        
Consolidated Balance Sheets at June 30, 2008 (Unaudited) and December 31, 2007     1  
Consolidated Statements of (Loss) Income for the Three and Six Months Ended June 30, 2008 and 2007 (Unaudited)     2  
Consolidated Statements of Comprehensive Loss for the Three and Six Months Ended June 30, 2008 and 2007 (Unaudited)     3  
Consolidated Statements of Stockholders’ Equity (Deficit) for the Six Months Ended June 30, 2008 and 2007 (Unaudited)     4  
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2008 and
2007 (Unaudited)
    5  
Notes to Consolidated Financial Statements     6  

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

    44  

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

    91  

Item 4.

Controls and Procedures

    91  
PART II
        

Item 1.

Legal Proceedings

    92  

Item 1A.

Risk Factors

    92  

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

    92  

Item 3.

Defaults upon Senior Securities

    92  

Item 4.

Submission of Matters to a Vote of Security Holders

    92  

Item 5.

Other Information

    93  

Item 6.

Exhibits

    93  
Signatures     94  

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TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

   
(In Thousands, Except Share Data)
(Unaudited)
  June 30,
2008
  December 31,
2007
ASSETS
                 
Real estate loans   $ 6,376,718     $ 7,204,151  
Real estate securities, at fair value:
                 
Trading securities     841,868       11,521  
Available-for-sale securities     399,759       2,110,080  
Total real estate securities     1,241,627       2,121,601  
Other investments     78,583       79,125  
Cash and cash equivalents     147,639       290,363  
Total earning assets     7,844,567       9,695,240  
Restricted cash     102,171       118,064  
Accrued interest receivable     40,948       45,553  
Derivative assets     4,914       5,598  
Deferred tax asset     8,087       8,875  
Deferred asset-backed securities issuance costs     14,339       39,909  
Other assets     30,910       25,233  
Total Assets   $ 8,045,936     $ 9,938,472  
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
                 
Liabilities
                 
Short-term debt – Redwood   $ 9,326     $ 7,561  
Asset-backed securities issued – Sequoia     6,174,571       6,946,166  
Asset-backed securities issued – Acacia     935,072       3,383,113  
Accrued interest payable     32,237       53,796  
Derivative liabilities     100,396       81,385  
Accrued expenses and other liabilities     8,866       10,441  
Dividends payable     24,887       24,289  
Long-term debt – Redwood     150,000       150,000  
Total liabilities     7,435,355       10,656,751  
Minority interest     46,583        
Stockholders’ Equity (Deficit)
                 
Common stock, par value $0.01 per share, 75,000,000 and 50,000,000 shares authorized; 33,184,317 and 32,385,073 issued and outstanding     334       324  
Additional paid-in capital     1,139,666       1,108,148  
Accumulated other comprehensive loss     (64,143 )      (573,766 ) 
Cumulative earnings (losses)     492,949       (299,626 ) 
Cumulative distributions to stockholders     (1,004,808 )      (953,359 ) 
Total stockholders’ equity (deficit)     563,998       (718,279 ) 
Total Liabilities and Stockholders’ Equity (Deficit)   $ 8,045,936     $ 9,938,472  

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TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
CONSOLIDATED STATEMENTS OF (LOSS) INCOME

       
(In Thousands, Except Share Data)
(Unaudited)
  Three Months Ended June 30,   Six Months Ended June 30,
  2008   2007   2008   2007
Interest Income
                                   
Real estate loans   $ 62,702     $ 119,576     $ 150,267     $ 246,427  
Real estate securities     61,529       95,862       138,057       181,785  
Other investments     514       464       1,246       464  
Cash and cash equivalents     2,196       3,756       5,377       6,088  
Total interest income     126,941       219,658       294,947       434,764  
Management fees     1,319       1,481       2,932       2,649  
Interest Expense
                                   
Short-term debt – Redwood     (68 )      (22,700 )      (250 )      (53,794 ) 
Asset-backed securities issued     (96,525 )      (142,022 )      (222,722 )      (278,136 ) 
Long-term debt – Redwood     (2,233 )      (2,516 )      (4,766 )      (4,572 ) 
Total interest expense     (98,826 )      (167,238 )      (227,738 )      (336,502 ) 
Net Interest Income Before Market Valuation Adjustments     29,434       53,901       70,141       100,911  
Market valuation adjustments, net     (60,619 )      (29,430 )      (254,551 )      (39,694 ) 
Net Interest (Loss) Income     (31,185 )      24,471       (184,410 )      61,217  
Operating expenses     (14,255 )      (12,772 )      (30,604 )      (30,554 ) 
Realized gains on sales and calls, net     2,837       2,738       2,879       3,884  
Minority interest allocation     (2,369 )            (2,624 )       
Net (loss) income before provision for income taxes     (44,972 )      14,437       (214,759 )      34,547  
Provision for income taxes     (937 )      (3,021 )      (2,737 )      (4,822 ) 
Net (Loss) Income   $ (45,909 )    $ 11,416     $ (217,496 )    $ 29,725  
Basic (loss) earnings per share:   $ (1.40 )    $ 0.42     $ (6.65 )    $ 1.10  
Diluted (loss) earnings per share:   $ (1.40 )    $ 0.41     $ (6.65 )    $ 1.06  
Total dividends declared per
common share
  $ 0.75     $ 0.75     $ 1.50     $ 1.50  
Basic weighted average shares
outstanding
    32,871,442       27,405,284       32,691,444       27,132,001  
Diluted weighted average shares outstanding     32,871,442       28,164,944       32,691,444       27,917,502  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

       
(In Thousands)
(Unaudited)
  Three Months Ended June 30,   Six Months Ended June 30,
  2008   2007   2008   2007
Net (Loss) Income   $ (45,909 )    $ 11,416     $ (217,496 )    $ 29,725  
Other Comprehensive Income (Loss)
                                   
Net unrealized gains (losses) on available-for-sale securities     9,152       (101,745 )      (43,120 )      (194,430 ) 
Reclassification adjustment for net losses included in net (loss) income     18,750       7,058       92,044       6,945  
Unrealized gains on cash flow hedges, net           19,952             13,814  
Reclassification of net realized cash flow hedge losses (gains) to interest expense on asset-backed securities issued and realized losses (gains) on sales and calls     1,246       5       2,492       (400 ) 
Total Other Comprehensive Income (Loss)     29,148       (74,730 )      51,416       (174,071 ) 
Comprehensive Loss   $ (16,761 )    $ (63,314 )    $ (166,080 )    $ (144,346 ) 

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
  

For the Six Months Ended June 30, 2008

             
(In Thousands, Except Share Data)
(Unaudited)
  Common Stock   Additional Paid-in Capital   Accumulated Other
Comprehensive (Loss) Income
  Cumulative (Losses) Earnings   Cumulative Distributions to Stockholders   Total
  Shares   Amount
December 31, 2007     32,385,073     $ 324     $ 1,108,148     $ (573,766 )    $ (299,626 )    $ (953,359 )    $ (718,279 ) 
Net loss                                (217,496 )            (217,496 ) 
Adoption of SFAS No. 159                       458,207       1,010,071             1,468,278  
Net unrealized gain/reclassification on assets AFS                       48,924                   48,924  
Net unrealized gain/reclassification on interest rate agreements                       2,492                   2,492  
Issuance of common stock:
                                                              
Dividend reinvestment & stock purchase plans     722,431       10       23,505                         23,515  
Employee option & stock purchase plan     76,813             975                         975  
Non-cash equity award compensation                       7,038                         7,038  
Common dividends declared                                            (51,449 )      (51,449 ) 
June 30, 2008     33,184,317     $ 334     $ 1,139,666     $ (64,143 )    $ 492,949     $ (1,004,808 )    $ 563,998  

For the Six Months Ended June 30, 2007

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

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

   
(In Thousands)
(Unaudited)
  Six Months Ended June 30,
  2008   2007
Cash Flows from Operating Activities:
                 
Net (loss) income   $ (217,496 )    $ 29,725  
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
                 
Amortization of premiums, discounts, and debt issuance costs     (5,405 )      (32,749 ) 
Depreciation and amortization of non-financial assets     536       830  
Provision for credit losses     18,119       6,329  
Non-cash equity award compensation     7,038       8,752  
Net recognized losses and valuation adjustments     254,551       39,694  
Realized gains on sales and calls, net     (2,879 )      (3,884 ) 
Net change in:
                 
Accrued interest receivable     15,581       13,432  
Deferred income taxes     788       568  
Other assets     11,585       4,111  
Accrued interest payable     (18,302 )      (2,117 ) 
Accrued expenses and other liabilities     (1,575 )      38,683  
Net cash provided by operating activities     62,541       103,374  
Cash Flows from Investing Activities:
                 
