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: September 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)

Not Applicable

(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)

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

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


Large accelerated filer x		Accelerated filer o		Non-accelerated filer o		Smaller reporting company 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 common stock, as of the latest practicable date.


Common Stock, $0.01 par value per share		33,436,075 shares as of November 5, 2008

TABLE OF CONTENTS

REDWOOD TRUST, INC.

2008 FORM 10-Q REPORT


	Page
PART I
Item 1. Financial Statements		1
Consolidated Balance Sheets at September 30, 2008 (Unaudited) and December 31, 2007		1
Consolidated Statements of (Loss) Income for the Three and Nine Months Ended September 30, 2008 and 2007 (Unaudited)		2
Consolidated Statements of Stockholders’ Equity (Deficit) and Comprehensive Loss for the Nine Months Ended September 30, 2008 and 2007 (Unaudited)		3
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2008 and 2007 (Unaudited)		4
Notes to Consolidated Financial Statements		5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		39
Item 3. Quantitative and Qualitative Disclosures About Market Risk		86
Item 4. Controls and Procedures		86
PART II
Item 1. Legal Proceedings		87
Item 1A. Risk Factors		87
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		88
Item 3. Defaults Upon Senior Securities		88
Item 4. Submission of Matters to a Vote of Security Holders		88
Item 5. Other Information		88
Item 6. Exhibits		88
Signatures		89

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)	September 30, 2008			December 31, 2007
ASSETS
Real estate loans	$	6,101,392		$	7,204,151
Real estate securities, at fair value:
Trading securities		573,842			11,521
Available-for-sale securities		288,174			2,110,080
Total real estate securities		862,016			2,121,601
Other investments		78,474			79,125
Cash and cash equivalents		177,041			290,363
Total earning assets		7,218,923			9,695,240
Restricted cash		62,649			118,064
Accrued interest receivable		37,380			45,553
Derivative assets		4,641			5,598
Deferred tax asset		7,593			8,875
Deferred asset-backed securities issuance costs		13,172			39,909
Other assets		30,916			25,233
Total Assets	$	7,375,274		$	9,938,472
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Liabilities
Short-term debt – Redwood	$	6,902		$	7,561
Accrued interest payable		31,762			53,796
Derivative liabilities		106,849			81,385
Accrued expenses and other liabilities		5,387			10,441
Dividends payable		25,184			24,289
Asset-backed securities issued – Sequoia		5,929,248			6,946,166
Asset-backed securities issued – Acacia		672,964			3,383,113
Long-term debt – Redwood		150,000			150,000
Total liabilities		6,928,296			10,656,751
Minority interest		35,089			—
Stockholders’ Equity (Deficit)
Common stock, par value $0.01 per share, 75,000,000 and 50,000,000 shares authorized; 33,237,676 and 32,385,073 issued and oustanding		334			324
Additional paid-in capital		1,144,796			1,108,148
Accumulated other comprehensive (loss) income		(83,740	)		(573,766	)
Cumulative earnings (losses)		381,645			(299,626	)
Cumulative distributions to stockholders		(1,031,146	)		(953,359	)
Total stockholders’ equity (deficit)		411,889			(718,279	)
Total Liabilities and Stockholders’ Equity (Deficit)	$	7,375,274		$	9,938,472

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF (LOSS) INCOME


(In Thousands, Except Share Data) (Unaudited)	Three Months Ended September 30,						Nine Months Ended September 30,
(In Thousands, Except Share Data) (Unaudited)	2008			2007			2008			2007
Interest Income
Real estate loans	$	68,400		$	118,177		$	236,786		$	370,933
Real estate securities		61,334			96,051			199,391			277,836
Other investments		487			1,143			1,733			1,607
Cash and cash equivalents		971			4,960			6,348			11,048
Total interest income		131,192			220,331			444,258			661,424
Management fees		1,307			1,893			4,239			4,542
Interest Expense
Short-term debt – Redwood		(65	)		(5,858	)		(315	)		(59,652	)
Asset-backed securities issued		(90,837	)		(158,115	)		(313,137	)		(436,251	)
Long-term debt – Redwood		(2,164	)		(3,150	)		(6,930	)		(7,722	)
Total interest expense		(93,066	)		(167,123	)		(320,382	)		(503,625	)
Net Interest Income		39,433			55,101			128,115			162,341
Provision for loan losses		(18,333	)		(1,507	)		(36,452	)		(7,836	)
Market valuation adjustments, net		(127,157	)		(102,766	)		(381,708	)		(142,460	)
Net Interest (Loss) Income After Provision and Market Valuation Adjustments		(106,057	)		(49,172	)		(290,045	)		12,045
Operating expenses		(17,247	)		(11,732	)		(48,273	)		(42,286	)
Realized (losses) gains on sales and calls, net		(54	)		1,824			2,825			5,708
Minority interest allocation		2,194			—			(430	)		—
Net (loss) income before provision for income taxes		(121,164	)		(59,080	)		(335,923	)		(24,533	)
Credit (provision) for income taxes		9,860			(1,837	)		7,123			(6,659	)
Net (Loss) Income	$	(111,304	)	$	(60,917	)	$	(328,800	)	$	(31,192	)
Basic (loss) earnings per share:	$	(3.34	)	$	(2.18	)	$	(9.99	)	$	(1.14	)
Diluted (loss) earnings per share:	$	(3.34	)	$	(2.18	)	$	(9.99	)	$	(1.14	)
Total dividends declared per common share	$	0.75		$	0.75		$	2.25		$	2.25
Basic weighted average shares outstanding		33,334,011			27,892,199			32,907,196			27,388,185
Diluted weighted average shares outstanding		33,334,011			27,892,199			32,907,196			27,388,185

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
AND COMPREHENSIVE LOSS

For the Nine Months Ended September 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
(In Thousands, Except Share Data) (Unaudited)	Shares			Amount			Additional Paid-In Capital			Accumulated Other Comprehensive (Loss) Income			Cumulative (Losses) Earnings			Cumulative Distributions to Stockholders			Total
December 31, 2007		32,385,073		$	324		$	1,108,148		$	(573,766	)	$	(299,626	)	$	(953,359	)	$	(718,279	)
Adoption of FAS 159		—			—			—			458,207			1,010,071			—			1,468,278
January 1, 2008		32,385,073			324			1,108,148			(115,559	)		710,445			(953,359	)		749,999
Net loss		—			—			—			—			(328,800	)		—			(328,800	)
Net unrealized loss on available-for-sale securities		—			—			—			(95,469	)		—			—			(95,469	)
Reclassification of other-than-temporary impairments to net (loss) income		—			—			—			123,536			—			—			123,536
Reclassification of unrealized loss on interest rate agreements		—			—			—			3,752			—			—			3,752
Total comprehensive loss																				(296,981	)
Issuance of common stock:
Dividend reinvestment & stock purchase plans		1,059,090			13			31,593			—			—			—			31,606
Employee option & stock purchase plan		135,169			—			1,023			—			—			—			1,023
Non-cash equity award compensation		—			—			10,211			—			—			—			10,211
Share repurchases		(341,656	)		(3	)		(6,179	)		—			—			—			(6,182	)
Common dividends declared		—			—			—			—			—			(77,787	)		(77,787	)
September 30, 2008		33,237,676		$	334		$	1,144,796		$	(83,740	)	$	381,645		$	(1,031,146	)	$	411,889

