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: March 31, 2009

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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).Yes x No o

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

     
Large accelerated filer o   Accelerated filer x   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   60,255,977 shares outstanding as of May 4, 2009
 

 


TABLE OF CONTENTS

REDWOOD TRUST, INC.
  
2009 FORM 10-Q REPORT
  
TABLE OF CONTENTS

 
  Page
PART I
 

Item 1.

Financial Statements

    1  
Consolidated Balance Sheets at March 31, 2009 (Unaudited) and December 31, 2008     1  
Consolidated Statements of (Loss) Income for the Three Months Ended March 31, 2009 and 2008 (Unaudited)     2  
Consolidated Statements of Equity and Comprehensive (Loss) Income for the Three Months Ended March 31, 2009 and 2008 (Unaudited)     3  
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2009 and 2008 (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

    87  

Item 3.

Defaults Upon Senior Securities

    87  

Item 4.

Submission of Matters to a Vote of Security Holders

    87  

Item 5.

Other Information

    87  

Item 6.

Exhibits

    88  
Signatures     89  

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TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
CONSOLIDATED BALANCE SHEETS

   
(In Thousands, Except Share Data)
(Unaudited)
  March 31,
2009
  December 31,
2008
ASSETS
                 
Real estate loans   $ 4,540,403     $ 4,659,336  
Real estate securities, at fair value:
                 
Trading securities     264,342       339,654  
Available-for-sale securities     255,223       232,470  
Total real estate securities     519,565       572,124  
Other investments     61,637       78,244  
Cash and cash equivalents     333,153       126,480  
Total earning assets     5,454,758       5,436,184  
Restricted cash     51,371       53,608  
Accrued interest receivable     25,561       31,415  
Derivative assets     4,784       3,071  
Deferred tax asset     2,739       3,608  
Deferred asset-backed securities issuance costs     9,129       9,921  
Other assets     32,254       43,942  
Total Assets   $ 5,580,596     $ 5,581,749  
LIABILITIES AND EQUITY
                 
Liabilities
                 
Short-term debt   $     $  
Accrued interest payable     14,697       29,417  
Derivative liabilities     155,856       177,590  
Accrued expenses and other liabilities     11,619       20,118  
Dividends payable     15,057       25,103  
Asset-backed securities issued – Sequoia     4,418,352       4,508,127  
Asset-backed securities issued – Acacia     290,645       346,931  
Long-term debt     150,000       150,000  
Total liabilities     5,056,226       5,257,286  
EQUITY
                 
Stockholders’ Equity
                 
Common stock, par value $0.01 per share, 101,450,000 and 75,000,000 shares authorized; 60,228,058 and 33,470,557 issued and outstanding     602       336  
Additional paid-in capital     1,433,685       1,149,392  
Accumulated other comprehensive loss     (85,467 )      (56,865 ) 
Cumulative earnings     231,115       266,059  
Cumulative distributions to stockholders     (1,073,663 )      (1,057,070 ) 
Total stockholders’ equity     506,272       301,852  
Noncontrolling interest     18,098       22,611  
Total equity     524,370       324,463  
Total Liabilities and Equity   $ 5,580,596     $ 5,581,749  

 
 
The accompanying notes are an integral part of these consolidated financial statements.

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TABLE OF CONTENTS

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

   
(In Thousands, Except Share Data)
(Unaudited)
  Three Months Ended
March 31,
  2009   2008
Interest Income
                 
Real estate loans   $ 33,969     $ 95,623  
Real estate securities     47,263       76,528  
Other investments     76       732  
Cash and cash equivalents     130       3,181  
Total interest income     81,438       176,064  
Interest Expense
                 
Short-term debt           (182 ) 
Asset-backed securities issued     (45,834 )      (124,585 ) 
Long-term debt     (1,808 )      (2,533 ) 
Total interest expense     (47,642 )      (127,300 ) 
Net Interest Income     33,796       48,764  
Provision for loan losses     (16,032 )      (8,058 ) 
Market valuation adjustments, net     (43,242 )      (193,932 ) 
Net Interest Loss After Provision and Market Valuation Adjustments     (25,478 )      (153,226 ) 
Operating expenses     (10,539 )      (16,348 ) 
Realized gains on sales and calls, net     462       42  
Net loss before provision for income taxes     (35,555 )      (169,532 ) 
Provision for income taxes     (105 )      (1,800 ) 
Net loss     (35,660 )      (171,332 ) 
Less: Net (loss) income attributable to noncontrolling interest     (716 )      255  
Net Loss Attributable to Redwood Trust, Inc.   $ (34,944 )    $ (171,587 ) 
Basic (loss) earnings per share:   $ (0.65 )    $ (5.28 ) 
Diluted (loss) earnings per share:   $ (0.65 )    $ (5.28 ) 
Regular dividends declared per common share   $ 0.25     $ 0.75  
Basic weighted average shares outstanding     53,632,132       32,511,445  
Diluted weighted average shares outstanding     53,632,132       32,511,445  

 
 
The accompanying notes are an integral part of these consolidated financial statements.

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TABLE OF CONTENTS

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

For the Three Months Ended March 31, 2009

               
               
(In Thousands, Except Share Data)
(Unaudited)
    
Common Stock
  Additional
Paid-In
Capital
  Accumulated
Other
Comprehensive
(Loss) Income
  Cumulative
(Losses)
Earnings
  Cumulative
Distributions
to Stockholders
  Noncontrolling
Interest
  Total
  Shares   Amount
December 31, 2008     33,470,557     $ 336     $ 1,149,392     $ (56,865 )    $ 266,059     $ (1,057,070 )    $ 22,611     $ 324,463  
Net loss                             (34,944 )            (716 )      (35,660 ) 
Net unrealized loss on available-for-sale securities                       (44,112 )                  (1,942 )      (46,054 ) 
Reclassification of other-than-temporary impairments to net loss                       14,411                         14,411  
Reclassification of unrealized loss on interest rate agreements to net loss                       1,099                         1,099  
Total other comprehensive loss                       (28,602 )                            
Total comprehensive loss                                               (66,204 ) 
Issuance of common stock:
                                                                       
Secondary offering     26,450,000       264       282,142                                           282,406  
Dividend reinvestment & stock purchase plans     132,406       1       1,462                               1,463  
Employee option & stock purchase plan     175,095       1       (1,105 )                              (1,104 ) 
Non-cash equity award compensation                 1,794                               1,794  
Accrued distributions                                         (1,855 )      (1,855 ) 
Common dividends declared                                   (16,593 )            (16,593 ) 
March 31, 2009     60,228,058     $ 602     $ 1,433,685     $ (85,467 )    $ 231,115     $ (1,073,663 )    $ 18,098     $ 524,370  