Purchases of real estate loans held-for-investment           (1,091,496 ) 
Proceeds from sales of real estate loans held-for-investment           2,191  
Principal payments on real estate loans held-for-investment     765,293       2,025,662  
Purchases of real estate securities available-for-sale     (244,252 )      (1,011,181 ) 
Proceeds from sales of real estate securities available-for-sale     7,300       175,559  
Principal payments on real estate securities available-for-sale     41,098       160,737  
Purchases of real estate securities trading     (3,341 )      (40,818 ) 
Proceeds from sales of real estate securities trading     454       2,237  
Principal payments on real estate securities trading     100,504       7,431  
Purchases of other investments           (80,000 ) 
Principal payments on other investments     541        
Net decrease (increase) in restricted cash     15,893       (94,497 ) 
Net cash provided by investing activities     683,490       55,825  
Cash Flows from Financing Activities:
                 
Net (repayments) borrowings on short-term Redwood debt     1,765       (1,007,546 ) 
Proceeds from issuance of asset-backed securities           3,332,925  
Deferred asset-backed security issuance costs           (19,147 ) 
Repayments on asset-backed securities     (905,000 )      (2,609,157 ) 
Proceeds from issuance of long-term Redwood debt           50,000  
Net purchases of interest rate agreements     (5,743 )      (2,798 ) 
Net proceeds from issuance of common stock     24,490       52,396  
Dividends paid     (50,850 )      (41,262 ) 
Change in minority interests     46,583        
Net cash used in financing activities     (888,755 )      (244,589 ) 
Net decrease in cash and cash equivalents     (142,724 )      (85,390 ) 
Cash and cash equivalents at beginning of period     290,363       168,016  
Cash and cash equivalents at end of period   $ 147,639     $ 82,626  
Supplemental Disclosure of Cash Flow Information:
                 
Cash paid for interest   $ 243,109     $ 335,970  
Cash (received) paid for taxes   $ (1,442 )    $ 8,480  
Non-Cash Financing Activity:
                 
Dividends declared but not paid at end of period   $ 24,887     $ 20,862  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 1. Redwood Trust

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

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

Redwood was incorporated in the State of Maryland on April 11, 1994, and commenced operations on August 19, 1994. Our executive offices are located at One Belvedere Place, Suite 300, Mill Valley, California 94941.

Note 2. Basis of Presentation

The consolidated financial statements presented herein are at June 30, 2008 and December 31, 2007, and for the three and six months ended June 30, 2008 and 2007.

These consolidated financial statements have been prepared in conformity with generally accepted accounting principles in the United States (GAAP) for interim financial information and with the Securities and Exchange Commission’s (SEC) instructions to Form 10-Q and Article 10 of Regulation S-X. Results for the three and six months ended June 30, 2008, may not necessarily be indicative of the results for the year ending December 31, 2008. The unaudited interim consolidated financial statements as of June 30, 2008, should be read in conjunction with our audited consolidated financial statements and related notes included in our Annual Report on Form 10-K for the year ended December 31, 2007.

Organization

Our consolidated financial statements include the accounts of Redwood, its direct and indirect wholly-owned subsidiaries, and other entities in which we have a controlling financial interest. All significant intercompany balances and transactions have been eliminated. A number of Redwood’s consolidated subsidiaries are qualifying REIT subsidiaries and the remainder are taxable subsidiaries. References to the Redwood REIT mean Redwood and its qualifying REIT subsidiaries, excluding taxable subsidiaries.

We currently sponsor two securitization programs. Our Sequoia program is used for the securitization of residential mortgage loans. References to Sequoia refer collectively to all the Sequoia securitization entities. Our Acacia program is used for the securitization of mortgage-backed securities and other types of financial assets. References to Acacia refer collectively to all of the Acacia CDO securitization entities.

We are the asset manager and investor in an Opportunity Fund LP (the Fund) that we sponsor. The Fund primarily invests in mortgage securities.

Principles of Consolidation

Under the provisions of FASB Interpretation No. 46 (revised), Consolidation of Variable Interest Entities (FIN 46R), we are required to consolidate the assets, liabilities, and non-controlling interests of any variable interest entity (VIE) in which we are the primary beneficiary. Under this principle, the primary beneficiary is the party that absorbs the majority of the VIE's anticipated losses and/or the majority of the expected returns.

We consolidate the Acacia and Sequoia securitization entities that we sponsor, since we are the primary beneficiary in these entities and they are not considered qualifying special purpose entities under the provisions of Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (FAS 140). Accordingly, the underlying loans and

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 2. Basis of Presentation  – (continued)

securities owned by these entities are shown on our consolidated balance sheets under real estate loans and real estate securities and the asset-back securities (ABS) issued to third parties are shown on our consolidated balance sheets under ABS issued. In our consolidated statements of (loss) income, we record interest income on the loans and securities and interest expense on the ABS issued. All significant intercompany balances and transactions, including transfers or repurchases of Sequoia or Acacia ABS, have been eliminated in consolidation.

We consolidate the Fund that we sponsor, since we are the primary beneficiary in this entity. The portion of the Fund that represents the interest of third parties is shown as minority allocation on our consolidated balance sheets and the portion of income allocable to third parties is shown as other expense in our consolidated statements of (loss) income.

Note 3. Summary of Significant Accounting Policies

Use of Estimates

The preparation of financial statements in conformity with GAAP requires us to make a significant number of estimates. These include estimates of fair value of certain assets and liabilities, amount and timing of credit losses, prepayment rates, the period of time during which we anticipate an increase in the fair values of real estate securities sufficient to recover unrealized losses in those securities, and other items that affect the reported amounts of certain assets and liabilities as of the date of the consolidated financial statements and the reported amounts of certain revenues and expenses during the reported period. It is likely that changes in these estimates (e.g., market values due to changes in supply and demand, credit performance, prepayments, interest rates, or other reasons; yields due to changes in credit outlook and loan prepayments) will occur in the near term. Our estimates are inherently subjective in nature and actual results could differ from our estimates and the differences may be material.

Our financial statements include assets and liabilities that are measured based on their estimated fair values and many of these assets and liabilities are illiquid in nature. Our fair value estimates reflect what we believe we could realize if we chose to sell our assets or pay if we chose to transfer liabilities in an orderly manner. Establishing fair values for illiquid assets and liabilities is inherently subjective and is dependent upon our estimates and modeling assumptions and indications of value obtained from brokers and dealers. There is currently a wide variance of opinion related to the assumptions underpinning our market valuation inputs. We expect that the market valuations will continue to be highly volatile. Nonetheless, we believe the fair values for our assets and liabilities and other estimates used in preparation of our financial statements are in conformity with GAAP principles.

Effective January 1, 2008, we adopted two pronouncements relating to fair value measurement: Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157) and Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an amendment of FASB Statement No. 115 (FAS 159).

See Note 4 and Note 5 for further discussion on fair value estimates and these accounting principles.

Real Estate Loans

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

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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 3. Summary of Significant Accounting Policies  – (continued)

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

Residential and commercial real estate loans classified as held-for-investment are carried at their unpaid principal balances adjusted for net unamortized premiums or discounts and net of any allowance for credit losses.

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

Pursuant to Statement of Financial Accounting Standards No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Cost of Leases (FAS 91), we use the interest method to determine an effective yield and amortize the premium or discount on real estate loans held-for-investment. For loans acquired prior to July 1, 2004, we use coupon interest rates as they change over time and anticipated principal payments to determine an effective yield to amortize the premium or discount. For loans acquired after July 1, 2004, we use the initial coupon interest rate of the loans (without regard to future changes in the underlying indices) and anticipated principal payments to calculate an effective yield to amortize the premium or discount.

We may exercise our right to call ABS issued by Sequoia and may subsequently sell the underlying loans to third parties. For balance sheet purposes, we reclassify held-for-investment loans to held-for-sale loans once we determine that loans will be sold to third parties.

Real Estate Loans — Reserve for Credit Losses

For real estate loans classified as held-for-investment, we establish and maintain credit reserves based on our estimate of credit losses inherent in our loan portfolios as of the reporting date. To calculate the reserve for credit losses, we assess inherent losses by determining loss factors (defaults, the timing of defaults, and loss severities upon defaults) that can be specifically applied to each of the consolidated loans or pool of loans.

We follow the guidelines of SEC Staff Accounting Bulletin No. 102, Selected Loan Loss Allowance Methodology and Documentation (SAB 102), Statement of Financial Accounting Standards No. 5, Accounting for Contingencies (FAS 5), Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (FAS 114), and Statement of Financial Accounting Standards No. 118, Accounting by Creditors for Impairment of a Loan-Income Recognition and Disclosures (FAS 118) in setting credit reserves for our real estate loans.