For the Nine Months Ended September 30, 2007



(In Thousands, Except Share Data) (Unaudited)	Common Stock				Additional Paid-In Capital		Accumulated Other Comprehensive (Loss) Income			Cumulative (Losses) Earnings			Cumulative Distributions to Stockholders
(In Thousands, Except Share Data) (Unaudited)	Shares		Amount		Additional Paid-In Capital		Accumulated Other Comprehensive (Loss) Income			Cumulative (Losses) Earnings			Cumulative Distributions to Stockholders			Total
December 31, 2006		26,733,460	$	267	$	903,808	$	93,158		$	809,011		$	(803,554	)	$	1,002,690
Net loss		—		—		—		—			(31,192	)		—			(31,192	)
Net unrealized loss on available-for-sale securities		—		—		—		(839,405	)		—			—			(839,405	)
Reclassification of other-than-temporary impairments to net (loss) income		—		—		—		25,853			—			—			25,853
Unrealized losses on cash flow hedges, net		—		—		—		(14,471	)		—			—			(14,471	)
Reclassification of unrealized loss (gain) on interest rate agreements		—		—		—		(217	)		—			—			(217	)
Total comprehensive loss																	(859,432	)
Issuance of common stock:
Dividend reinvestment & stock purchase plans		1,168,721		12		59,128		—			—			—			59,140
Employee option & stock purchase plan		83,773		1		438		—			—			—			439
Non-cash equity award compensation		—		—		11,374		—			—			—			11,374
Common dividends declared		—		—		—		—			—			(65,419	)		(65,419	)
September 30, 2007		27,985,954	$	280	$	974,748	$	(735,082	)	$	777,819		$	(868,973	)	$	148,792

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS


(In Thousands) (Unaudited)	Nine Months Ended September 30,
(In Thousands) (Unaudited)	2008			2007
Cash Flows From Operating Activities:
Net loss	$	(328,800	)	$	(31,192	)
Adjustments to reconcile net loss to net cash provided by operating activities:
Amortization of premiums, discounts, and debt issuance costs		(9,419	)		(48,418	)
Depreciation and amortization of non-financial assets		882			1,334
Provision for credit losses		36,452			7,836
Non-cash equity award compensation		10,211			11,374
Net recognized losses and valuation adjustments		381,708			142,460
Realized gains on sales and calls, net		(2,825	)		(5,708	)
Net change in:
Accrued interest receivable		19,622			20,296
Deferred income taxes		1,282			(716	)
Other assets		14,633			9,052
Accrued interest payable		(15,917	)		12,587
Accrued expenses and other liabilities		(5,054	)		12,635
Net cash provided by operating activities		102,775			131,540
Cash Flows From Investing Activities:
Purchases of real estate loans held-for-investment		—			(1,173,029	)
Proceeds from sales of real estate loans held-for-investment		—			15,454
Principal payments on real estate loans held-for-investment		1,008,765			2,797,271
Purchases of real estate securities available-for-sale		(257,668	)		(1,173,627	)
Proceeds from sales of real estate securities available-for-sale		7,300			353,506
Principal payments on real estate securities available-for-sale		60,100			256,521
Purchases of real estate securities trading		(3,341	)		(40,818	)
Proceeds from sales of real estate securities trading		7,771			2,237
Principal payments on real estate securities trading		137,181			11,345
Purchases of other investments		—			(80,000	)
Principal payments on other investments		650			—
Net decrease (increase) in restricted cash		55,415			(24,895	)
Net cash provided by investing activities		1,016,173			943,965
Cash Flows From Financing Activities:
Net repayments on short-term Redwood debt		(659	)		(1,816,830	)
Proceeds from issuance of asset-backed securities		—			4,217,357
Deferred asset-backed security issuance costs		—			(22,339	)
Repayments on asset-backed securities		(1,206,387	)		(3,352,784	)
Proceeds from issuance of long-term Redwood debt		—			50,000
Net purchases of interest rate agreements		(9,870	)		(5,814	)
Net proceeds from issuance of common stock		32,629			59,579
Share repurchase		(6,182	)		—
Dividends paid		(76,890	)		(63,146	)
Change in minority interests		35,089			—
Net cash used in financing activities		(1,232,270	)		(933,977	)
Net (decrease) increase in cash and cash equivalents		(113,322	)		141,528
Cash and cash equivalents at beginning of period		290,363			168,016
Cash and cash equivalents at end of period	$	177,041		$	309,544
Supplemental Disclosure of Cash Flow Information:
Cash paid for interest	$	338,997		$	486,496
Cash (received) paid for taxes	$	(1,331	)	$	10,580
Non-Cash Financing Activity:
Dividends declared but not paid at end of period	$	25,184		$	20,989

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 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 securitized real estate loans by acquiring and managing the first-loss and other credit-sensitive securities that bear the bulk of the credit risk of these 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 September 30, 2008 and December 31, 2007, and for the three and nine months ended September 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 nine months ended September 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 September 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 securitization entities.

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

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 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 interest on our consolidated balance sheets and the portion of income allocable to third parties is shown as minority interest allocation in our consolidated statements of (loss) income.

Note 3. Summary of Significant Accounting Policies

Reclassifications

During the third quarter of 2008, we changed the presentation of our consolidated statements of (loss) income to reclassify as a separate line item the provision for loan losses. We determined that this expense had become a material component of net interest income this quarter and no longer present it as a component of interest income. This reclassification did not impact our current or prior period financial statements. The associated allowance for loan losses continues to be presented as a component of real estate loans on our consolidated balance sheets.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires us to make a number of significant 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 estimates 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., valuation changes due to supply and demand, credit performance, prepayments, interest rates, or other reasons) 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.

Fair Value Measurements

Our financial statements include assets and liabilities that are measured at their estimated fair values. Effective January 1, 2008, we adopted two pronouncements relating to fair value measurements: 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).

A fair value measurement represents the price at which a transaction would occur between market participants. This price implies an orderly transaction, or exit price, that is not a forced liquidation or distressed sale at the measurement date. Redwood’s approach to developing fair values for financial assets or liabilities focuses on available inputs and pricing that is observed in the market place. Examples of the market information that we attempt to obtain include the following:

•

Quoted prices for the same or similar securities;

•

Relevant reports issued by analysts and ratings agencies;

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

•

The current level of interest rates and any directional movements in relevant indexes, such as credit risk indexes;

•

Information about the performance of the underlying mortgage loans, such as delinquency and foreclosure rates, loss experience, and prepayment rates;

•

Indicative prices or yields from broker/dealers; and,

•

Other relevant observable inputs, including nonperformance risk and liquidity premiums.