For the Three Months Ended March 31, 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
  Noncontrolling
Interest
  Total
  Shares   Amount
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) income                             (171,587 )            255       (171,332 ) 
Net unrealized loss on available-for-sale securities                       (52,272 )                        (52,272 ) 
Reclassification of other-than-temporary impairments to net loss                       73,294                         73,294  
Reclassification of unrealized loss on interest rate agreements to net loss                       1,246                         1,246  
Total other comprehensive
income
                      22,268                             
Total comprehensive loss                                               (149,064 ) 
Issuance of common stock:
                                                                       
Dividend reinvestment & stock purchase plans     273,740       2       9,389                               9,391  
Employee option & stock purchase plan     51,150             611                               611  
Non-cash equity award compensation                 1,406                               1,406  
Contributions from noncontrolling interest                                                           8,046       8,046  
Common dividends declared                                   (25,454 )            (25,454 ) 
March 31, 2008     32,709,963     $ 326     $ 1,119,554     $ (93,291 )    $ 538,858     $ (978,813 )    $ 8,301     $ 594,935  

 
 
The accompanying notes are an integral part of these consolidated financial statements.

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

   
(In Thousands)
(Unaudited)
  Three Months Ended
March 31,
  2009   2008
Cash Flows From Operating Activities:
                 
Net (loss) income   $ (34,944 )    $ (171,587 ) 
Adjustments to reconcile net (loss) income to net cash provided by operating activities:
                 
Amortization of premiums, discounts, and debt issuance costs, net     2,965       (7,664 ) 
Depreciation and amortization of non-financial assets     273       266  
Provision for loan losses     16,032       8,058  
Non-cash equity award compensation     1,794       1,406  
Market valuation adjustments, net     43,242       193,932  
Realized gains on sales and calls, net     (462 )      (42 ) 
Net change in:
                 
Accrued interest receivable     6,244       8,020  
Deferred income taxes     869       394  
Other assets     20,087       6,180  
Accrued interest payable     (10,483 )      (9,914 ) 
Accrued expenses and other liabilities     (8,499 )      (3,216 ) 
Net cash provided by operating activities     37,118       25,833  
Cash Flows From Investing Activities:
                 
Principal payments on real estate loans held-for-investment     83,866       399,844  
Purchases of real estate securities available-for-sale     (97,551 )      (54,875 ) 
Proceeds from sales of real estate securities available-for-sale     711        
Principal payments on real estate securities available-for-sale     18,588       17,936  
Purchases of real estate securities trading           (3,341 ) 
Principal payments on real estate securities trading     28,571       57,298  
Principal payments on other investments     3,942       354  
Net decrease (increase) in restricted cash     2,237       (31,189 ) 
Net cash provided by investing activities     40,364       386,027  
Cash Flows From Financing Activities:
                 
Net (repayments) borrowings on short-term debt           (5,475 ) 
Repayments on asset-backed securities     (117,142 )      (431,228 ) 
Net purchases of interest rate agreements     (7,223 )      (1,718 ) 
Net proceeds from issuance of common stock     282,765       10,002  
Dividends paid     (26,639 )      (25,210 ) 
Change in noncontrolling interests     (2,570 )      8,301  
Net cash provided by (used in) financing activities     129,191       (445,328 ) 
Net increase (decrease) in cash and cash equivalents     206,673       (33,468 ) 
Cash and cash equivalents at beginning of period     126,480       290,363  
Cash and cash equivalents at end of period   $ 333,153     $ 256,895  
Supplemental Disclosures:
                 
Cash paid for interest   $ 62,362     $ 137,214  
Cash received for taxes   $ (806 )    $  
Dividends declared but not paid at end of period   $ 15,057     $ 24,532  

 
 
The accompanying notes are an integral part of these consolidated financial statements.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(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. 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 March 31, 2009 and December 31, 2008, and for the three months ended March 31, 2009 and 2008. 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 months ended March 31, 2009, may not necessarily be indicative of the results for the year ending December 31, 2009. The unaudited interim consolidated financial statements as of March 31, 2009, 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, 2008. All amounts presented herein, except per share data, are shown in thousands.

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 include Redwood and its qualifying REIT subsidiaries, excluding taxable subsidiaries.

We are the asset manager and an investor in the Redwood Opportunity Fund LP (the Fund) that we sponsor. The Fund primarily invests in mortgage-backed securities. We also sponsor two securitization programs. Our Sequoia program is used for the securitization of residential mortgage loans. References to Sequoia refer collectively to all the consolidated 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 the consolidated Acacia securitization entities.

Principles of Consolidation

We apply the principles of Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities (FAS 140) and FASB Interpretation No. 46 (revised), Consolidation of Variable Interest Entities (FIN 46(R)) to determine whether we must consolidate any entities where we have continuing involvement.

We consolidate the assets, liabilities, and noncontrolling interests of the Fund that we sponsor, as we are the primary beneficiary of this entity as defined by FIN 46(R). The primary beneficiary is the party that absorbs the majority of a variable interest entity’s (VIEs) anticipated losses and/or the majority of the expected returns. Our significant limited partnership interests and ongoing asset management responsibilities constitute this majority. We do not service any assets, including assets owned at the Fund.

We consolidate the assets and liabilities of the Sequoia and Acacia securitization entities that we sponsor that are not accounted for as sales. These entities did not meet the criteria for sale accounting as prescribed by FAS 140 at the time we transferred financial assets to them. Our continuing involvement includes our

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 2. Basis of Presentation  – (continued)

retention of junior interests and call rights and certain ongoing management responsibilities or other discretionary activities. We do not service any assets, including assets owned at Sequoia or Acacia. For financial reporting purposes, the underlying loans and securities owned at Sequoia and Acacia 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 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.

During the fourth quarter of 2008, we derecognized the assets and liabilities of certain Sequoia entities due to a sale of our variable interests in those entities and lack of continuing involvement. These assets and liabilities are no longer shown on our consolidated balance sheets as of December 31, 2008.

Note 3. Summary of Significant Accounting Policies

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 could be material.

Fair Value Option

Statement of Financial Accounting Standards No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FAS No. 115 (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 these 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 available-for-sale (AFS) securities under FAS 115. Securities that we anticipate funding with a combination of debt and equity or those financed through the issuance of asset-backed liabilities will generally be accounted for at fair value under FAS 159 along with the corresponding liabilities.

See Note 4 for further discussion on the fair value option.