We consider the following factors in making such determinations:

Ongoing analyses of loans, including, but not limited to, the age of loans, underwriting standards, business climate, economic conditions, geographical considerations, and other observable data;
Historical loss rates and past performance of similar loans;
Relevant environmental factors;
Relevant market research and publicly available third-party reference loss rates;
Trends in delinquencies and charge-offs;

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 3. Summary of Significant Accounting Policies  – (continued)

Effects and changes in credit concentrations;
Information supporting a borrower’s ability to meet obligations;
Ongoing evaluations of fair values of collateral using current appraisals and other valuations; and,
Discounted cash flow analyses.

Once we determine applicable default amounts, the timing of the defaults, and severity of losses upon defaults, we estimate expected losses for each individual loan or pool of loans over its expected life. We then estimate the timing of these losses and the losses probable to occur over an effective loss confirmation period. This period is defined as the range of time between the probable occurrence of a credit loss (such as the initial deterioration of the borrower’s financial condition) and the confirmation of that loss (the actual impairment or charge-off of the loan). The losses expected to occur within the estimated loss confirmation period are the basis of our credit reserves, because we believe those losses exist as of the reported date of the financial statements. We re-evaluate the level of our credit reserves on at least a quarterly basis, and we record provision, charge-offs, and recoveries monthly.

See Note 7 for further discussion on reserves for credit losses.

Since we do not originate real estate loans, we do not currently maintain a loan repurchase reserve, as any risk of loss due to loan repurchases (i.e., due to breach of representations) is generally covered by recourse to the companies from whom we acquired the loans.

Real Estate Securities, at Fair Value

Trading Securities

Real estate securities classified as trading include residential, commercial, and CDO securities and are carried at their estimated fair values. Coupon interest is recognized as revenue when earned and deemed collectible and changes in fair value (gains and losses) are reported through our consolidated statements of (loss) income in market valuation adjustments, net. Trading securities are primarily those securities where we have adopted the fair value option under FAS 159.

Available-for-Sale Securities

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

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

When recognizing revenue on AFS securities where credit risk is not remote, we employ the interest method as prescribed under the Emerging Issues Task Force of the Financial Accounting Standards Board 99-20, Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets (EITF 99-20) to account for purchase premiums, discounts, and fees associated with these securities. The use of this method requires us to project cash flows over the remaining life of each asset. These projections include assumptions about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. We review and make adjustments to our cash flow projections on an ongoing

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 3. Summary of Significant Accounting Policies  – (continued)

basis and monitor these projections based on input and analyses received from external sources, internal models, and our own judgment and experience. Actual maturities of the AFS securities are affected by the contractual lives of the associated mortgage collateral, periodic payments of principal, and prepayments of principal. Actual maturities of AFS securities are generally shorter than stated contractual maturities. Stated contractual maturities are generally greater than ten years. There can be no assurance that our assumptions used to estimate future cash flows or the current period’s yield for each asset would not change in the near term, and the change could be material.

Yields recognized for each security can vary as a function of credit results, prepayment rates, and interest rates. For the securities we acquire, if estimated future credit losses are less than our prior estimate, credit losses occur later than expected, or prepayment rates are faster than expected (meaning the present value of projected cash flows is greater than previously expected), the yield over the remaining life of the security may be adjusted upwards. If estimated future credit losses exceed our prior expectations, credit losses occur more quickly than expected, or prepayments occur more slowly than expected (meaning the present value of projected cash flows is less than previously expected), the yield over the remaining life of the security may be adjusted downward. In cases where the fair value of our securities is below our cost basis we may have an other-than-temporary impairment.

For determining other-than-temporary impairment on our real estate securities accounted for as AFS securities, we use the guidelines prescribed under EITF 99-20, Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (FAS 115), and SEC Staff Accounting Bulletin No. 5(m), Other-Than-Temporary Impairment for Certain Investments in Debt and Equity Securities (SAB 59). Other-than-temporary impairments are reported under market valuation adjustments, net in our consolidated statements of income (loss). We assess whether a drop in fair value below our cost of the AFS security should be deemed as other-than-temporary impairment. If there has been no adverse change in the projected future cash flows of the security, we have the ability and intent to hold the security, and we have determined that within a reasonable period of time there will likely be a recovery of fair value up to (or beyond) the amortized cost of the security, there is no other-than-temporary impairment.

Other Investments

Other investments include a guaranteed investment contract (GIC) entered into by an Acacia securitization entity that we consolidate for financial statements purposes. We elected the fair value option for this investment as of January 1, 2008. Other investments are recorded on our consolidated balance sheets at their estimated fair values. Changes in fair value are reported through our consolidated statements of (loss) income through market valuation adjustments, net.

See Note 9 for further discussion on other investments.

Cash and Cash Equivalents

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

Restricted Cash

Restricted cash includes principal and interest payments from real estate loans and securities owned by consolidated securitization entities that are collateral for, or payable to, owners of ABS issued by those entities and cash pledged as collateral on interest rate agreements. Restricted cash may also include cash retained in Acacia or Sequoia securitization entities or in the Fund prior to the purchase of loans or securities, payments on or redemption of outstanding ABS issued, or distributions to limited partners.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 3. Summary of Significant Accounting Policies  – (continued)

Accrued Interest Receivable

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

Derivative Financial Instruments

Derivative financial instruments include contractual interest rate agreements and credit default swaps (CDS). All derivative financial instruments are reported at fair value on our consolidated balance sheets, in accordance with Statement of Financial Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging Activities (FAS 133). Derivatives with a positive value to us are reported as an asset and derivatives with a negative value to us are reported as a liability. The changes in fair value of derivatives accounted for as trading instruments are reported in the consolidated statements of (loss) income through market valuation adjustments, net. Net purchases and proceeds from interest rate agreements are classified as financing activities within our consolidated statements of cash flows.

We generally enter into interest rate agreements to help manage some of our interest rate risks. Prior to 2008, we accounted for derivatives used to hedge interest rate exposure in Acacia securitization entities as cash flow hedges under FAS 133. As of January 1, 2008, all derivatives designated as cash flow hedges were de-designated as cash flow hedges and accounted for as trading instruments. Since the associated hedged items continue to exist, the fair value of cash flow hedges at the time of de-designation remains in accumulated other comprehensive loss and is being amortized using the straight line method through interest expense over the remaining lives of the Acacia ABS issued.

We may enter into CDS contracts from time to time. A CDS is an agreement to provide (receive) credit event protection based on a financial index or specific security in exchange for receiving (paying) a fixed-rate fee or premium over the term of the contract. Prior to 2008, we accounted for CDS as trading instruments under FAS 133. As of January 1, 2008, we have accounted for CDS as trading instruments under FAS 159 as they were all owned by Acacia entities. In both cases, changes in fair value of CDS are reported in the consolidated statements of (loss) income through market valuation adjustments, net.

As of each period end, we may also have outstanding commitments to purchase real estate loans. These commitments are accounted for as derivatives under Statement of Financial Accounting Standards No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities (FAS 149), and are classified as trading instruments.

See Note 10 for further discussion on derivative financial instruments.

Deferred Tax Assets

Income recognition for GAAP and tax differ in material respects. As a result, we may recognize taxable income in periods prior to or later than when we recognize income for GAAP. When this occurs, we pay the tax liability and establish a deferred tax asset for GAAP. When the income is subsequently realized in future periods under GAAP, the deferred tax asset is recognized as an expense. Our deferred tax assets are generated by differences in GAAP and taxable income at our taxable subsidiaries. GAAP and tax differences at the REIT may create additional deferred tax assets or liabilities to the extent we do not distribute all of our taxable income.

See Note 20 for further discussion of taxes.

Deferred Asset-Backed Securities Issuance Costs

Asset-backed securities (ABS) issuance costs are costs associated with the issuance of ABS from securitization entities we sponsor. These costs typically include underwriting, rating agency, legal, accounting,

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 3. Summary of Significant Accounting Policies  – (continued)

and other fees. ABS issuance costs associated with liabilities accounted for under the fair value option are expensed as incurred. ABS issuance costs associated with liabilities reported at cost are deferred. Deferred ABS issuance costs are reported on our consolidated balance sheets as deferred charges and are amortized as an adjustment to interest expense using the interest method, based upon the actual and estimated repayment schedules of the related ABS issued under the principles prescribed in Accounting Practice Bulletin 21, Interest on Receivables and Payables (APB 21). Sequoia deferred ABS issuance costs are reporting in accordance with APB 21. As of January 1, 2008, the deferred issuance costs associated with Acacia were included in the fair value of ABS issued by Acacia and were accounted for under FAS 159. As a result, these costs were included in our one-time adjustment upon the adoption of FAS 159 and were reclassified into retained earnings.

See Note 4 for further discussion on FAS 159.

Other Assets

Other assets on our consolidated balance sheets include real estate owned (REO), fixed assets, purchased interest, principal receivable, and other prepaid expenses. REO is reported at the lower of cost or fair value. All other assets are reported at cost.