After considering all available indications of the appropriate rate of return that market participants would consider relevant in estimating fair value, we consider the reasonableness of the range indicated by the results to determine an estimate that is representative of fair value.

Establishing fair values for illiquid assets and liabilities is inherently subjective and is often dependent upon our estimates and modeling assumptions. The use of our internal assumptions about future cash flows and appropriately risk-adjusted discount rates are used in determining fair value when relevant observable inputs are not available. In cases where the volume and level of trading activity in the asset declined significantly, the available prices vary significantly over time or among market participants, or the prices are not current, the observable inputs might not be relevant and could require significant adjustment. While broker (or pricing service) quotes may be an appropriate input when measuring fair value, they are not necessarily determinative if an active market does not exist for the financial asset or liability. The nature of the quote (for example, whether the quote is an indicative price or a binding offer) is considered when weighing the available evidence.

Since the second half of 2007, the market for residential, commercial, and collateralized debt obligation (CDO) credit enhancement securities (CES), and most real estate investment grade securities (IGS), has become increasingly inactive. The inactivity was evidenced by a significant widening of the bid-ask spread in the brokered markets in which these securities trade and by a significant decrease in the volume of trades relative to historical levels. There were few observable transactions for our securities or similar securities, if any, and indicative prices for these securities varied substantially over time and among market makers, thus reducing the potential relevance of those observations.

In October 2008, the FASB issued FASB Staff Position 157-3, Determining Fair Value of a Financial Asset in a Market That Is Not Active (FSP 157-3). FSP 157-3 clarified the application of FAS 157 in an inactive market. The implementation of this standard did not have a material impact on our consolidated financial position and results of operations as our existing valuation methodology is consistent with the FASB’s clarification.

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

Real Estate Loans

Residential and Commercial Real Estate Loans — Fair Value

Residential and commercial real estate loans at fair value are loans where we have elected the fair value option under FAS 159. These loans are carried at their estimated fair values. Coupon interest is recognized as revenue when earned and deemed collectible or until a loan becomes more than 90 days past due. Changes in fair value (gains and losses) are recurring and are reported through our consolidated statements of (loss) income in market valuation adjustments, net. The fair value option was elected on January 1, 2008, for all the loans owned by Acacia securitization entities as of that date.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

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

Residential and commercial real estate loans held-for-sale are loans that we are marketing for sale to independent third parties. These loans are carried at the lower of their cost or fair value in accordance with Statement of Financial Accounting Standards No. 65, Accounting for Certain Mortgage Banking Activities (FAS 65). Coupon interest is recognized as revenue when earned and deemed collectible or until a loan becomes more than 90 days past due. If fair value is lower than amortized cost, changes in fair value (gains and losses) are reported through our consolidated statements of (loss) income in market valuation adjustments, net.

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

Residential and commercial real estate loans held-for-investment are loans owned by Sequoia entities. These loans are carried at their unpaid principal balances adjusted for net unamortized premiums or discounts and net of any allowance for credit losses. Coupon interest is recognized as revenue when earned and deemed collectible or until a loan becomes more than 90 days past due. 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 to amortize the premium or discount on real estate loans held-for-investment. For residential 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 residential 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. We reclassify held-for-investment loans to held-for-sale loans once we determine that loans will be sold to third parties. Gains or losses on the sale of real estate loans are based on the specific identification method.

See Note 6 for further discussion on real estate loans.

Real Estate Loans — Allowance for Loan Losses

For real estate loans classified as held-for-investment, we establish and maintain an allowance for loan losses based on our estimate of credit losses inherent in our loan portfolios as of the reporting date. To calculate the allowance for loan 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 the allowance for loan losses.

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;

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

•

Relevant market research and publicly available third-party reference loss rates;

•

Trends in delinquencies and charge-offs;

•

Effects and changes in credit concentrations;

•

Information supporting 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 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 allowance for loan losses, since we believe these losses exist as of the reported date of the financial statements. We re-evaluate the adequacy of our allowance for loan losses on at least a quarterly basis, and we record provision expense, charge-offs, and recoveries monthly.

See Note 7 for further discussion on the allowance for loan losses.

We do not currently maintain a loan repurchase reserve, as we do not originate real estate loans and we believe that any risk of loss due to loan repurchases (i.e., due to breach of representations and warranties) would be a contingency to the companies from whom we acquired the loans and therefore would be covered by our recourse to those companies. There are no outstanding repurchase claims against Redwood.

Real Estate Securities, at Fair Value

Trading Securities

Trading securities include residential, commercial, and CDO real estate securities. Trading securities are carried at their estimated fair values. Coupon interest is recognized as interest income when earned and deemed collectible and all changes in fair value are reported through our consolidated statements of (loss) income in market valuation adjustments, net.

We primarily denote trading securities as those securities where we have adopted the fair value option under FAS 159. We currently account for certain IGS and CES at Redwood and all securities at Acacia entities as trading securities. Prior to the adoption of FAS 159, trading securities were accounted for in accordance with Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities (FAS 115).

Available-for-Sale Securities

Available-for-sale (AFS) securities include certain residential, commercial, and CDO real estate securities. AFS securities are carried at their estimated fair values with cumulative unrealized gains and losses reported as a component of accumulated other comprehensive income (loss) in our consolidated statements of stockholders’ equity (deficit), in accordance with FAS 115. We currently account for most IGS and CES at Redwood and all securities at the Fund as AFS securities.

When recognizing revenue on our AFS securities, we have determined that credit risk is not remote and therefore 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). Coupon interest is recognized as

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

interest income when earned and deemed collectible, and the interest method is used to determine an effective yield to amortize purchase premiums, discounts, and fees associated with these securities into income over time. This requires us to project cash flows over the remaining life of each asset, which includes assumptions about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. We review and make adjustments to our cash flow projections on an ongoing basis and monitor these projections based on input and analyses received from external sources, internal models, and our own judgment and experience. Actual maturities of the AFS securities are affected by the contractual lives of the associated mortgage collateral, periodic payments of principal, and prepayments of principal. Therefore 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.

We assess each quarter whether a decline in fair value below our cost of the AFS security is other-than-temporary impairment. For determining other-than-temporary impairment, we use the guidelines prescribed under FAS 115, EITF 99-20, and SEC Staff Accounting Bulletin No. 5(m), Other-Than-Temporary Impairment for Certain Investments in Debt and Equity Securities (commonly referred to as SAB 59). If there has been an adverse change in the projected future cash flows of the security, we no longer have the ability and intent to hold the security, or we have determined that there will not likely be a recovery of fair value up to (or beyond) the amortized cost of the security within a reasonable period of time, there is other-than-temporary impairment. Upon the determination of other-than-temporary impairment, any associated accumulated other comprehensive income (loss) is reclassified into earnings using the specific identification method and reported under market valuation adjustments, net, in our consolidated statements of (loss) income.