Fair Value Measurements

Our financial statements include assets and liabilities that are measured at their estimated fair values. We estimate fair values in accordance with Statement of Financial Accounting Standards No. 157, Fair Value Measurements (FAS 157). Under this standard, 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. We develop fair values for financial assets or liabilities based on available inputs and pricing that is observed in the marketplace. Examples of market information that we attempt to obtain include the following:

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

Quoted prices for the same or similar securities;
Relevant reports issued by analysts and rating agencies;
The current level of interest rates and any directional movements in relevant indices, such as credit risk indices;
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 require, we consider the reasonableness of the range indicated by the results to determine an estimate that is most representative of fair value.

The markets for the real estate securities that we invest in and issue are generally illiquid. Establishing fair values for illiquid assets and liabilities is inherently subjective and is often dependent upon our estimates and modeling assumptions. If we determine that either the volume and/or level of trading activity for an asset or liability has significantly decreased from normal conditions for that asset or liability, or price quotations or observable inputs are not associated with orderly transactions, the market inputs that we obtain might not be relevant. For example, broker (or pricing service) quotes may not be a relevant 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) must also be evaluated. In circumstances where relevant market inputs cannot be obtained, increased analysis and management judgment are required to estimate fair value. This may require the use of our internal assumptions about future cash flows and appropriate risk-adjusted discount rates. Regardless of the valuation inputs we apply, the objective of fair value measurement is unchanged from what it would be if markets were operating at normal activity levels and/or transactions were orderly; that is, to determine the current exit price.

See Note 5 for further discussion on fair value measurements.

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. The fair value option was elected on January 1, 2008, for all the loans owned by Acacia securitization entities as of that date. 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.

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), as measured on an individual basis. 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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

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

Real estate loans held-for-investment include residential real estate loans owned and securitized at Sequoia entities and commercial real estate loans owned at Redwood. These loans are carried at their unpaid principal balances adjusted for net unamortized premiums or discounts and net of any allowance for loan losses. Coupon interest is recognized as revenue when earned and deemed collectible or until a loan becomes more than 90 days past due. Interest previously accrued on loans that become greater than 90 days past due is reserved against in the allowance for loan losses. Cash principal and interest that is advanced from servicers subsequent to a loan becoming greater than 90 days past due is used to reduce the outstanding loan principal balance. 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 if 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.

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), and Statement of Financial Accounting Standards No. 114, Accounting by Creditors for Impairment of a Loan (FAS 114), 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, and other observable data;
Historical loss rates and past performance of similar loans;
Relevant environmental factors;
Relevant market research and publicly available third-party reference loss rates;
Trends in delinquencies and charge-offs;
Effects and changes in credit concentrations;
Information supporting 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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

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.

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. Management is not aware of any outstanding repurchase claims against Redwood.

Real Estate Securities, at Fair Value

Trading Securities

Trading securities include residential, commercial, and collateralized debt obligation (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 securities at Redwood and all securities at Acacia entities as trading securities. Prior to the adoption of FAS 159, these 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

AFS securities include certain residential, commercial, and CDO securities. AFS securities are carried at their estimated fair values with cumulative unrealized gains and losses reported as a component of accumulated other comprehensive (loss) income in our consolidated statements of equity, in accordance with FAS 115. We currently account for most securities 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 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 our 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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

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 will 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. 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 for assets acquired at a discount to face value), 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 for assets acquired at a discount to face value), 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 an other-than-temporary impairment (OTTI). For determining OTTI, 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 an OTTI. Upon the determination of an OTTI, any associated accumulated other comprehensive loss is reclassified into earnings using the specific identification method and reported under market valuation adjustments, net, in our consolidated statements of (loss) income.

In January 2009, the FASB issued FASB Staff Position EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20 (FSP EITF 99-20-1). FSP EITF 99-20-1 clarified the impairment guidance in EITF 99-20 to ensure a more consistent determination of whether an OTTI has occurred. The implementation of this standard did not impact our consolidated financial position and results of operations as our existing valuation methodology is consistent with the FASB’s clarification.

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 non-restricted cash on hand and highly liquid investments with original maturities of three months or less. At March 31, 2009, we did not have any significant concentrations of credit risk arising from cash deposits as all of our cash and cash equivalents were invested in U.S. Government Treasury Bills or FDIC-insured bank products.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

Restricted Cash

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

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. 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.

On January 1, 2009, we adopted the 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 required 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. Our adoption of FAS 161 resulted in increased disclosures, which can be found in Note 10.

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 and accounted for as trading instruments. To the extent 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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

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. 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.

Deferred Asset-Backed Securities Issuance Costs

ABS issuance costs are costs associated with the issuance of ABS from the Sequoia 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, deferred issuance costs associated with Acacia securitizations were included as part of our adoption of FAS 159 for assets and liabilities at Acacia. As a result, these deferred costs were charged to retained earnings as a part of a one-time cumulative effect adjustment on January 1, 2008.

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

Short-term debt can include master repurchase agreements, bank borrowings, and other forms of collateralized borrowings with various commercial banks and investment banks that expire within one year. These facilities may be unsecured or collateralized by loans or securities. Since late November 2008 we have had no short-term debt outstanding.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

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.

Asset Backed Securities Issued — Sequoia and Acacia

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

Sequoia and Acacia assets are held in the custody of trustees. These 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 our 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 12 for further discussion on ABS issued.

Long-Term Debt

Long-term debt includes trust preferred securities and subordinated notes at Redwood and is carried at its unpaid principal balance. Both are unsecured debt, requiring quarterly interest payments at a floating rate equal to the three-month 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.

See Note 13 for further discussion on long-term debt.

Equity

(Loss) Earnings Per Share

Basic (loss) earnings per share (EPS) are computed by dividing net (loss) income by the weighted average number of common shares outstanding during the period. Diluted (loss) EPS 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) EPS is calculated in the same manner as basic (loss) EPS.

On January 1, 2009, we adopted, FASB 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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

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 EPS using the two-class method. Our adoption of EITF 03-6-1 required us to recast previously reported EPS, and did not have a significant impact on EPS.

Other Comprehensive (Loss) Income

Net unrealized gains and losses on real estate securities available-for-sale and interest rate agreements previously designated as cash flow hedges under FAS 133 are reported as components of other comprehensive (loss) income on our consolidated statements of equity 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.

Noncontrolling Interest

Noncontrolling interest represents the aggregate limited partnership interests in the Fund held by third parties. In accordance with Financial Accounting Standards No. 160, Noncontrolling Interests in Consolidated Financial Statements (FAS 160), the noncontrolling interest of the Fund is shown as a component of equity on our consolidated balance sheets, and the portion of income allocable to third parties is shown as net income attributable to noncontrolling interest in our consolidated statements of (loss) income. A reconciliation of equity attributable to noncontrolling interest is disclosed in our consolidated statements of equity and comprehensive (loss) income.