Short-Term Debt — Redwood

Short-term debt includes our credit facilities at Redwood that mature within one year. Open facilities may be unsecured or collateralized by loans or securities. We report short-term Redwood debt at its unpaid principal balance.

Asset Backed Securities Issued — Sequoia and Acacia

The majority of the liabilities reported on our consolidated balance sheets represent ABS, as issued by bankruptcy-remote securitization entities sponsored by Redwood.

Sequoia and Acacia assets are held in the custody of trustees. Trustees collect principal and interest payments (less servicing and related fees) from the assets and make corresponding principal and interest payments to the ABS investors. ABS obligations are payable solely from the assets of these entities and are not obligations of Redwood.

Sequoia ABS Issued

Sequoia ABS issued are carried at their unpaid principal balances net of any unamortized discount or premium.

Acacia ABS Issued

Effective January 1, 2008, Acacia ABS issued are accounted for under the fair value option under FAS 159 and carried at their fair values on our consolidated balance sheets. Changes in fair value (gains or losses) are reported in the consolidated statements of (loss) income through market valuation adjustments, net. Prior to January 1, 2008, Acacia ABS issued were accounted for under the same method as Sequoia ABS issued.

Long-Term Debt — Redwood

Long-term debt includes trust preferred securities and subordinated notes at Redwood. Both are unsecured debt, requiring quarterly interest payments at a floating rate equal to London Interbank Offered Rate (LIBOR) plus a margin until they are redeemed in whole or mature at a future date. These notes contain an earlier optional redemption date without penalty. Long-term Redwood debt is reported on our consolidated balance sheet at cost.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 3. Summary of Significant Accounting Policies  – (continued)

See Note 14 for further discussion on long-term Redwood debt.

Minority Interest

Minority interest represents the aggregate limited partnership interests in the Opportunity Fund held by third parties.

See Note 16 for further discussion on minority interest.

Earnings (Loss) Per Share

Basic (loss) earnings per share are computed by dividing net (loss) income by the weighted average number of common shares outstanding during the period. Diluted (loss) earnings per share are computed by dividing net (loss) income by the weighted average number of common shares and potential common shares outstanding during the period. Potential common shares outstanding are calculated using the treasury stock method, which assumes that all dilutive common stock equivalents are exercised and the funds generated by the exercises are used to buy back outstanding common stock at the average market price of the common stock during the reporting period. In accordance with Statement of Financial Accounting Standards No. 128, Earnings per Share (FAS 128), if there is a loss from continuing operations, the common stock equivalents are deemed antidilutive and diluted (loss) earnings per share is calculated in the same manner as basic (loss) earnings per share.

Other Comprehensive Income (Loss)

Current period net unrealized gains and losses on real estate securities available-for-sale and interest rate agreements previously designated as cash flow hedges under FAS 133 are reported as components of other comprehensive income (loss) on our consolidated statements of comprehensive income (loss). Net unrealized gains and losses on securities and interest rate agreements held by our taxable subsidiaries that are reported in other comprehensive income (loss) are adjusted for the effects of taxation and may create deferred tax assets or liabilities.

Stock-Based Compensation

As of June 30, 2008 and December 31, 2007, we had one stock-based employee compensation plan and one employee stock purchase plan.

We adopted Statement of Financial Accounting Standards No. 123R, Share-Based Payment (FAS 123R), on January 1, 2006. With the adoption of FAS 123R, the grant date fair values of all remaining unvested stock compensation awards (stock options, deferred stock units, and restricted stock) are expensed on the consolidated statements of (loss) income over their remaining vesting periods.

See Note 18 for further discussion on stock based compensation.

Recent Accounting Pronouncements

In December 2007, the FASB issued Statement of Financial Accounting Standards No. 160, The Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (FAS 160). FAS 160 establishes accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. FAS 160 clarifies that a noncontrolling interest in a subsidiary should be reported as a component of equity in the consolidated financial statements and requires disclosure, on the face of the consolidated statement of (loss) income, of the amounts of consolidated net income attributable to the parent and to the noncontrolled interest. FAS 160 is effective beginning January 1, 2009, with early adoption not permitted. FAS 160 is to be applied prospectively, except for the presentation and disclosure requirements, which upon adoption will be applied retrospectively for all periods presented. We are currently evaluating the disclosure requirements of FAS 160.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 3. Summary of Significant Accounting Policies  – (continued)

In February 2008, the FASB issued FASB Staff Position 140-3, Accounting for Transfers of Financial Assets and Repurchase Financing Transactions (FSP 140-3). FSP 140-3 provides that a transferor and a transferee must account for a transfer of a financial asset and a repurchase financing with the same counterparty (or consolidated affiliates of either counterparty) as a linked transaction if the transfer and repurchase financing were entered into contemporaneously or in contemplation of each other unless certain specified criteria are met. Under FSP 140-3, a repurchase financing is a transaction in which the buyer (initial transferee) of a financial asset obtains financing from the seller (initial transferor) and transfers the financial asset back to the seller as collateral until the financing is repaid. FSP 140-3 is effective beginning January 1, 2009, with early adoption not permitted. FSP 140-3 is to be applied prospectively to initial transfers and repurchase financings for which the initial transfer is executed on or after the beginning of the fiscal year in which this FSP is initially applied.

In March 2008, the FASB issued Statement of Financial Accounting Standards No. 161, Disclosures about Derivative Instruments and Hedging Activities, an Amendment of FASB Statement No. 133 (FAS 161). FAS 161 amends and expands the disclosure requirements of FAS 133 to provide greater transparency about how and why an entity uses derivative instruments, how derivative instruments and related hedge items are accounted for under FAS 133 and its related interpretations, and how derivative instruments and related hedged items affect an entity’s financial position, results of operations, and cash flows. To meet those objectives, FAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit risk related contingent features in derivative agreements. FAS 161 is effective January 1, 2009, and early adoption is encouraged. We are currently evaluating the impact of FAS 161, although we do not expect a significant impact on our financial position, results of operations or cash flows.

In June 2008, the FASB issued Staff Position EITF 03-6-1, Determining Whether Instruments Granted in Share-Based Payment Transactions Are Participating Securities (EITF 03-6-1). EITF 03-6-1 states that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are “participating securities” as defined in EITF 03-6, Participating Securities and the Two-Class Method under FASB Statement No. 128 (EITF 03-6), and therefore should be included in computing earnings per share using the two-class method. According to EITF 03-6-1, a share-based payment award is a participating security when the award includes nonforfeitable rights to dividends or dividend equivalents. The rights result in a noncontingent transfer of value each time an entity declares a dividend or dividend equivalent during the award's vesting period. However, the award would not be considered a participating security if the holder forfeits the right to receive dividends or dividend equivalents in the event that the award does not vest. EITF 03-6-1 is effective for financial statements issued in fiscal years beginning after December 15, 2008, and interim periods within those years. When adopted, its requirements are applied by recasting previously reported EPS. We are currently evaluating the requirements of EITF 03-6-1 and have not yet determined the impact of adoption.

Note 4. Adoption of FAS 159

On January 1, 2008, we elected to apply the fair value option under FAS 159 to the assets and liabilities of our consolidated Acacia securitization entities and the investment grade securities (IGS) at Redwood. FAS 159 gives us the option of electing to measure eligible financial assets, financial liabilities, and commitments, at fair value on an instrument-by-instrument basis. The election to use the fair value option is available when we first recognize a financial asset or financial liability or enter into a firm commitment, or upon the initial election of the fair value option on existing instruments on January 1, 2008. Subsequent changes in the fair value of assets, liabilities, and commitments valued under FAS 159 are recorded in the consolidated statements of (loss) income.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 4. Adoption of FAS 159  – (continued)

Prior to the application of FAS 159, we were required to mark-to-market the assets, but not the liabilities, of Acacia entities, even though the assets and liabilities were paired within the same legal structure and the ABS issued by each Acacia entity would be repaid directly and solely from the cash flows generated by the assets of that entity. Electing the fair value option for the assets and liabilities (including derivatives) of Acacia enabled us to mitigate the volatility in earnings and book value that results from the use of different measurement attributes, to correlate more closely the values of the assets and liabilities that are paired within the same securitization entity, and to reduce the complexity of accounting with regards to derivatives under FAS 133. We also elected the fair value option for certain investment grade securities (IGS) held at Redwood, since we expect to pair these investments with a future liability for which we will also elect the fair value option under FAS 159.

As a result of the one-time election of FAS 159 on January 1, 2008, we reclassified $459 million of net unrealized gains and losses on Acacia assets and IGS at Redwood from accumulated other comprehensive income (loss) to retained earnings. We also recorded to retained earnings the $1.5 billion aggregate difference between the reported values and fair values of Acacia liabilities. As part of the revaluation of the Acacia liabilities to fair value, we also reclassified to retained earnings the associated unamortized deferred ABS issuance costs of $21 million. Adjustments resulting from the one-time election at the adoption date of FAS 159 are reflected on the balance sheet as a cumulative effect adjustment to stockholders’ equity (deficit).