See Note 8 for further discussion on real estate securities.

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 under FAS 159 for this investment on January 1, 2008, and it is recorded on our consolidated balance sheets at its estimated fair value. Changes in fair value are reported through our consolidated statements of (loss) income through market valuation adjustments, net. Interest income is reported through our consolidated statements of (loss) income through interest income, other investments.

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

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September 30, 2008
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Note 3. Summary of Significant Accounting Policies – (continued)

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.

Accrued Interest Receivable

Accrued interest receivable represents interest that is due and payable to us. Cash interest is generally received within thirty days of recording the receivable. For financial assets where we have elected the fair value option under FAS 159, the associated accrued interest on these assets is measured at fair value. For financial assets where we have not elected to adopt FAS 159, the associated accrued interest carrying values approximate fair values.

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) and FAS 159. 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.

Interest Rate Agreements

We maintain an overall interest rate risk management strategy that incorporates the use of interest rate agreements. We enter into interest rate agreements for a variety of reasons, including minimizing significant fluctuations in earnings or market values on certain assets or liabilities that may be caused by interest rate volatility. Interest rate agreements that we use as part of our interest rate risk management strategy may include interest rate options, swaps, options on swaps, futures contracts, options on futures contracts, and options on forward purchases.

Prior to 2008, we accounted for derivatives used to hedge interest rate exposure in Acacia securitization entities as cash flow hedges. At January 1, 2008, all of our consolidated 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 amortized using the straight line method through interest expense over the remaining lives of the hedged Acacia ABS issued. Net purchases and proceeds from interest rate agreements are classified as financing activities within our consolidated statements of cash flows.

Credit Derivatives

A credit default swap (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. These instruments enable us to synthetically assume the credit risk of a reference security or index of securities. All of our existing CDS contracts were initiated during 2007 by one of the Acacia entities that we have consolidated for financial reporting purposes. Net purchases and proceeds from CDS are classified as financing activities within our consolidated statements of cash flows.

See Note 10 for further discussion on derivative financial instruments.

Deferred Tax Assets

Income recognition for GAAP and tax differ in material respects. These differences often reflect differing accounting treatments for tax and GAAP, such as accounting for discount and premium amortization, credit losses, equity awards, asset impairments, and certain valuation estimates. Some of these differences are

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

temporary in nature and create timing mismatches between when taxable income is earned and the tax is paid versus when the GAAP income is recognized and the tax provision is recorded. Some of these differences are permanent since certain income (or expense) may be recorded for tax but not for GAAP (or vice-versa). One such significant permanent difference is our ability as a REIT to deduct dividends paid to shareholders as an expense for tax, but not for GAAP.

As a result of these differences, we may recognize taxable income in periods prior to when we recognize income for GAAP. When this occurs, we pay the tax liability and establish a deferred tax asset for GAAP. As the income is subsequently realized in future periods under GAAP, the deferred tax asset is recognized as an expense. Our deferred tax assets are primarily 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 on deferred tax assets.

Deferred Asset-Backed Securities Issuance Costs

ABS issuance costs are costs associated with the issuance of ABS from securitization entities we sponsor. These costs typically include underwriting, rating agency, legal, accounting, and other fees. 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 accounted for 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.

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.

See Note 11 for further discussion on other assets.

Short-Term Debt — Redwood

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

See Note 12 for further discussion on short-term Redwood debt.

Accrued Interest Payable

Accrued interest payable represents interest that is due and payable to third parties. Interest is generally paid within thirty days to three months of recording the payable, based upon our remittance requirements. For borrowings where we have elected the fair value option under FAS 159, the associated accrued interest on these liabilities is measured at fair value. For financial liabilities where we have not elected to adopt FAS 159, the associated accrued interest carrying values approximate fair values.

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NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

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 FAS 159 and carried at their estimated 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.

See Note 13 for further discussion on asset backed securities 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 carried at its unpaid principal balance.

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

Minority Interest

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

See Note 16 for further discussion on minority interest.

Stockholders’ Equity

(Loss) Earnings 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 (Loss) Income

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

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NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

comprehensive (loss) income on our consolidated statements of stockholders’ equity (deficit) and comprehensive (loss) income. Net unrealized gains and losses on securities and interest rate agreements held by our taxable subsidiaries that are reported in other comprehensive (loss) income are adjusted for the effects of taxation and may create deferred tax assets or liabilities.

Equity Compensation Plans

Incentive Plan

In March 2008, we amended our previously amended 2002 Redwood Trust, Inc. Incentive Stock Plan (Incentive Plan) for executive officers, employees, and non-employee directors. This amendment was approved by our shareholders in May 2008. The Incentive Plan authorizes our Board of Directors (or a committee appointed by our Board of Directors) to grant incentive stock options (ISOs), non-qualifying stock options (NQSOs), deferred stock units (DSUs), restricted stock, performance shares, stock appreciation rights, limited stock appreciation rights (awards), and dividend equivalent rights (DERs) to eligible recipients other than non-employee directors.

The cost of equity awards is determined in accordance with Statement of Financial Accounting Standards No. 123R, Share-Based Payment (FAS 123R), and amortized over the vesting term using an accelerated method in accordance with FASB Interpretation No. 28 Accounting for Stock Appreciation Rights and Other Variable Stock Options or Award Plans (FIN 28) and FAS 123R. Stock options, deferred stock units, and restricted stock granted to employees generally vest over a four-year period. Non-employee directors are provided annual awards under the Incentive Plan that generally vest immediately.

Executive Deferred Compensation Plan

In May 2002, our Board of Directors approved our 2002 Executive Deferred Compensation Plan (EDCP). The EDCP allows eligible employees and directors to defer portions of current salary and certain other forms of compensation. Redwood matches some deferrals. Compensation deferred under the EDCP is an asset of Redwood and subject to the claims of the general creditors of Redwood. The EDCP allows for the investment of deferrals in either an interest crediting account or additional DSUs. Participants may also use their deferrals to acquire additional DSUs.

Employee Stock Purchase Plan

In May 2002, our stockholders approved our 2002 Redwood Trust, Inc. Employee Stock Purchase Plan (ESPP), effective July 1, 2002. The purpose of the ESPP is to give our employees an opportunity to acquire an equity interest in Redwood through the purchase of shares of common stock at a discount. The ESPP allows eligible employees to purchase common stock at 85% of its fair value, subject to limits. Fair value as defined under the ESPP is the lesser of the closing market price of the common stock on the first day of the calendar year or the first day of the calendar quarter.

See Note 18 for further discussion on equity compensation plans.

Taxes

We have elected to be taxed as a REIT under the Internal Revenue Code and the corresponding provisions of state law. To qualify as a REIT we must distribute at least 90% of our annual REIT taxable income to shareholders (not including taxable income retained in our taxable subsidiaries) within the time frame set forth in the tax code and we also meet certain other requirements. We currently distribute 100% of our REIT taxable income to shareholders.