Equity Compensation Plans

Incentive Plan

In March 2008, we amended our previously amended 2002 Redwood Trust, Inc. Incentive 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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

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 certain 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.

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 DSUs.

See Note 16 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 also meet certain other requirements. Beginning in 2003, we elected to retain up to 10% of our REIT ordinary taxable income and had provisioned for corporate income taxes on the retained income while maintaining our REIT status. In August 2008, our Board of Directors decided to distribute as dividends 100% of our REIT taxable income generated in 2007 and 2008 and our tax provisions changed accordingly.

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 18 for further discussion on taxes.

Recent Accounting Pronouncements

In April 2009, the FASB issued FASB Staff Position FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (FSP 157-4). The purpose of this FSP is to provide additional guidance on estimating fair value when the volume and level of activity for an asset or liability have significantly decreased, and determining when a transaction is not orderly. FSP 157-4 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We do not anticipate the implementation of this standard to 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.

In April 2009, FASB issued FASB Staff Position FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments (FSP 107-1), which expands the fair value disclosures required for all financial instruments within the scope of FAS 107 to interim periods for publicly traded entities. The FSP also requires companies to disclose the method(s) and significant assumptions used to estimate the fair value of

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

financial instruments in financial statements on an interim basis and to highlight any changes of the methods and significant assumptions from prior periods. FSP 107-1 is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We do not anticipate the implementation of this standard to have a material impact on our consolidated financial position and results of operations as our existing disclosures are consistent with the FASB’s clarification.

In April 2009, the FASB issued FASB Staff Position FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments (FSP 115-2), which establishes a new method of recognizing and reporting OTTI of debt securities, as well as additional disclosure requirements related to debt and equity securities. Prior to the effective date of this FSP (April 1, 2009), OTTI were based on a market value decline below a security’s cost basis and a corresponding adverse change in expected future cash flows due to credit related factors, as defined by EITF 99-20. Impairments were also evaluated based on whether an entity could assert the ability and intent to hold the investment until a recovery of fair value. If the entity could not make this assertion, the cost basis of the security was written down to current fair value, with the entire write-down recognized in current earnings. Under FSP 115-2, the determination of OTTI for debt securities is changed. The presence of impairment continues to be based upon a market value decline below a security’s cost basis and a corresponding adverse change in expected future cash flows. However, the provisions of EITF 99-20 are amended to now consider any adverse changes in cash flows, including non-credit factors such as changes in floating interest rates. This FSP also eliminates the “ability and intent” provision and requires impairment to be considered other-than-temporary if an entity (i) intends to sell the security, (ii) will more likely than not be required to the sell the security before it recovers in value, or (iii) does not expect to recover the security’s amortized cost basis, even if the entity does not intend to sell the security. Under these scenarios, the impairment is other than temporary and the full amount of impairment should be recognized currently in earnings. However, if an entity does not intend to sell the impaired debt security and it is more likely than not that it will not be required to sell before recovery, the OTTI should be separated into (i) the estimated amount relating to credit loss, and (ii) the amount relating to all other factors. Only the estimated credit loss amount is recognized currently in earnings, with the remainder of the loss amount recognized in other comprehensive income.

FSP 115-2 is effective for interim and annual periods ending after June 15, 2009. Upon adoption of this FSP, a cumulative effect transition adjustment is required to reclassify the non-credit portion of any OTTI previously recorded through earnings to accumulated other comprehensive (loss) income for investments held as of the beginning of the period of adoption. The cumulative effect adjustment is determined based on the difference between the present value of the cash flows expected to be collected and the amortized cost basis of the debt security as of the beginning of the period of adoption and should include any related tax effects. The difference between the new amortized cost basis and the cash flows expected to be collected should be accreted as interest income in accordance with existing guidance. We expect that adoption of this standard will have a significant impact on our reported results for the following reasons (i) the cumulative effect adjustment of adopting the standard will be significant, and (ii) a significant portion of OTTI taken during periods prior to the effective date of this standard will no longer be recoverable through earnings in future periods. We are currently evaluating these amounts.

In April 2009, the SEC issued Staff Accounting Bulletin 111, Other than Temporary Impairment of Certain Investments in Equity Securities (SAB 111), which amends SAB 59 to exclude OTTI on debt securities from its scope. The SEC issued SAB 111 to align its guidance with that of the FASB and FAS 115-2, ensuring consistency in standards for determining impairments. SAB 111 is effective upon adoption of FAS 115-2.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 4. Fair Value Option

We have not elected the fair value option for any financial instruments that were acquired from third parties subsequent to our initial adoption of FAS 159 on January 1, 2008. We did elect the fair value option for certain ABS issued by Sequoia and acquired by Acacia as a result of the deconsolidation of certain Sequoia entities during the fourth quarter of 2008. These ABS issued had been previously eliminated as intercompany assets for financial reporting purposes. Upon recognition of these ABS, we recorded a $7 million negative market valuation adjustment through the consolidated statement of (loss) income in accordance with our election to adopt FAS 159 for these securities.

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 (i.e., cost basis) and do not generally create substantial volatility in our earnings. We also did not elect the fair value option for most subordinate securities 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, or securitized. The one-time election of FAS 159 resulted in a $1.5 billion cumulative effect transition adjustment at January 1, 2008.

As of March 31, 2009, the loans at Acacia had an aggregate fair value of $10 million and an unpaid principal balance of $26 million, the securities had an aggregate fair value of $260 million and face value of $3.1 billion, and asset-backed securities issued at Acacia had an aggregate fair value of $291 million and an unpaid principal balance of $3.1 billion.

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 all cash flow hedge accounting elections for our interest rate agreements, which reduced the complexity of accounting with regards to derivatives under FAS 133. Additionally, there was no deferred tax impact associated with the adoption since the net unrealized losses in accumulated other comprehensive loss that were reclassified to retained earnings were generated at the REIT, which distributes predominantly all of its taxable income.

Note 5. Fair Value of Financial Instruments

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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(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 March 31, 2009 and December 31, 2008.