We did not elect the fair value option for the assets and liabilities of Sequoia, as these assets and liabilities are currently accounted for using similar measurement attributes and do not generally create substantial volatility in our earnings. We also did not elect the fair value option for our credit enhancement securities (CES) at Redwood, which are funded with equity. There is no paired liability for these assets and our intent upon acquisition of these assets is to hold them to maturity and to generate long-term cash flows.

Our decision to adopt FAS 159 for new financial instruments is generally based upon our funding strategy for the specific financial asset acquired or financial liability incurred. Assets that we anticipate funding with equity will generally be accounted for as AFS securities under FAS 115. Assets that we anticipate financing with a combination of debt and equity will generally be accounted for as trading securities under FAS 159 along with the corresponding liabilities.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 4. Adoption of FAS 159  – (continued)

The following table presents the transition adjustments and their effect on the Consolidated Total Assets and Total Liabilities and Stockholders’ Equity at January 1, 2008, following the adoption of FAS 159.

Adoption of FAS 159

     
(In Millions)   December 31,
2007
Redwood Consolidated
  Transition Adjustment   January 1,
2008
Redwood Consolidated
Real estate loans   $ 7,204     $     $ 7,204  
Real estate securities and other investments     2,201             2,201  
Cash and cash equivalents     290             290  
Total earning assets     9,695             9,695  
Restricted cash     118             118  
Other assets     126       (21 )      105  
Total Assets     9,939       (21 )      9,918  
Redwood debt     8             8  
Asset-backed securities issued     10,329       (1,490 )      8,839  
Subordinated notes     150             150  
Other liabilities     170             170  
Total liabilities     10,657       (1,490 )      9,167  
Common stock and additional paid-in capital     1,108             1,108  
Accumulated other comprehensive (loss) income     (574 )      459       (115 ) 
Retained earnings     (1,252 )      1,010       (242 ) 
Total stockholders’ (deficit) equity     (718 )      1,469       751  
Total Liabilities and Stockholders’ Equity   $ 9,939     $ (21 )    $ 9,918  

Included in the $1 billion transition adjustment to retained earnings is an additional $1.5 million that was recorded during the second quarter of 2008. This amount relates to securities where we adopted FAS 159 on January 1, 2008, but was excluded in our original transition adjustment.

Note 5. Fair Value of Financial Instruments

In September 2006, the FASB issued FAS 157, which sought to consolidate and clarify the definition of “fair value” that is used throughout GAAP. FAS 157 defines fair value, establishes a methodology for measuring fair value, establishes a hierarchy of information used in measuring fair value, and enhances the disclosure of information about fair value measurements. FAS 157 provides that the “exit price,” which is the price at which an asset could be sold or a liability could be transferred in an orderly process, should be used to value the asset or liability. FAS 157 also provides that market data, to the extent available, and not internally generated or entity specific information, should be used to determine fair value. We adopted FAS 157 on January 1, 2008. The financial impact on Redwood of the adoption of FAS 157 was not significant since our valuation methodology used in prior periods did not need to be revised to comply with FAS 157.

FAS 157 also provided a set of disclosures, the most significant being the requirements to disclose the valuations based on a framework that would group the valuations into a three-level hierarchy based on the ability to observe the significant inputs into the valuation:

Level 1:  Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 5. Fair Value of Financial Instruments  – (continued)

Level 2:  Inputs other than quoted prices included in Level 1 that are observable for the asset or liability either directly or through corroboration with observable market data.

Level 3:  Unobservable inputs (e.g., an entity’s own data or assumptions).

Level 3 inputs include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls is determined based on the lowest level input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement requires judgment and considers factors specific to the asset or liability. FAS 157 also requires a roll forward of the items in Level 3 along with additional discussions on how these valuations are developed.

The following table presents information about financial assets and liabilities reported at fair value as of June 30, 2008, and indicates the fair value hierarchy of the valuation techniques used to measure fair value.

Assets and Liabilities Measured at Fair Value on a Recurring Basis as of June 30, 2008

       
    Fair Value Measurements Using
(In Thousands)   Carrying
Value
  Quoted
Prices in
Active
Markets
(Level 1)
  Significant
Other
Observable
Inputs
(Level 2)
  Significant
Unobservable
Inputs
(Level 3)
Assets
                                   
Real estate loans (held-for-sale)   $ 3,695     $     $     $ 3,695  
Real estate loans (fair value)     18,800                   18,800  
Trading securities     841,868                   841,868  
Available-for-sale securities     399,759                   399,759  
Other investments     78,583                   78,583  
Derivative assets     4,914             4,635       279  
Liabilities
                                   
ABS issued – Acacia     935,072                   935,072  
Derivative liabilities     100,396             25,106       75,290  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 5. Fair Value of Financial Instruments  – (continued)

The following table presents additional information about the assets and liabilities reported at fair value on our consolidated balance sheets on a recurring basis for which Level 3 inputs were used to determine fair value. These changes in fair value occurred after the adoption of FAS 159 on January 1, 2008.

Changes in Level 3 Assets and Liabilities Measured at Fair Value on a Recurring Basis

           
Three Months Ended June 30, 2008
(In Thousands)
  Beginning
Balance
4/1/2008
  Principal
Paydowns
  Total Realized and
Unrealized Gains (Losses)
Included in Income
  Purchases,
Sales, Other
Settlements
and Issuances,
Net
  Ending
Balance
6/30/2008
  Realized
Gains or
(Losses)
  Unrealized
Gains or
(Losses)
Assets
                                                     
Real estate loans (held-for-sale)   $ 4,443     $ (626 )    $ (81 )    $ (41 )    $     $ $3,695  
Real estate loans (fair value)     18,801       (113 )      112                   18,800  
Trading securities     952,576       (43,206 )      (67,171 )            (331 )      841,868  
Available-for-sale securities     242,030       (23,162 )      (30,822 )      27,901       183,812       399,759  
Other investments     78,770       (187 )                        78,583  
Derivative assets     72             207                   279  
Liabilities
                                                     
Acacia ABS issued     1,046,160       (109,881 )      (4,464 )            3,257       935,072  
Derivative liabilities     72,501             2,789                   75,290  

           
Six Month Ended June 30, 2008
(In Thousands)
  Beginning
Balance
1/1/2008
  Principal
Paydowns
  Total Realized and
Unrealized Gains (Losses)
Included in Income
  Purchases,
Sales, Other
Settlements
and Issuances,
Net
  Ending
Balance
6/30/2008
  Realized
Gains or
(Losses)
  Unrealized
Gains or
(Losses)
Assets
                                                     
Real estate loans (held-for-sale)   $ 4,533     $ (642 )    $ (155 )    $ (41 )    $     $ 3,695  
Real estate loans (fair value)     25,426       (229 )      (4,548 )      (1,849 )            18,800  
Trading securities     1,804,511       (100,504 )      (865,151 )            3,012       841,868  
Available-for-sale securities     317,090       (30,234 )      (174,920 )      49,094       238,729       399,759  
Other investments     79,125       (542 )                        78,583  
Derivative assets     114             165                   279  
Liabilities
                                                     
Acacia ABS issued     1,893,441       (140,046 )      (814,305 )            (4,018 )      935,072  
Derivative liabilities     57,397             17,893                   75,290  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 5. Fair Value of Financial Instruments  – (continued)

The following table presents information for total net interest income for assets and liabilities measured under the fair value option for the three and six months ended June 30, 2008.

Net Interest Income on Fair Value Option Assets and Liabilities

           
  Net Interest Income on FVO Assets and Liabilities
Three Months Ended June 30, 2008
  Net Interest Income on FVO Assets and Liabilities
Six Months Ended June 30, 2008
(In Thousands)   Change in
Market
Value
  Interest
Income
(Expense)
  Total Effect On
Net Interest
Income
  Change in
Market
Value
  Interest
Income
(Expense)
  Total Effect On
Net Interest
Income
Assets
                                                     
Real estate loans (fair value)   $ 112     $ 373     $ 485     $ (4,548 )    $ 744     $ (3,804 ) 
Trading securities     (62,537 )      37,858       (24,679 )      (857,821 )      84,004       (773,817 ) 
Other investments           514       514             1,246       1,246  
Derivative assets     989             989       792             792  
Liabilities
                                                     
Acacia ABS issued     4,464       (30,306 )      (25,842 )      814,305       (74,826 )      739,479  
Derivative liabilities     27,769             27,769       (21,818 )            (21,818 ) 
Total   $ (29,203 )    $ 8,439     $ (20,764 )    $ (69,090 )    $ 11,168     $ (57,922 ) 

Market valuation adjustments include fair value adjustments as well as other valuation changes in assets and liabilities consolidated on our financial statements that are recorded through our consolidated statements of (loss) income. The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of (loss) income for the three and six months ended June 30, 2008.