The tax provisions we record are determined by applying our expected annual effective tax rate to our GAAP pre-tax (loss) income. The effective tax rate is determined as the ratio of our estimated current year tax

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NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

liability to our estimated GAAP pre-tax (loss) income. This annual estimate is based on our annualized actual GAAP results to date. The estimate of the annual effective tax rate used by annualizing year-to-date results may not reflect actual GAAP earnings for the year. However, we believe that applying the effective tax rate to annualized GAAP income is an appropriate estimate due to the inherent volatility of our GAAP earnings, in part due to significant market valuation adjustments on our assets and liabilities that are recorded on our GAAP consolidated statements of (loss) income.

We assess our tax positions for all open tax years and determine whether we have any material unrecognized liabilities in accordance with Financial Accounting Standard Board Interpretation Number 48, Accounting for Uncertainty in Income Taxes, (FIN 48). We record these liabilities to the extent we deem them incurred. We classify interest and penalties on material uncertain tax positions as interest expense and operating expense, respectively, in our consolidated statements of (loss) income.

See Note 20 for further discussion on taxes.

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.

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. We are currently evaluating the disclosure requirements of FSP 140-3.

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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

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 adopting this principle.

Note 4. FAS 159

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. This election is available when we first recognize a financial asset or financial liability or enter into a firm commitment, or upon the initial adoption of FAS 159 on January 1, 2008. Subsequent changes in the fair value of assets, liabilities, and commitments are recorded in the consolidated statements of (loss) income.

Our decision to adopt FAS 159 for new financial instruments is generally based upon our funding strategy for the specific financial asset acquired. For example, securities that we anticipate funding with equity will generally be accounted for as AFS securities under FAS 115. Securities that we anticipate funding with a combination of debt and equity will generally be accounted for at fair value under FAS 159 along with the corresponding liabilities. We did not elect the fair value option under FAS 159 for any financial instruments that were acquired during the third quarter of 2008.

Transition Adjustment Due to the Adoption of FAS 159 on January 1, 2008.

We adopted FAS 159 on January 1, 2008, and elected to apply the fair value option for the assets (loans, securities, and unamortized deferred ABS issuance costs) and liabilities (ABS issued) of our consolidated Acacia securitization entities. We also elected the fair value option for certain securities at Redwood that we anticipated potentially selling or securitizing in the future. We did not elect the fair value option for the assets and liabilities at Sequoia, as these assets and liabilities are 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 most CES and other investments at Redwood, as these assets were funded with equity and are not anticipated to be funded with a combination of debt and equity in the future.

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 of Acacia enabled us to mitigate the volatility in earnings and book value that results from the use of different measurement attributes. As a result of this fair value election we de-designated the cash flow hedge accounting elections for interest rate agreements, which reduced the complexity of accounting with regards to derivatives under FAS 133.

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

Note 4. FAS 159 – (continued)

The following table presents the resulting $1.5 billion cumulative effect transition adjustment of this one-time election of FAS 159 and its effect on the consolidated total assets and total liabilities and stockholders’ equity (deficit) at January 1, 2008.


(In Millions)	December 31, 2007 Redwood Consolidated			Transition Adjustment			January 1, 2008 Redwood Consolidated
Real estate loans	$	7,204		$	(2	)	$	7,202
Real estate securities and other investments		2,201			—			2,201
Cash and cash equivalents		290			—			290
Total earning assets		9,695			(2	)		9,693
Restricted cash		118			—			118
Deferred asset-backed issuance costs		40			(21	)		19
Other assets		86			—			86
Total Assets		9,939			(23	)		9,916
Redwood debt		8			—			8
Asset-backed securities issued – Sequoia		6,946			—			6,946
Asset-backed securities issued – Acacia		3,383			(1,490	)		1,893
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	)		1,008			(244	)
Total stockholders’ (deficit) equity		(718	)		1,467			749
Total Liabilities and Stockholders’ Equity	$	9,939		$	(23	)	$	9,916

As of September 30, 2008, the Acacia loans had an aggregate fair value of $14 million and an unpaid principal balance of $27 million, and asset-backed securities issued had an aggregate fair value of $673 million and an unpaid principal balance of $3.2 billion.

Note 5. Fair Value of Financial Instruments

We adopted FAS 157 on January 1, 2008. FAS 157 defines 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” should be used to value an asset or liability, which is the price at which an asset could be sold or a liability could be transferred in an orderly process that is not a forced liquidation or distressed sale at the measurement date. FAS 157 also provides that relevant market data, to the extent available, and not internally generated or entity specific information should be used to determine fair value. The financial impact on Redwood from 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 the new standard.

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REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

The following table presents the carrying values and estimated fair values of assets and liabilities that are required to be recorded or disclosed at fair value as of September 30, 2008 and December 31, 2007.


	September 30, 2008				December 31, 2007
(In Thousands)	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets
Real estate loans (held-for-investment)	$	6,083,781	$	4,870,278	$	7,199,618	$	6,860,574
Real estate loans (held-for-sale)		3,150		3,150		4,533		4,533
Real estate loans (fair value)		14,461		14,461		—		—
Trading securities		573,842		573,842		11,521		11,521
Available-for-sale securities		288,174		288,174		2,110,080		2,110,080
Other investments		78,474		78,474		79,125		79,125
Cash and equivalents		177,041		177,041		290,363		290,363
Derivative assets		4,641		4,641		5,598		5,598
Restricted cash		62,649		62,649		118,064		118,064
Accrued interest receivable		37,380		37,380		45,553		45,553
REO (included in other assets)		20,950		20,950		15,118		15,118
Liabilities
Short-term debt – Redwood		6,902		6,902		7,561		7,561
Derivative liabilities		106,849		106,849		81,385		81,385
Accrued interest payable		31,762		31,762		53,796		53,796
ABS Issued
ABS issued – Sequoia		5,929,248		5,087,333		6,946,166		6,693,087
ABS issued – Acacia		672,964		672,964		3,383,113		1,893,441
Total ABS issued		6,602,212		5,760,297		10,329,279		8,586,528
Long-term debt – Redwood		150,000		63,258		150,000		94,000

FAS 157 requires us to perform and disclose fair value estimates based on the following three-level hierarchy that prioritizes market inputs.

Level 1:

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

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 unobservable inputs that are used when there is little, if any, market activity for the asset or liability measured at fair value. In certain cases, the inputs used to measure fair value fall into different levels of the fair value hierarchy. In such cases, the level in 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 requires judgment and considers factors specific to the asset or liability being measured.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

The following table presents assets and liabilities recorded at fair value on our consolidated balance sheet on a recurring basis 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 September 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		14,461		—		—		14,461
Trading securities		573,842		—		—		573,842
Available-for-sale securities		288,174		—		—		288,174
Other investments		78,474		—		—		78,474
Derivative assets		4,641		—		4,529		112
Liabilities
ABS issued – Acacia		672,964		—		—		672,964
Derivative liabilities		106,849		—		30,716		76,133

The following table presents additional information about the assets and liabilities recorded at fair value on our consolidated balance sheet on a recurring basis for which Level 3 inputs were used.