       
  March 31, 2009   December 31, 2008
(In Thousands)   Carrying Value   Fair Value   Carrying Value   Fair Value
Assets
                                   
Real estate loans (held-for-investment)   $ 4,528,220     $ 2,595,656     $ 4,644,734     $ 2,618,323  
Real estate loans (held-for-sale)     2,577       2,577       2,624       2,624  
Real estate loans (fair value)     9,606       9,606       11,977       11,977  
Trading securities     264,342       264,342       339,654       339,654  
Available-for-sale securities     255,223       255,223       232,470       232,470  
Other investments     61,637       61,637       78,244       78,244  
Cash and equivalents     333,153       333,153       126,480       126,480  
Restricted cash     51,371       51,371       53,608       53,608  
Accrued interest receivable     25,561       25,561       31,415       31,415  
Derivative assets     4,784       4,784       3,071       3,071  
REO (included in other assets)     18,926       18,926       19,264       19,264  
Liabilities
                                   
Short-term debt                        
Accrued interest payable     14,697       14,697       29,417       29,417  
Derivative liabilities     155,856       155,856       177,590       177,590  
ABS Issued
                                   
ABS issued – Sequoia     4,418,352       2,548,264       4,508,127       2,967,763  
ABS issued – Acacia     290,645       290,645       346,931       346,931  
Total ABS issued     4,708,997       2,838,909       4,855,058       3,314,694  
Long-term debt     150,000       42,000       150,000       41,628  

FAS 157 requires us to estimate and disclose fair values 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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(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 March 31, 2009

       
  Carrying Value   Fair Value Measurements Using
(In Thousands)   Level 1   Level 2   Level 3
Assets
                                   
Real estate loans   $ 9,606           $     $ 9,606  
Trading securities     264,342                   264,342  
Available-for-sale securities     255,223                   255,223  
Other investments     61,637             61,637        
Derivative assets     4,784             4,514       270  
Liabilities
                                   
ABS issued – Acacia     290,645                   290,645  
Derivative liabilities     155,856             94,311       61,545  

Assets and Liabilities Measured at Fair Value on a Recurring Basis as of December 31, 2008

       
  Carrying Value   Fair Value Measurements Using
(In Thousands)   Level 1   Level 2   Level 3
Assets
                                   
Real estate loans   $ 11,977           $     $ 11,977  
Trading securities     339,654                   339,654  
Available-for-sale securities     232,470                   232,470  
Other investments     78,244             78,244        
Derivative assets     3,071             2,829       242  
Liabilities
                                   
ABS issued – Acacia     346,931                   346,931  
Derivative liabilities     177,590             99,698       77,892  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

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
  Ending
Balance
3/31/2009
Three Months Ended March 31, 2009
(In Thousands)
  Beginning
Balance
12/31/2008
  Principal
Paydowns
  Net Loss   Other
Comprehensive
Loss
Assets
                                                     
Real estate loans   $ 11,977     $ (125 )    $ (2,246 )    $     $     $ 9,606  
Trading securities     339,654       (28,571 )      (46,425 )            (316 )      264,342  
Available-for-sale securities     232,470       (18,588 )      (29,035 )      (31,644 )      102,020       255,223  
Derivative assets     242             160             (132 )      270  
Liabilities
                                                     
ABS issued – Acacia     346,931       (28,834 )      (31,689 )            4,237       290,645  
Derivative liabilities     77,892             (271 )            (16,076 )      61,545  

           
     
  
Gains (Losses) Included in
  Purchases,
Sales, Other
Settlements and
Issuances,
Net
Three Months Ended March 31, 2008
(In Thousands)
  Beginning
Balance
1/1/2008(1)
  Principal
Paydowns
  Net Loss   Other
Comprehensive
Loss
  Ending
Balance
3/31/2008
Assets
                                                     
Real estate loans   $ 25,426     $ (116 )    $ (4,660 )    $ (1,849 )    $     $ 18,801  
Trading securities     1,804,511       (57,298 )      (797,980 )            3,343       952,576  
Available-for-sale securities     317,090       (17,936 )      (133,058 )      21,017       54,917       242,030  
Derivative assets     114             31             (75 )      70  
Liabilities
                                                     
ABS issued – Acacia     1,893,441       (37,440 )      (809,841 )                  1,046,160  
Derivative liabilities     57,397             17,809             (2,707 )      72,499  

(1) Beginning balance reflects the adoption of FAS 159 on January 1, 2008.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(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 March 31, 2009 and 2008. Gains or losses incurred on assets or liabilities sold or otherwise disposed of during the three months ended March 31, 2009 and 2008 are not included in this presentation.

Portion of Gains or (Losses) Attributable to Level 3 Assets and Liabilities Still Held at March 31, 2009 and 2008 Included in Net Loss

   
  Included in Net Loss
Three Months Ended
(In Thousands)   March 31, 2009   March 31, 2008
Assets
                 
Real estate loans   $ (2,246 )    $ (4,660 ) 
Trading securities     (46,471 )      (794,133 ) 
Available-for-sale securities     (29,035 )      (143,922 ) 
Derivative assets     160       31  
Liabilities
                 
ABS issued – Acacia     31,689       809,841  
Derivative liabilities     271       (14,604 ) 

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 March 31, 2009

         
      Gain (Loss)
     Carrying Value     
Fair Value Measurements Using
  Three Months Ended March 31, 2009
(In Thousands)   Level 1   Level 2   Level 3
Assets
                                            
Real estate loans (held-for-sale)   $ 2,577                 $ 2,577     $ (21 ) 
REO     18,926                   18,926       (765 ) 

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis as of December 31, 2008

       
  Carrying Value   Fair Value Measurements Using
(In Thousands)   Level 1   Level 2   Level 3
Assets
                                   
Real estate loans (held-for-sale)   $ 2,624                 $ 2,624  
REO     19,264                   19,264  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(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 months ended March 31, 2009 and 2008.

Market Valuation Adjustments, Net

   
  Three Months Ended
March 31,
(In Thousands)   2009   2008
Assets
                 
Real estate loans (fair value)   $ (2,246 )    $ (4,660 ) 
Real estate loans (held-for-sale)     (786 )      (860 ) 
Trading securities     (46,425 )      (797,979 ) 
Impairments on AFS securities     (29,035 )      (144,098 ) 
Liabilities
                 
ABS issued – Acacia     31,689       809,841  
Derivative instruments, net     3,561       (56,176 ) 
Market Valuation Adjustments, Net   $ (43,242 )    $ (193,932 ) 

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 is listed below.

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. (Level 3).
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 2).
Derivative assets and liabilities
Our derivative instruments include interest rate agreements and credit default swaps. Fair values of derivative instruments are determined using valuation models and are verified by valuations provided by dealers active in derivative markets. Valuation models require a variety of inputs, including contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates, and correlations of such inputs. Model inputs for interest rate agreements can

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

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

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
Short-term debt includes our credit facilities that mature within one year. Short-term debt is generally at 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 (Level 3).
Long-term debt
Long-term 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. Estimated fair values are based on applying the market indicators to generate discounted cash flows (Level 3).
REO
REO 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 (Level 3).

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 6. Real Estate Loans

We invest in residential and commercial real estate loans that we acquire from third party originators. We finance these loans through the Sequoia and Acacia entities that we sponsor or with equity.

The following table summarizes the classifications and carrying value of the residential and commercial real estate loans reported on our consolidated balance sheets at March 31, 2009 and December 31, 2008.