Market Valuation Adjustments, Net

   
(In Thousands)   Three Months Ended
June 30, 2008
  Six Months Ended
June 30, 2008
Total Market Valuations of Fair Value Assets and Liabilities   $ (29,203 )    $ (69,090 ) 
Other Market Valuation Adjustments
                 
Impairments on AFS securities     (28,970 )      (173,067 ) 
Derivative instruments     1,981       (4,411 ) 
Other real estate investments (trading)     (3,362 )      (6,058 ) 
Real estate loans (held-for-sale)     (1,065 )      (1,925 ) 
Market Valuation Adjustments, Net   $ (60,619 )    $ (254,551 ) 

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 5. Fair Value of Financial Instruments  – (continued)

Fair Value of Financial Instruments

The following table presents the carrying values and estimated fair values of our financial instruments as of June 30, 2008 and December 31, 2007.

       
  June 30, 2008   December 31, 2007
(In Thousands)   Carrying
Value
  Fair
Value
  Carrying
Value
  Fair
Value
Assets
 
Real estate loans (held-for-investment)   $ 6,354,223     $ 5,666,056     $ 7,199,618     $ 6,860,574  
Real estate loans (held-for-sale)     3,695       3,695       4,533       4,533  
Real estate loans (fair value)     18,800       18,800              
Trading securities     841,868       841,868       11,521       11,521  
Available-for-sale securities     399,759       399,759       2,110,080       2,110,080  
Other investments     78,583       78,583       79,125       79,125  
Cash and equivalents     147,639       147,639       290,363       290,363  
Derivative assets     4,914       4,914       5,598       5,598  
Restricted cash     102,171       102,171       118,064       118,064  
Accrued interest receivable     40,948       40,948       45,553       45,553  
Liabilities
                                   
Short-term debt – Redwood     9,326       9,326       7,561       7,561  
ABS Issued
                                   
ABS issued – Sequoia     6,174,571       5,425,929       6,946,166       6,693,087  
ABS issued – Acacia(1)     935,072       935,072       3,383,113       1,893,441  
Total ABS issued     7,109,643       6,361,001       10,329,279       8,586,528  
Derivative liabilities     100,396       100,396       81,385       81,385  
Accrued interest payable     32,237       32,237       53,796       53,796  
Long-term debt – Redwood     150,000       72,000       150,000       94,000  

(1) We elected the fair value option under FAS 159 for all Acacia ABS as of January 1, 2008. Acacia ABS were recorded at their amortized cost at and prior to December 31, 2007.

The following is a description of the instruments measured at fair value under FAS 157 as well as the general classification of such instruments pursuant to the valuation hierarchy described above under FAS 157.

Real estate loans
Residential real estate loan fair values are determined by available market quotes and discounted cash flow analyses (Level 2 and 3).
Commercial real estate loan fair values are determined by available market quotes and discounted cash flow analyses (Level 2 and 3).
Real estate securities
Real estate securities are residential, commercial, CDO, and other asset-backed securities that are illiquid in nature and trade infrequently. Fair values are determined by discounted cash flow analyses and other valuation techniques using market pricing assumptions that are confirmed by third party dealer/pricing indications, to the extent available. Significant inputs in the valuation

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 5. Fair Value of Financial Instruments  – (continued)

analysis are predominantly Level 3 in nature, due to the lack of readily available market quotes and related inputs. Relevant market indicators that are factored in the analyses include bid/ask spreads, credit losses, interest rates, and prepayment speeds. Estimated fair values are based on applying the market indicators to generate discounted cash flows.
Other investments
Other investments currently include a GIC. Management currently considers the GIC’s fair value to approximate contract value, as the interest rate is variable at LIBOR less 5 basis points and resets on a monthly basis (Level 2).
Derivative assets and liabilities
Our derivative instruments include interest rate agreements and credit default swaps. Fair values of derivative instruments are determined using valuation models and are verified by valuations provided by dealers active in derivative markets. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates, and correlations of such inputs. Model inputs for interest rate agreements can generally be verified and model selection does not involve significant management judgment (these are Level 2 inputs). For other derivatives, valuations are based on various factors such as liquidity, bid/offer spreads, and credit considerations for which we rely on available market evidence. In the absence of such evidence, management’s best estimate is used (these are Level 3 inputs).
Cash and cash equivalents
Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less. Fair values equal carrying values.
Restricted cash
Restricted cash primarily includes interest-earning cash balances in ABS entities and the Fund for the purpose of distribution to bondholders or limited partners, and reinvestment. Due to the short-term nature of the restrictions, fair values approximate carrying values.
Accrued interest receivable and payable
Accrued interest receivable and payable includes interest due on our assets and payable on our liabilities. Due to the short-term nature of when these interest payments will be received or paid, fair values approximate carrying values.
Short-term debt — Redwood
Short-term Redwood debt includes our credit facilities that mature within one year. Short-term Redwood debt is set to an adjustable rate. Fair values approximate carrying values (Level 1 and 2).
ABS issued
ABS issued includes asset-backed securities issued through our Sequoia and Acacia programs. These instruments are illiquid in nature and trade infrequently, if at all. Fair values are determined by discounted cash flow analyses and other valuation techniques using market pricing assumptions that are confirmed by third party dealer/pricing indications, to the extent available. Significant inputs in the valuation analysis are predominantly Level 3, due to the nature of these instruments and the lack of readily available market quotes. Relevant market

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 5. Fair Value of Financial Instruments  – (continued)

indicators factored into the analyses include dealer price indications to the extent available, bid/ask spreads, external spreads, collateral credit losses, interest rates and collateral prepayment speeds. Estimated fair values are based on applying the market indicators to generate discounted cash flows.
Long-term debt — Redwood
Long-term Redwood debt includes our subordinated notes and trust preferred securities. Fair values are determined using comparable market indicators of current pricing. Significant inputs in the valuation analysis are predominantly Level 3 due to the nature of these instruments and the lack of readily available market quotes.

Note 6. Real Estate Loans

We acquire residential and commercial real estate loans from third party originators. The majority of these loans are sold to securitization entities sponsored by us under our Sequoia and Acacia programs which, in turn, issue ABS. The remainder of the loans we invest in are held and financed with short-term Redwood debt and equity.

The following table summarizes the carrying value of the residential and commercial real estate loans, as reported on our consolidated balance sheets at June 30, 2008 and December 31, 2007.

   
(In Thousands)   June 30,
2008
  December 31,
2007
Residential real estate loans (held-for-sale)   $ 3,695     $ 4,533  
Residential real estate loans (held-for-investment)     6,353,972       7,173,940  
Total residential real estate loans     6,357,667       7,178,473  
Commercial real estate loans (fair value)     18,800        
Commercial real estate loans (held-for-investment)     251       25,678  
Total Real Estate Loans   $ 6,376,718     $ 7,204,151  

At June 30, 2008, we had $5 million in outstanding principal of residential loans held-for-sale with a lower of cost or fair value of $4 million. At December 31, 2007, there was $6 million in outstanding principal for these loans with a lower of cost or fair value of $5 million.

Real Estate Loans Held-for-Investment

The following table provides additional information on real estate loans classified as held-for-investment as of June 30, 2008 and December 31, 2007.

     
June 30, 2008
(In Thousands)
  Residential
Real Estate
Loans
  Commercial
Real Estate
Loans
  Total
Current face   $ 6,318,090     $ 11,102     $ 6,329,192  
Current premium (discount) – net, unamortized     68,479       (362 )      68,117  
Discount designated as credit reserve           (8,141 )      (8,141 ) 
Reserve for credit losses     (32,597 )      (2,348 )      (34,945 ) 
Carrying Value   $ 6,353,972     $ 251     $ 6,354,223  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 6. Real Estate Loans  – (continued)

     
December 31, 2007
(In Thousands)
  Residential
Real Estate
Loans
  Commercial
Real Estate
Loans
  Total
Current face   $ 7,106,018     $ 38,111     $ 7,144,129  
Current premium (discount) – net, unamortized     86,204       (1,944 )      84,260  
Discount designated as credit reserve           (8,141 )      (8,141 ) 
Reserve for credit losses     (18,282 )      (2,348 )      (20,630 ) 
Carrying Value   $ 7,173,940     $ 25,678     $ 7,199,618  

Of the $6.3 billion of principal face and $68 million of unamortized premium on our residential real estate loans at June 30, 2008, $2.2 billion of principal face and $50 million of unamortized premium relates to residential loans acquired prior to July 1, 2004. For these residential loans, we determine an effective yield using coupon interest rates as they change over time and anticipated principal payments to amortize the premium into income. During the first half of 2008, 13% of these residential loans prepaid and we amortized 23% of the premium. Of the $7.1 billion of principal face and $86 million of unamortized premium on our residential real estate loans at December 31, 2007, $2.5 billion of principal face and $66 million of unamortized premium relates to residential loans acquired prior to July 1, 2004.