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


						Gains (Losses) Included in						Purchases, Sales, Other Settlements and Issuances, Net
Three Months Ended September 30, 2008 (In Thousands)	Beginning Balance 7/1/2008		Principal Paydowns			Net Loss			Other Comprehensive Loss			Purchases, Sales, Other Settlements and Issuances, Net			Ending Balance 9/30/2008
Assets
Real estate loans	$	18,800	$	(115	)	$	(4,224	)	$	—		$	—		$	14,461
Trading securities		841,868		(36,677	)		(223,719	)		—			(7,630	)		573,842
Available-for-sale securities		399,759		(19,002	)		(84,944	)		(20,855	)		13,216			288,174
Other investments		78,583		(109	)		—			—			—			78,474
Derivative assets		279		—			(142	)		—			(25	)		112
Liabilities
Acacia ABS issued		935,072		(58,044	)		(204,064	)		—			—			672,964
Derivative liabilities		75,290		—			356			—			487			76,133


						Gains (Losses) Included in						Purchases, Sales, Other Settlements and Issuances, Net
Nine Months Ended September 30, 2008 (In Thousands)	Beginning Balance 1/1/2008		Principal Paydowns			Net Loss			Other Comprehensive Loss			Purchases, Sales, Other Settlements and Issuances, Net			Ending Balance 9/30/2008
Assets
Real estate loans	$	25,426	$	(344	)	$	(8,772	)	$	(1,849	)	$	—		$	14,461
Trading securities		1,804,511		(137,181	)		(1,088,870	)		—			(4,618	)		573,842
Available-for-sale securities		317,090		(60,100	)		(249,000	)		28,239			251,945			288,174
Other investments		79,125		(651	)		—			—			—			78,474
Derivative assets		114		—			66			—			(68	)		112
Liabilities
Acacia ABS issued		1,893,441		(198,090	)		(1,018,369	)		—			(4,018	)		672,964
Derivative liabilities		57,397		—			20,455			—			(1,719	)		76,133

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

The following table presents the portion of gains or losses included in our consolidated statement of (loss) income that were attributable to Level 3 assets and liabilities recorded at fair value on a recurring basis and still held at September 30, 2008. Gains or losses incurred on assets or liabilities sold during the three or nine months ended September 30, 2008 are not included in the table below.

Portion of Gains or (Losses) Attributable to Level 3 Asset and Liabilities Still Held at September 30, 2008


	Included in Net Loss
(In Thousands)	Three Months Ended September 30, 2008			Nine Months Ended September 30, 2008
Assets
Real estate loans (fair value)	$	(4,224	)	$	(8,772	)
Trading securities		(223,730	)		(1,084,896	)
Available-for-sale securities		(92,794	)		(267,179	)
Other investments		—			—
Derivative assets		(142	)		66
Liabilities
Acacia ABS issued		206,924			1,017,972
Derivative liabilities		(356	)		(17,250	)

The following table presents assets and liabilities recorded at fair value on a non-recurring basis and indicates the fair value hierarchy of the valuation techniques used to measure fair value.

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


			Fair Value Measurements Using						Gains/(Losses)
(In Thousands)	Carrying Value		Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Three Months Ended September 30, 2008			Nine Months Ended September 30, 2008
Assets
Real estate loans (held-for-sale)		3,150		—		—		3,150		(415	)		(791	)
Real estate owned		20,950		—		—		20,950		(2,076	)		(3,624	)

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of (loss) income for the three and nine months ended September 30, 2008.

Market Valuation Adjustments, Net


(In Thousands)	Three Months Ended September 30, 2008			Nine Months Ended September 30, 2008
Assets
Real estate loans (fair value)	$	(4,224	)	$	(8,772	)
Real estate loans (held-for-sale)		(2,491	)		(4,417	)
Trading securities		(223,719	)		(1,087,597	)
Impairments on AFS securities		(92,794	)		(265,861	)
Other investments		—			—
Liabilities
Acacia ABS issued		206,924			1,021,229
Derivative instruments, net		(10,853	)		(36,290	)
Market Valuation Adjustments, Net	$	(127,157	)	$	(381,708	)

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 3).

•

Commercial real estate loan fair values are determined by available market quotes and discounted cash flow analyses (Level 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 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 considers the GIC’s fair value to approximate its contract value, as the GIC earns a variable interest rate of LIBOR less 5 basis points and resets on a monthly basis (Level 3).

•

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,

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

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

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 (Level 2). 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 (Level 3).

•

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.

•

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 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.

•

Real estate owned

•

Real estate owned includes properties owned in satisfaction of foreclosed loans. Fair values are determined using available market quotes, appraisals, broker price opinions, comparable properties, or other indications of value.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

Note 6. Real Estate Loans

We acquire residential and commercial real estate loans from third party originators. These loans are generally sold to securitization entities sponsored by us under our Sequoia program which, in turn, issue ABS. The remainder of the loans we invest in are held and financed through our Acacia program or 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 September 30, 2008 and December 31, 2007.


(In Thousands)	September 30, 2008		December 31, 2007
Commercial real estate loans (fair value)	$	14,461	$	—
Residential real estate loans (held-for-sale)		3,150		4,533
Residential real estate loans (held-for-investment)		6,083,531		7,173,940
Commercial real estate loans (held-for-investment)		250		25,678
Total Real Estate Loans	$	6,086,931	$	7,204,151

On January 1, 2008, we elected the fair value option under FAS 159 for commercial real estate loans owned by Acacia entities, and record these loans at their estimated fair values. At September 30, 2008 we owned $14 million ($27 million principal face) of commercial loans, none of which are delinquent. Prior to 2008, these loans were classified as held-for-investment.

At September 30, 2008, we had $5 million in outstanding principal of residential loans held-for-sale with a lower of cost or fair value of $3 million. At December 31, 2007, there was $6 million in outstanding principal of residential loans held-for-sale 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 September 30, 2008 and December 31, 2007.


September 30, 2008 (In Thousands)	Residential Real Estate Loans			Commercial Real Estate Loans			Total
Face value	$	6,065,324		$	11,100		$	6,076,424
Unamortized premium (discount), net		65,088			(361	)		64,727
Discount designated as credit reserve		—			(8,141	)		(8,141	)
Allowance for loan losses		(46,881	)		(2,348	)		(49,229	)
Carrying Value	$	6,083,531		$	250		$	6,083,781


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

Residential real estate loans held-for-investment at September 30, 2008 and December 31, 2007, are owned by Sequoia entities. Of the $6.1 billion of principal face and $65 million of unamortized premium on these loans at September 30, 2008, $2.1 billion of principal face and $48 million of unamortized premium

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

Note 6. Real Estate Loans – (continued)

relates to residential loans acquired prior to July 1, 2004. During the first nine months of 2008, 17% of these residential loans prepaid and we amortized 27% of the premium. For residential loans acquired after July 1, 2004, the principal face was $4 billion and the unamortized premium was $17 million at September 30, 2008. During the first nine months of 2008, 13% of these residential loans prepaid and we amortized 16% of the premium.