   
(In Thousands)   March 31,
2009
  December 31,
2008
Residential real estate loans (held-for-sale)   $ 2,577     $ 2,624  
Residential real estate loans (held-for-investment)     4,527,972       4,644,486  
Commercial real estate loans (fair value)     9,606       11,977  
Commercial real estate loans (held-for-investment)     248       249  
Total Real Estate Loans   $ 4,540,403     $ 4,659,336  

Residential Real Estate Loans Held-for-Sale

Residential real estate loans held-for-sale are owned with equity. At March 31, 2009, there were 15 residential loans held-for-sale with $5 million in outstanding principal value and a lower of cost or fair value of $3 million. At December 31, 2008, there were 15 residential loans held-for-sale with $5 million in outstanding principal value and a lower of cost or fair value of $3 million.

Residential Real Estate Loans Held-for-Investment

Residential real estate loans held-for-investment are owned at Sequoia entities that we consolidate for financial reporting purposes. The following table provides additional information on residential real estate loans held-for-investment at March 31, 2009 and December 31, 2008.

Residential Real Estate Loans Held-for-Investment

   
(In Thousands)   March 31, 2009   December 31, 2008
Principal value   $ 4,515,744     $ 4,612,564  
Unamortized premium, net     60,175       67,635  
Allowance for loan losses     (47,947 )      (35,713 ) 
Carrying Value   $ 4,527,972     $ 4,644,486  

Of the $4.5 billion of principal face and $60 million of unamortized premium on these loans at March 31, 2009, $2.0 billion of principal face and $41 million of unamortized premium relates to residential loans acquired prior to July 1, 2004. During the first quarter of 2009, 2% of these residential loans prepaid and we amortized 14% of the premium based upon the accounting elections we apply. For residential loans acquired after July 1, 2004, the principal face was $2.5 billion and the unamortized premium was $19 million at March 31, 2009. During the first quarter of 2009, 2% of these residential loans prepaid and we amortized 4% of the premium.

Of the $4.6 billion of principal face and $68 million of unamortized premium on these loans at December 31, 2008, $2.0 billion of principal face and $48 million of unamortized premium relates to residential loans acquired prior to July 1, 2004, and $2.6 billion of principal face and $20 million of unamortized premium relates to residential loans acquired after July 1, 2004.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 6. Real Estate Loans  – (continued)

Commercial Real Estate Loans at Fair Value

Commercial real estate loans at fair value are owned at Acacia entities that we consolidate for financial reporting purposes. On January 1, 2008, we elected the fair value option under FAS 159 for loans at Acacia and record them at their estimated fair values. Prior to 2008, these loans were classified as held-for-investment. At March 31, 2009, there were five commercial loans at fair value, none of which are delinquent, with an outstanding principal value of $26 million and a fair value of $10 million.

Commercial Real Estate Loans Held-for-Investment

Commercial real estate loans held-for-investment are owned with equity. The following table provides additional information on commercial real estate loans held-for-investment as of March 31, 2009 and December 31, 2008.

Commercial Real Estate Loans Held-for-Investment

   
(In Thousands)   March 31, 2009   December 31, 2008
Principal value   $ 11,096     $ 11,098  
Unamortized discount     (359 )      (360 ) 
Discount designated as credit reserve     (8,141 )      (8,141 ) 
Allowance for loan losses     (2,348 )      (2,348 ) 
Carrying Value   $ 248     $ 249  

At March 31, 2009, there were two commercial loans held-for-investment with $11 million in outstanding principal value and a carrying value of $0.2 million. During the first quarter of 2007, we fully reserved for an anticipated loss on a $10 million mezzanine commercial loan, which was originated to finance a condominium-conversion project. We do not expect to recover any outstanding principal upon completion and sale of the condominium units, and thus maintained the reserve as of March 31, 2009.

Note 7. Allowance for Loan Losses

We establish an allowance for loan losses on our residential and commercial loans held-for-investment based on our estimate of losses incurred in these loan portfolios.

Activity in the Allowance for Losses on Residential Loans

At March 31, 2009 and December 31, 2008, 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 on residential loans held-for-investment for the three months ended March 31, 2009 and 2008.

   
  Three Months Ended
March 31,
(In Thousands)   2009   2008
Balance at beginning of period   $ 35,713     $ 18,282  
Charge-offs, net     (3,798 )      (1,896 ) 
Provision for credit losses     16,032       8,058  
Balance at End of Period   $ 47,947     $ 24,444  

Serious delinquencies on consolidated Sequoia loans were $158 million and $84 million as of March 31, 2009 and 2008, respectively. Serious delinquencies include loans delinquent more than 90 days and in foreclosure. As a percentage of current loan balances, serious delinquencies were 3.50% and 1.25% at March 31, 2009 and 2008, respectively.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 7. Allowance for Loan Losses  – (continued)

When foreclosure is pursued 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 quarter of 2009, there were $4 million of charge-offs that reduced our allowance for loan losses. These charge-offs arose from $15 million of defaulted loan principal. Foreclosed property is subsequently recorded as REO, a component of other assets. Subsequent declines in the value of an REO property below its cost basis are recorded in our consolidated statements of (loss) income as a component of market valuation adjustments, net. We had $1 million of negative market valuation adjustments during the first quarter of 2009 stemming from a decrease in the fair value of REO.

Activity in the Allowance for Losses on Commercial Loans

There was no activity in the allowance for loan losses for our commercial loans for the three months ended March 31, 2009 and 2008.

Note 8. Real Estate Securities

We invest in third party residential, commercial, and CDO securities. The following table presents the fair values of our real estate securities by collateral type and entity as of March 31, 2009 and December 31, 2008.

       
March 31, 2009
(In Thousands)
  Redwood   The Fund   Acacia   Total
Securities
Residential   $ 195,698     $ 31,231     $ 202,440     $ 429,369  
Commercial     22,915             42,520       65,435  
CDO     2,657       7,030       15,074       24,761  
Total Real Estate Securities   $ 221,270     $ 38,261     $ 260,034     $ 519,565  

       
December 31, 2008
(In Thousands)
  Redwood   The Fund   Acacia   Total Securities
Residential   $ 144,885     $ 36,172     $ 244,523     $ 425,580  
Commercial     42,490             67,889       110,379  
CDO     3,610       11,318       21,237       36,165  
Total Real Estate Securities   $ 190,985     $ 47,490     $ 333,649     $ 572,124  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 8. Real Estate Securities  – (continued)

The following table presents our securities by trading and AFS, collateral type, and entity as of March 31, 2009 and December 31, 2008. We present this information by senior and subordinate interests. Senior interests are those interests in a securitization that have the first right to cash flows and are last in line to absorb losses. Subordinate interests are all interests below senior interests and may not necessarily be in a first-loss position.