For residential loans acquired after July 1, 2004, the principal face and unamortized premium was $4.1 billion and $18 million at June 30, 2008, respectively, and $4.6 billion and $20 million at December 31, 2007, respectively. For these residential loans, we use the initial coupon interest rate of the loans (without regard to future changes in the underlying indices) and anticipated principal payments to calculate an effective yield to amortize the premium or discount. During the first half of 2008, 10% of these residential loans prepaid and we amortized 11% of the premium.

On January 1, 2008, we elected the fair value option under FAS 159 for commercial real estate loans owned by Acacia entities, and accordingly record these loans at their fair values. At June 30, 2008 we owned $26 million face of commercial loans that had a fair value of $19 million. Prior to 2008, these loans were classified as held-for-investment.

The following table presents information regarding real estate loans pledged and unpledged under our borrowing agreements at June 30, 2008 and December 31, 2007.

Real Estate Loans Pledged and Unpledged

       
  June 30, 2008   December 31, 2007
(In Thousands)   Face
Value
  Carrying
Value
  Face
Value
  Carrying
Value
Unpledged   $ 15,880     $ 3,946     $ 16,606     $ 4,785  
Owned by securitization entities, financed through ABS issued     6,344,867       6,372,772       7,133,022       7,199,366  
Total   $ 6,360,747     $ 6,376,718     $ 7,149,628     $ 7,204,151  

Unpledged real estate loans at June 30, 2008 consist of residential loans held-for-sale with a face value of $5 million and a carrying value of $4 million and two commercial loans held-for-investment with a face value of $11 million and a carrying value of $0.2 million.

Note 7. Reserves for Credit Losses

We establish reserves for credit losses on our real estate loans held-for-investment based on our estimate of losses inherent in our loan portfolio. At both June 30, 2008 and December 31, 2007, all residential loans

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 7. Reserves for Credit Losses  – (continued)

classified as held-for-investment were owned by Sequoia entities. At June 30, 2008, we had a reserve for credit losses of $33 million on these residential loans, an increase from the $18 million reserve at December 31, 2007.

The following table summarizes the activity in reserves for credit losses for our consolidated residential loans classified as held-for-investment for the three and six months ended June 30, 2008 and 2007.

Activity in Residential Real Estate Loan Reserves for Credit Losses

       
  Three Months Ended June 30,   Six Months Ended June 30,
(In Thousands)   2008   2007   2008   2007
Balance at beginning of period   $ 24,444     $ 19,954     $ 18,282     $ 20,119  
Provision for credit losses     10,061       2,500       18,119       3,981  
Charge-offs     (1,908 )      (6,038 )      (3,804 )      (7,684 ) 
Balance at End of Period   $ 32,597     $ 16,416     $ 32,597     $ 16,416  

Delinquencies in our consolidated residential real estate loan portfolio were $118 million and $68 million as of June 30, 2008 and December 31, 2007, respectively. Delinquencies include loans delinquent more than 90 days and in foreclosure. As a percentage of our current residential real estate loan balances, delinquencies were 1.87% and 0.96% at June 30, 2008 and December 31, 2007, respectively. As a percentage of the original balances, delinquencies were 0.42% and 0.24% at June 30, 2008 and December 31, 2007, respectively.

Our residential loan servicers advance payment on delinquent loans to the extent they deem them recoverable. We accrue interest on loans until they are more than 90 days past due or deemed uncollectible at which point they are placed on nonaccrual status. When we pursue foreclosure in full satisfaction for a defaulted loan, we estimate the specific loan loss, if any, based on estimated net proceeds from the sale of the property (including accrued but unpaid interest), and charge this specific estimated loss (or recovery) against the reserve for credit losses. During the first half of 2008, there were $4 million of charge-offs that reduced our reserve for credit losses. These charge-offs arose from $24 million of defaulted loan principal. Foreclosed property is subsequently recorded as REO, a component of other assets (See Note 11). Subsequent changes in value of REO are recorded through market valuation adjustments, net, in our consolidated statements of (loss) income.

The following table summarizes the activity in reserves for credit losses for our commercial real estate loans held-for-investment, for the three and six months ended June 30, 2008 and 2007.

Activity in Commercial Real Estate Loan Reserves for Credit Losses

       
  Three Months Ended June 30,   Six Months Ended June 30,
(In Thousands)   2008   2007   2008   2007
Balance at beginning of period   $ 2,348     $ 2,348     $ 2,348     $  
Provision for credit losses                       2,348  
Charge-offs                        
Balance at End of Period   $ 2,348     $ 2,348     $ 2,348     $ 2,348  

During the first quarter of 2007, we fully reserved for an anticipated loss on a mezzanine commercial loan, which was made to finance a condominium-conversion project. We do not expect to recover any outstanding principal upon completion of the conversion project and sale of the condominium units.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 8. Real Estate Securities

We invest in third party residential, commercial, and CDO securities. The following table presents our real estate securities by collateral type and entity, as of June 30, 2008 and December 31, 2007.

       
June 30, 2008
(In Thousands)
  Redwood   The Fund   Acacia   Total
Securities
Residential   $ 247,579     $ 45,750     $ 596,366     $ 889,695  
Commercial     90,969             176,162       267,131  
CDO     14,763       19,989       49,974       84,726  
Other real estate investments     75                   75  
Total Real Estate Securities   $ 353,386     $ 65,739     $ 822,502     $ 1,241,627  

       
December 31, 2007
(In Thousands)
  Redwood   The Fund   Acacia   Total
Securities
Residential   $ 163,235     $ 3,126     $ 1,393,048     $ 1,559,409  
Commercial     148,508             278,003       426,511  
CDO     20,822       12,075       91,263       124,160  
Other real estate investments     11,521                   11,521  
Total Real Estate Securities   $ 344,086     $ 15,201     $ 1,762,314     $ 2,121,601  

The following table presents our trading and available-for-sale (AFS) real estate securities by collateral type and entity, as of June 30, 2008 and December 31, 2007.

           
June 30, 2008
(In Thousands)
  Redwood   The Fund   Acacia   Total Securities
  Trading   AFS   AFS   Trading   Trading   AFS
Residential IGS
                                                     
Prime   $ 1,319     $ 100,664     $ 1,220     $ 169,564     $ 170,883     $ 101,884  
Non-prime     3,251       55,230       44,530       312,473       315,724       99,760  
Total Residential IGS     4,570       155,894       45,750       482,037       486,607       201,644  
Residential CES
 
Prime           79,304             61,760       61,760       79,304  
Non-prime     282       7,529             52,569       52,851       7,529  
Total Residential CES     282       86,833             114,329       114,611       86,833  
Commercial IGS                       61,818       61,818        
Commercial CES           90,969             114,344       114,344       90,969  
CDO IGS     14,364             12,853       45,615       59,979       12,853  
CDO CES     75       324       7,136       4,359       4,434       7,460  
Other real estate investments     75                         75        
Total Real Estate Securities   $ 19,366     $ 334,020     $ 65,739     $ 822,502     $ 841,868     $ 399,759  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 8. Real Estate Securities  – (continued)

           
December 31, 2007
(In Thousands)
  Redwood   The Fund   Acacia   Total Securities
  Trading   AFS   AFS   AFS   Trading   AFS
Residential IGS
                                                     
Prime   $     $ 1,360     $     $ 514,045     $     $ 515,405  
Non-prime           10,865       3,126       628,068             642,059  
Total Residential IGS           12,225       3,126       1,142,113             1,157,464  
Residential CES
 
Prime           127,612             193,676             321,288  
Non-prime           23,398             57,259             80,657  
Total Residential CES           151,010             250,935             401,945  
Commercial IGS                       89,676             89,676  
Commercial CES           148,508             188,327             336,835  
CDO IGS           18,450       12,075       83,094             113,619  
CDO CES           2,372             8,169             10,541  
Other real estate investments     11,521                         11,521        
Total Real Estate Securities   $ 11,521     $ 332,565     $ 15,201     $ 1,762,314     $ 11,521     $ 2,110,080  

We finance securities through a combination of Redwood debt and equity as well as investments in the Fund and Acacia entities that we consolidate. Of the total securities owned at Redwood as of June 30, 2008 and December 31, 2007, $9 million and $8 million, respectively, were pledged for short-term Redwood debt.

Trading securities are recorded at fair value with changes in fair value recorded in market valuation adjustments, net, in the consolidated statements of (loss) income. We currently account for Redwood IGS, securities owned by Acacia entities, and other real estate investments (OREI), as trading securities. Prior to the adoption of FAS 159, Redwood IGS and securities owned by Acacia were recorded at fair value in accordance with FAS 115.