Of the $7.1 billion of principal face and $86 million of unamortized premium on our residential real estate loans held-for-investment 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, and $4.6 billion of principal face and $20 million of unamortized premium relates to residential loans acquired after July 1, 2004.

Commercial real estate loans held-for-investment had a carrying value of $0.3 million at September 30, 2008. During the first quarter of 2007, we fully reserved for an anticipated loss on a $2 million 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, and thus maintain the reserve as of September 30, 2008.

Note 7. Allowance for Loan Losses

We establish an allowance for loan losses on our residential loans held-for-investment based on our estimate of losses incurred in our loan portfolio. At both September 30, 2008 and December 31, 2007, all residential loans classified as held-for-investment were owned by Sequoia entities.

The following table summarizes the activity in the allowance for loan losses for our consolidated Sequoia loans for the three and nine months ended September 30, 2008 and 2007.

Activity in the Allowance for Loan Losses


	Three Months Ended September 30,						Nine Months Ended September 30,
(In Thousands)	2008			2007			2008			2007
Balance at beginning of period	$	32,597		$	16,416		$	18,282		$	20,119
Charge-offs, net		(4,049	)		(2,728	)		(7,853	)		(10,412	)
Provision for loan losses		18,333			1,507			36,452			5,488
Balance at End of Period	$	46,881		$	15,195		$	46,881		$	15,195

Serious delinquencies on Sequoia loans were $143 million and $68 million as of September 30, 2008 and December 31, 2007, respectively. Serious delinquencies include loans delinquent more than 90 days and in foreclosure. As a percentage of current loan balances, serious delinquencies were 2.36% and 0.96% at September 30, 2008 and December 31, 2007, respectively. As a percentage of original balances, serious delinquencies were 0.51% and 0.24% at September 30, 2008 and December 31, 2007, respectively.

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 other costs), and charge this specific estimated loss against the allowance for loan losses. During the first nine months of 2008, there were $8 million of charge-offs that reduced our allowance for loan losses. These charge-offs arose from $31 million of defaulted loan principal. Foreclosed property is subsequently recorded as REO, a component of other assets. Subsequent changes in the value of an REO property below its cost basis flow through market valuation adjustments, net, in our consolidated statements of (loss) income.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 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 September 30, 2008 and December 31, 2007.


September 30, 2008 (In Thousands)	Redwood		The Fund		Acacia		Total Securities
Residential	$	160,986	$	52,729	$	403,893	$	617,608
Commercial		63,686		—		128,000		191,686
CDO		4,065		14,116		34,541		52,722
Total Real Estate Securities	$	228,737	$	66,845	$	566,434	$	862,016


December 31, 2007 (In Thousands)	Redwood		The Fund		Acacia		Total Securities
Residential	$	174,756	$	3,126	$	1,393,048	$	1,570,930
Commercial		148,508		—		278,003		426,511
CDO		20,822		12,075		91,263		124,160
Total Real Estate Securities	$	344,086	$	15,201	$	1,762,314	$	2,121,601

The following table presents our trading and AFS real estate securities by collateral type and entity as of September 30, 2008 and December 31, 2007.


September 30, 2008 (In Thousands)	Trading				AFS				Total Securities
September 30, 2008 (In Thousands)	Redwood		Acacia		Redwood		The Fund		Trading		AFS
Residential IGS
Prime	$	1,121	$	80,090	$	65,133	$	—	$	81,211	$	65,133
Non-prime		476		236,787		46,624		52,230		237,263		98,854
Total Residential IGS		1,597		316,877		111,757		52,230		318,474		163,987
Residential CES
Prime		—		34,684		41,414		—		34,684		41,414
Non-prime		1,901		52,332		4,317		499		54,233		4,816
Total Residential CES		1,901		87,016		45,731		499		88,917		46,230
Commercial IGS		—		46,909		—		—		46,909		—
Commercial CES		—		81,091		63,686		—		81,091		63,686
CDO IGS		3,835		31,754		—		7,487		35,589		7,487
CDO CES		75		2,787		155		6,629		2,862		6,784
Total Real Estate Securities	$	7,408	$	566,434	$	221,329	$	66,845	$	573,842	$	288,174

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

Note 8. Real Estate Securities – (continued)


December 31, 2007 (In Thousands)	Trading		AFS						Total Securities
December 31, 2007 (In Thousands)	Redwood		Acacia		Redwood		The Fund		Trading		AFS
Residential IGS
Prime	$	—	$	514,045	$	1,360	$	—	$	—	$	515,405
Non-prime		—		628,068		10,865		3,126		—		642,059
Total Residential IGS		—		1,142,113		12,225		3,126		—		1,157,464
Residential CES
Prime		—		193,676		127,612		—		—		321,288
Non-prime		11,521		57,259		23,398		—		11,521		80,657
Total Residential CES		11,521		250,935		151,010		—		11,521		401,945
Commercial IGS		—		89,676		—		—		—		89,676
Commercial CES		—		188,327		148,508		—		—		336,835
CDO IGS		—		83,094		18,450		12,075		—		113,619
CDO CES		—		8,169		2,372		—		—		10,541
Total Real Estate Securities	$	11,521	$	1,762,314	$	332,565	$	15,201	$	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 September 30, 2008 and December 31, 2007, $10 million and $8 million, respectively, were pledged for short-term Redwood debt.

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

AFS Securities


September 30, 2008 (In Thousands)	Residential			Commercial			CDO			Total
Face Value	$	945,618		$	514,882		$	93,086		$	1,553,586
Discount – designated credit reserve		(556,489	)		(470,660	)		(59,818	)		(1,086,967	)
Discount – net unamortized		(129,504	)		23,847			(17,910	)		(123,567	)
Amortized cost		259,625			68,069			15,358			343,052
Gross unrealized gains		5,998			2,090			—			8,088
Gross unrealized losses		(55,406	)		(6,473	)		(1,087	)		(62,966	)
Carrying Value	$	210,217		$	63,686		$	14,271		$	288,174


December 31, 2007 (In Thousands)	Residential			Commercial			CDO			Total
Face Value	$	3,553,064		$	988,653		$	393,010		$	4,934,727
Discount – designated credit reserve		(723,489	)		(318,456	)		(100,617	)		(1,142,562	)
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

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

Note 8. Real Estate Securities – (continued)

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. We additionally may expense a portion of our investment in the security to the extent we believe that principal losses will exceed the discount. The portion of the total face that we do not amortize into income is designated as a credit reserve on the security, with net unamortized discounts or premiums amortized into income over time using the interest method in accordance with EITF 99-20.