           
March 31, 2009
(In Thousands)
  Trading   AFS
  Redwood   Acacia   Total   Redwood   The Fund   Total
Senior Securities
                                                     
Residential prime   $     $ 3,389     $ 3,389     $ 87,766     $     $ 87,766  
Residential non-prime     711       85,347       86,058       73,672       22,386       96,058  
Commercial           7,800       7,800                    
Total Senior Securities     711       96,536       97,247       161,438       22,386       183,824  
Subordinate Securities
                                                     
Residential prime     692       37,063       37,755       28,320             28,320  
Residential non-prime     273       76,641       76,914       4,264       8,845       13,109  
Commercial           34,720       34,720       22,915             22,915  
CDO     2,632       15,074       17,706       25       7,030       7,055  
Total Subordinate Securities     3,597       163,498       167,095       55,524       15,875       71,399  
Total Real Estate Securities   $ 4,308     $ 260,034     $ 264,342     $ 216,962     $ 38,261     $ 255,223  

           
December 31, 2008
(In Thousands)
  Trading   AFS
  Redwood   Acacia   Total   Redwood   The Fund   Total
Senior Securities
                                                     
Residential prime   $ 60     $ 11,934     $ 11,994     $ 50,904     $     $ 50,904  
Residential non-prime     905       90,638       91,543       41,915       26,531       68,446  
Commercial           7,540       7,540                    
Total Senior Securities     965       110,112       111,077       92,819       26,531       119,350  
Subordinate Securities
                                                     
Residential prime     1,141       44,983       46,124       42,646             42,646  
Residential non-prime     314       96,968       97,282       7,000       9,641       16,641  
Commercial           60,349       60,349       42,490             42,490  
CDO     3,585       21,237       24,822       25       11,318       11,343  
Total Subordinate Securities     5,040       223,537       228,577       92,161       20,959       113,120  
Total Real Estate Securities   $ 6,005     $ 333,649     $ 339,654     $ 184,980     $ 47,490     $ 232,470  

We finance securities using equity as well as through our investments in the Fund and Acacia entities that we consolidate. Securities owned at the Fund and Acacia entities are pledged to those entities.

AFS Securities

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 may also expense a portion of our investment in the security to the extent we believe that principal losses will exceed the purchase discount. The amount of

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 8. Real Estate Securities  – (continued)

principal face that we do not amortize into income is designated as a credit reserve on the security, with any remaining 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 carrying value (which equals fair value) of AFS securities as of March 31, 2009 and December 31, 2008.

       
March 31, 2009
(In Thousands)
  Residential   Commercial   CDO   Total
Current face   $ 1,141,994     $ 512,117     $ 89,256     $ 1,743,367  
Credit reserve     (601,864 )      (497,784 )      (86,962 )      (1,186,610 ) 
Net unamortized (discount) premium     (254,228 )      13,798       8,240       (232,190 ) 
Amortized cost     285,902       28,131       10,534       324,567  
Gross unrealized gains     3,756       1,998             5,754  
Gross unrealized losses     (64,405 )      (7,214 )      (3,479 )      (75,098 ) 
Carrying Value   $ 225,253     $ 22,915     $ 7,055     $ 255,223  

       
December 31, 2008
(In Thousands)
  Residential   Commercial   CDO   Total
Current face   $ 1,146,071     $ 514,169     $ 92,522     $ 1,752,762  
Credit reserve     (731,468 )      (497,047 )      (59,828 )      (1,288,343 ) 
Net unamortized (discount) premium     (211,262 )      35,069       (18,056 )      (194,249 ) 
Amortized cost     203,341       52,191       14,638       270,170  
Gross unrealized gains     7,989       2,308       19       10,316  
Gross unrealized losses     (32,693 )      (12,009 )      (3,314 )      (48,016 ) 
Carrying Value   $ 178,637     $ 42,490     $ 11,343     $ 232,470  

The following table presents the changes for the three months ended March 31, 2009, of the unamortized discount and designated credit reserves on AFS securities.

Changes in Unamortized Discount and Designated Credit Reserves on AFS Securities

           
Three Months Ended March 31, 2009
(In Thousands)
  Residential   Commercial   CDO
  Credit
Reserve
  Unamortized
Discount Net
  Credit
Reserve
  Unamortized
Discount Net
  Credit
Reserve
  Unamortized Discount Net
Beginning balance – January 1, 2009   $ 731,468     $ 211,262     $ 497,047     $ (35,069 )    $ 59,828     $ 18,056  
Amortization of net discount           (8,857 )            4,050             (109 ) 
Realized credit losses     (136,522 )            (2,052 )            (3,000 )       
Acquisitions     327       57,626                          
Sales, calls, other     (3,810 )      (537 )                  58        
Impairments     5,135             20,010             3,889        
Transfers/release of credit reserves     5,266       (5,266 )      (17,221 )      17,221       26,187       (26,187 ) 
Ending Balance – March 31, 2009   $ 601,864     $ 254,228     $ 497,784     $ (13,798 )    $ 86,962     $ (8,240 ) 

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 8. Real Estate Securities  – (continued)

The loans underlying our residential subordinate securities totaled $110 billion at March 31, 2009, and consist of $94 billion prime and $16 billion non-prime loans. These loans are located nationwide with a large concentration in California (46%). Serious delinquencies (90+ days, in foreclosure or REO) at March 31, 2009 were 5.22% of current principal balances. For loans in prime pools, serious delinquencies were 2.44% of current balances. For loans in non-prime pools, serious delinquencies were 21.75% of current balances.

The loans underlying our commercial subordinate securities totaled $48 billion at March 31, 2009, and consist primarily of office (39%), retail (28%), and multifamily (16%) commercial loans. These loans are located nationwide. Serious delinquencies (60+ days and in foreclosure or REO) at March 31, 2009 were 1.41% of current 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 March 31, 2009 and December 31, 2008.

AFS Securities with Unrealized Losses

           
  Less Than 12 Consecutive Months   12 Consecutive Months or Longer
March 31, 2009
(In Thousands)
  Total
Amortized
Cost
  Gross
Unrealized Losses
  Total
Fair Value
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair Value
Residential   $ 267,741     $ (63,615 )    $ 204,126     $ 1,831     $ (790 )    $ 1,041  
Commercial     18,480       (7,214 )      11,266                    
CDO     6,297       (3,479 )      2,818                    
Total Securities   $ 292,518     $ (74,308 )    $ 218,210     $ 1,831     $ (790 )    $ 1,041  

           
  Less Than 12 Consecutive Months   12 Consecutive Months or Longer
December 31, 2008
(In Thousands)
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair Value
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair Value
Residential   $ 100,635     $ (32,693 )    $ 67,942     $     $     $  
Commercial     38,001       (12,009 )      25,992                    
CDO     14,351       (3,314 )      11,037                    
Total Securities   $ 152,987     $ (48,016 )    $ 104,971     $     $     $  

Of the $75 million of unrealized losses at March 31, 2009, $20 million relates to securities owned at the Fund.