AFS Securities

AFS securities are measured at fair value, with unrealized gains and losses recorded as a component of other comprehensive income (loss), net of deferred taxes, in stockholders’ equity (deficit). We currently account for most securities at Redwood and all securities at the Fund as AFS securities. Prior to the adoption of FAS 159 on January 1, 2008, all securities at Redwood and Acacia (except for OREI) were classified as AFS.

The following table presents the carrying value (which equals fair value) of AFS securities as of June 30, 2008 and December 31, 2007.

       
June 30, 2008
(In Thousands)
  Residential   Commercial   CDO   Total
Current face   $ 1,019,761     $ 517,615     $ 99,089     $ 1,636,465  
Current discount – designated credit reserve     (555,702 )      (384,487 )      (33,743 )      (973,932 ) 
Current discount – net unamortized     (154,465 )      (31,871 )      (42,415 )      (228,751 ) 
Amortized cost     309,594       101,257       22,931       433,782  
Gross unrealized gains     14,995       2,820       625       18,440  
Gross unrealized losses     (36,112 )      (13,108 )      (3,243 )      (52,463 ) 
Carrying Value   $ 288,477     $ 90,969     $ 20,313     $ 399,759  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 8. Real Estate Securities  – (continued)

       
December 31, 2007
(In Thousands)
  Residential   Commercial   CDO   Total
Current face   $ 3,553,064     $ 988,653     $ 393,010     $ 4,934,727  
Current discount – designated credit reserve     (723,489 )      (318,456 )      (100,617 )      (1,142,562 ) 
Current discount – net unamortized     (886,118 )      (98,509 )      (156,305 )      (1,140,932 ) 
Amortized cost     1,943,457       571,688       136,088       2,651,233  
Gross unrealized gains     14,074       4,965       822       19,861  
Gross unrealized losses     (398,122 )      (150,142 )      (12,750 )      (561,014 ) 
Carrying Value   $ 1,559,409     $ 426,511     $ 124,160     $ 2,110,080  

When we purchase a credit-sensitive AFS security at a significant discount to its face value, we often do not amortize into income a significant portion of this discount that we are entitled to earn but do not expect to collect due to the inherent credit risk of the security. The portion of the total discount that we do not amortize into income is designated as a credit reserve on the security, with the remaining portion amortized into income over time using the interest method in accordance with EITF 99-20. Our estimate of required credit reserves is based upon various factors, including economic conditions, characteristics of the underlying loans, delinquency status, past performance of similar securities, external credit enhancements or guarantees, and priority of cash flows and credit loss attribution within the securitization from which our security interest participates. We use a variety of internal and external credit risk cash flow modeling and portfolio analytical tools to assist in our assessments. We review our assessments at least quarterly and determine the appropriate level of credit reserve required for each security we own. The designated credit reserve is specific to each security.

The following table presents the detail investment activity affecting our gross purchase discount on AFS securities and the resulting net unamortized discount that we currently expect to recognize into income over the remaining lives of these securities.

Changes in Unamortized Discount and Designated Credit Reserves on AFS Securities

           
  Residential   Commercial   CDO
Three Months Ended
June 30, 2008
(In Thousands)
  Designated
Credit Reserve
  Unamortized
Net Discount
  Designated
Credit Reserve
  Unamortized
Net Discount
  Designated
Credit Reserve
  Unamortized
Net Discount
Beginning balance –  March 31, 2008   $ 586,174     $ 83,714     $ 378,388     $ 36,955     $ 37,374     $ 47,472  
Amortization of net discount           (7,925 )            2,123             (456 ) 
Realized credit losses     (60,507 )            (5,502 )            (4,150 )       
Acquisitions     4,773       71,774                          
Sales, calls, other           7,909                         (4,402 ) 
Impairments     24,255             4,394             320        
Transfers/release of credit reserves     1,007       (1,007 )      7,207       (7,207 )      199       (199 ) 
Ending balance –  June 30, 2008   $ 555,702     $ 154,465     $ 384,487     $ 31,871     $ 33,743     $ 42,415  

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TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 8. Real Estate Securities  – (continued)

           
  Residential   Commercial   CDO
Six Months Ended
June 30, 2008
(In Thousands)
  Designated
Credit Reserve
  Unamortized
Net Discount
  Designated
Credit Reserve
  Unamortized
Net Discount
  Designated
Credit Reserve
  Unamortized
Net Discount
Beginning balance –  December 31, 2007   $ 723,489     $ 886,118     $ 318,456     $ 98,509     $ 100,617     $ 156,305  
Reclassification due to fair value option     (213,356 )      (794,395 )            (80,642 )      (78,762 )      (122,384 ) 
Beginning balance –  January 1, 2008     510,133       91,723       318,456       17,867       21,855       33,921  
Amortization of net discount           (19,877 )            3,646             (891 ) 
Realized credit losses     (91,169 )            (5,540 )            (4,150 )       
Acquisitions     28,030       93,723                   15,000       13,569  
Sales, calls, other           7,866                         (4,545 ) 
Impairments     89,738             81,929             1,399        
Transfers/release of credit reserves     18,970       (18,970 )      (10,358 )      10,358       (361 )      361  
Ending balance –  June 30, 2008   $ 555,702     $ 154,465     $ 384,487     $ 31,871     $ 33,743     $ 42,415  

The loans underlying our residential CES totaled $145 billion at June 30, 2008, and consist of $107 billion prime and $38 billion non-prime. These loans are located nationwide with a large concentration in California (49%). Serious delinquencies (90+ days, in foreclosure or REO) at June 30, 2008 were 4.23% of current principal balances and 1.93% of original principal balances. For loans in prime pools, delinquencies were 1.01% of current balances and 0.47% of original balances. Non-prime pools had delinquencies of 13.29% of current balances and 5.94% of original balances.

The loans underlying our commercial CES totaled $49 billion at June 30, 2008, and consist primarily of office (39%), retail (28%), and multifamily (16%) fixed rate commercial loans. These loans are located nationwide. Serious delinquencies (90+ days, in foreclosure or REO) at June 30, 2008 were 0.79% of current principal balances and 0.74% of original principal balances.

For the three and six months ended June 30, 2008, we recognized other-than-temporary impairments on AFS securities of $29 million and $173 million, respectively, through market valuation adjustments, net, in our consolidated statements of (loss) income. For the three and six months ended June 30, 2007, we recognized other-than-temporary impairments of $22 million and $24 million, respectively.

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TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
(Unaudited)

Note 8. Real Estate Securities  – (continued)

The following table presents the components comprising the carrying value of AFS securities that were in an unrealized loss position and not deemed to be other than temporarily impaired as of June 30, 2008, and December 31, 2007.

AFS Securities with Unrealized Losses

           
  Less Than 12
Consecutive Months
  12 Consecutive
Months or Longer
June 30, 2008
(In Thousands)
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair
Value
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair
Value
Residential   $ 220,003     $ (35,665 )    $ 184,338     $ 1,661     $ (447 )    $ 1,214  
Commercial     75,430       (10,987 )      64,443       5,111       (2,122 )      2,989  
CDO     12,410       (3,242 )      9,168                    
Total Securities   $ 307,843     $ (49,894 )    $ 257,949     $ 6,772     $ (2,569 )    $ 4,203  

           
  Less Than 12
Consecutive Months
  12 Consecutive
Months or Longer
December 31, 2007
(In Thousands)
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair
Value
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair
Value
Residential   $ 930,965     $ (303,546 )    $ 627,419     $ 315,304     $ (94,576 )    $ 220,728  
Commercial     400,942       (112,769 )      288,173       130,681       (37,373 )      93,308  
CDO     42,113       (12,750 )      29,363                    
Total Securities   $ 1,374,020     $ (429,065 )    $ 944,955     $ 445,985     $ (131,949 )    $ 314,036  

At June 30, 2008, we owned 601 AFS securities, of which, 198 were in an unrealized loss position and 8 were in a continuous unrealized loss position for twelve months or longer. At December 31, 2007, we owned 1,722 AFS securities, of which 855 were in an unrealized loss position and 188 were in a continuous loss position for twelve months or longer. The number of AFS securities reported on our consolidated balance sheets declined as a result of our adoption of FAS 159 on January 1, 2008.

Gross Realized Gains and Losses

Gains and losses from AFS securities are recorded to realized gains (losses) on sales and calls, net, in our consolidated statements of (loss) income. The following table presents the gross realized gains and losses on sales and calls of AFS securities for the six months ended June 30, 2008 and 2007.

       
  Three Months Ended
June 30,
  Six Months Ended
June 30,
(In Thousands)   2008   2007   2008   2007
Gross realized gains – sales   $ 1,831     $ 2,746     $ 1,831     $ 3,415  
Gross realized gains – calls           1,310       42       2,153  
Gross realized losses – sales           (1,284 )            (2,737 ) 
Gross realized losses – calls     (43 )            (43 )       
Total realized gains on sales and calls, net   $ 1,788     $ 2,772