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


Three Months Ended September 30, 2008 (In Thousands)	Residential						Commercial						CDO
Three Months Ended September 30, 2008 (In Thousands)	Designated Credit Reserve			Unamortized Net Discount			Designated Credit Reserve			Unamortized Net Discount			Designated Credit Reserve			Unamortized Net Discount
Beginning balance – June 30, 2008	$	555,702		$	154,465		$	384,487		$	31,871		$	33,743		$	42,415
Amortization of net (discount) premium		—			(9,952	)		—			2,581			—			(479	)
Realized credit losses		(79,804	)		—			(2,733	)		—			(5,000	)		—
Acquisitions		—			10,244			—			—			—			—
Sales, calls, other		106			—			—			—			43			51
Impairments		55,232			—			30,607			—			6,955			—
Transfers/release of credit reserves		25,253			(25,253	)		58,299			(58,299	)		24,077			(24,077	)
Ending balance – September 30, 2008	$	556,489		$	129,504		$	470,660		$	(23,847	)	$	59,818		$	17,910


Nine Months Ended September 30, 2008 (In Thousands)	Residential						Commercial						CDO
Nine Months Ended September 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) premium		—			(29,829	)		—			6,227			—			(1,370	)
Realized credit losses		(170,973	)		—			(8,273	)		—			(9,150	)		—
Acquisitions		28,030			103,967			—			—			15,000			13,569
Sales, calls, other		106			7,866			—			—			43			(4,494	)
Impairments		144,970			—			112,536			—			8,354			—
Transfers/release of credit reserves		44,223			(44,223	)		47,941			(47,941	)		23,716			(23,716	)
Ending balance – September 30, 2008	$	556,489		$	129,504		$	470,660		$	(23,847	)	$	59,818		$	17,910

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

Note 8. Real Estate Securities – (continued)

The loans underlying our residential CES totaled $132 billion at September 30, 2008, and consist of $101 billion prime and $31 billion non-prime loans. These loans are located nationwide with a large concentration in California (49%). Serious delinquencies (90+ days, in foreclosure or REO) at September 30, 2008 were 4.60% of current principal balances and 2.00% of original principal balances. For loans in prime pools, serious delinquencies were 1.43% of current balances and 0.62% of original balances. Non-prime pools had serious delinquencies of 14.94% of current balances and 6.48% of original balances.

The loans underlying our commercial CES totaled $49 billion at September 30, 2008, and consist primarily of office (39%), retail (28%), and multifamily (16%) commercial loans. These loans are located nationwide. Serious delinquencies (90+ days, in foreclosure or REO) at September 30, 2008 were 0.96% of current principal balances and 0.90% of original principal balances.

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 September 30, 2008, and December 31, 2007.

AFS Securities with Unrealized Losses


	Less than 12 Consecutive Months							12 Consecutive Months or Longer
September 30, 2008 (In Thousands)	Total Amortized Cost		Gross Unrealized Losses			Total Fair Value		Total Amortized Cost		Gross Unrealized Losses		Total Fair Value
Residential	$	202,613	$	(55,406	)	$	147,207	$	—	$	—	$	—
Commercial		21,773		(6,473	)		15,300		—		—		—
CDO		7,282		(1,087	)		6,195		—		—		—
Total Securities	$	231,668	$	(62,966	)	$	168,702	$	—	$	—	$	—


	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 September 30, 2008, we owned 593 AFS securities, of which, 128 were in an unrealized loss position and none were in an unrealized loss position for twelve consecutive 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.

For the three and nine months ended September 30, 2008, we recognized other-than-temporary impairments on AFS securities of $93 million and $266 million, respectively, through market valuation adjustments, net, in our consolidated statements of (loss) income. For the three and nine months ended September 30, 2007, we recognized other-than-temporary impairments of $83 million and $107 million, respectively.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

Note 8. Real Estate Securities – (continued)

Gross Realized Gains and Losses

Gains and losses from the sale of 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 three and nine months ended September 30, 2008 and 2007.

Three Months Ended
September 30,

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

FORM 10-Q

For the Quarterly Period Ended: September 30, 2008

OR

For the Transition Period from to .

Commission File Number 1-13759

REDWOOD TRUST, INC.

(415) 389-7373

Not Applicable

REDWOOD TRUST, INC.

2008 FORM 10-Q REPORT

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

REDWOOD TRUST, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS

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

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

For the Nine Months Ended September 30, 2008

For the Nine Months Ended September 30, 2007

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

REDWOOD TRUST, INC. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTSSeptember 30, 2008(Unaudited)

Note 1. Redwood Trust

Note 2. Basis of Presentation

Organization

Principles of Consolidation

REDWOOD TRUST, INC. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTSSeptember 30, 2008(Unaudited)

Note 2. Basis of Presentation – (continued)

Note 3. Summary of Significant Accounting Policies

Reclassifications

Use of Estimates

Fair Value Measurements

REDWOOD TRUST, INC. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTSSeptember 30, 2008(Unaudited)

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

Real Estate Loans

Residential and Commercial Real Estate Loans — Fair Value

REDWOOD TRUST, INC. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTSSeptember 30, 2008(Unaudited)

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

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

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

Real Estate Loans — Allowance for Loan Losses

REDWOOD TRUST, INC. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTSSeptember 30, 2008(Unaudited)

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

Real Estate Securities, at Fair Value

Trading Securities

Available-for-Sale Securities

REDWOOD TRUST, INC. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTSSeptember 30, 2008(Unaudited)

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

Other Investments

Cash and Cash Equivalents

Restricted Cash

REDWOOD TRUST, INC. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTSSeptember 30, 2008(Unaudited)

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

Accrued Interest Receivable

Derivative Financial Instruments

Interest Rate Agreements

Credit Derivatives

Deferred Tax Assets

REDWOOD TRUST, INC. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTSSeptember 30, 2008(Unaudited)

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

Deferred Asset-Backed Securities Issuance Costs

Other Assets

Short-Term Debt — Redwood

Accrued Interest Payable

REDWOOD TRUST, INC. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTSSeptember 30, 2008(Unaudited)

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

Asset Backed Securities Issued — Sequoia and Acacia

Sequoia ABS Issued

Acacia ABS Issued

Long-Term Debt — Redwood

Minority Interest

Stockholders’ Equity

(Loss) Earnings Per Share

Other Comprehensive (Loss) Income

REDWOOD TRUST, INC. AND SUBSIDIARIES NOTES TO FINANCIAL STATEMENTSSeptember 30, 2008(Unaudited)

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

Equity Compensation Plans

Incentive Plan

Executive Deferred Compensation Plan

Employee Stock Purchase Plan

Taxes

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

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF (LOSS) INCOME

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
AND COMPREHENSIVE LOSS

REDWOOD TRUST, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)

REDWOOD TRUST, INC. AND SUBSIDIARIES

NOTES TO FINANCIAL STATEMENTS
September 30, 2008
(Unaudited)