At March 31, 2009, our consolidated balances sheets included 616 AFS securities, of which 247 were in an unrealized loss position and eight were in an unrealized loss position for twelve consecutive months or longer. At December 31, 2008, our consolidated balance sheets included 594 AFS securities, of which 194 were in an unrealized loss position and none were in a continuous loss position for twelve months or longer. The number of AFS securities reported on our consolidated balance sheets increased as a result of acquisitions during the quarter.

For the three months ended March 31, 2009, we recognized other-than-temporary impairments on AFS securities of $29 million, through market valuation adjustments, net, in our consolidated statements of (loss) income. For the three months ended March 31, 2008, we recognized other-than-temporary impairments of $144 million.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(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 on sales and calls of AFS securities for the three months ended March 31, 2009 and 2008.

   
  Three Months Ended
March 31,
(In Thousands)   2009   2008
Gross realized gains – sales   $ 337     $  
Gross realized gains – calls           42  
Total Realized Gains on Sales and Calls   $ 337     $ 42  

Note 9. Other Investments

Other investments include a GIC owned by an Acacia securitization entity and recorded on our consolidated balance sheets at its estimated fair value. This GIC represents a deposit certificate issued by a rated investment bank and serves as collateral to cover realized losses on CDS entered into by this same Acacia entity. The CDS references residential mortgage-backed securities issued in 2006 that were initially A and BBB-rated. The fair value of the GIC was $62 million as of March 31, 2009, which is equal to its carrying value. The GIC has been drawn down by $18 million since its acquisition to cover credit losses and principal reductions on the referenced securities.

Note 10. Derivative Financial Instruments

We report our derivative financial instruments at fair value as determined using third-party models and confirmed by broker/dealers that make markets in these instruments.

The following table shows the aggregate fair value and notional amount of our derivative financial instruments as of March 31, 2009 and December 31, 2008.

       
  March 31, 2009   December 31, 2008
(In Thousands)   Fair
Value
  Notional
Amount
  Fair
Value
  Notional
Amount
Interest rate caps purchased   $ 3,455     $ 712,400     $ 1,683     $ 714,400  
Interest rate caps sold                 (1,084 )      250,000  
Interest rate swaps     (92,982 )      975,834       (97,226 )      1,013,781  
Credit default swaps     (61,545 )      61,604       (77,892 )      78,206  
Total Derivative Financial Instruments   $ (151,072 )    $ 1,749,838     $ (174,519 )    $ 2,056,387  

Of the negative $151 million value of derivative financial instruments at March 31, 2009, $5 million was recorded as derivative assets and $156 million was recorded as derivative liabilities on our consolidated balance sheet. Of the negative $175 million value of derivative financial instruments at December 31, 2008, $3 million was recorded as derivative assets and $178 million was recorded as derivative liabilities on our consolidated balance sheet.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 10. Derivative Financial Instruments  – (continued)

Interest Rate Agreements

We currently account for our interest rate agreements as trading instruments in accordance with FAS 133. Changes in the fair value of the interest rate agreements and all associated income and expenses are reported in our consolidated statements of (loss) income as a component of market valuation adjustments, net. We had net valuation adjustments on interest rate agreements of positive $3 million for the three months ended March 31, 2009, and negative $38 million for the three months ended March 31, 2008.

We did not have any interest rate agreements designated as cash flow hedges during the three months ended March 31, 2009. For interest rate agreements previously designated as cash flow hedges, our total unrealized loss included in accumulated other comprehensive loss was negative $26 million at March 31, 2009 and negative $27 million at December 31, 2008.

For both the three months ending March 31, 2008 and 2009, we reclassified $1 million of previously designated cash flow hedge other comprehensive loss to interest expense.

Credit Derivatives

All of our existing CDS contracts were initiated during 2007 by an Acacia securitization entity that we have consolidated for financial reporting purposes. As the seller of these contracts we receive a fixed-rate premium and have assumed the credit risk of the reference securities.

These CDS are accounted for as trading instruments. The estimated fair values of these contracts fluctuate for a variety of reasons, such as the likelihood or occurrence of a specific credit event, the market perception of default risk and counterparty risk, and supply and demand changes. A qualifying credit event, defined as an interest shortfall, a failure to pay principal, or a distressed rating downgrade, may trigger Acacia as the seller of protection to compensate the counterparty (which it does so by drawing down on the GIC it owns). During the three months ended March 31, 2009 the reference securities underlying our CDS experienced principal losses resulting in a $17 million obligation. During the three months ended March 31, 2009 and 2008, the fair value of these CDS increased less than $1 million and decreased $18 million, respectively.

The following table presents the fair value of our CDS along with certain risk characteristics as of March 31, 2009 and December 31, 2008. All of these CDS have expiration dates of greater than 15 years.

       
  March 31, 2009   December 31, 2008
(In Thousands)   Fair Value   Maximum
Payout/
Notional
Amount
  Fair Value   Maximum
Payout/
Notional
Amount
Credit rating of referenced securities
                                   
BB/B   $     $     $ (9,943 )    $ 9,967  
CCC/CC/C     (61,545 )      61,604       (67,949 )      68,239  
Total   $ (61,545 )    $ 61,604     $ (77,892 )    $ 78,206  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 10. Derivative Financial Instruments  – (continued)

Counterparty Credit Risk

We incur credit risk to the extent that counterparties to our derivative financial instruments do not perform their obligations under specified contractual agreements. If a derivative counterparty does not perform, we may not receive the proceeds to which we may be entitled under these agreements. To mitigate this risk, we enter into agreements that are either a) transacted on a national exchange or b) transacted with counterparties that are either i) designated by the Federal Reserve Bank of New York as a primary government dealer, ii) affiliates of primary government dealers, or iii) rated A or higher. We also attempt to transact with several different counterparties in order to reduce our specific counterparty exposure. We consider counterparty risk as part of our fair value assessments of all derivative financial instruments.

As of March 31, 2009, Redwood and its affiliates had nineteen International Swaps and Derivatives Association (ISDA) agreements with ten different bank counterparties. We had one open derivative position at March 31, 2009, and were in compliance with our ISDA counterparty.

Note 11. Other Assets

Other assets as of March 31, 2009, and December 31, 2008, are summarized in the following table.

Other Assets

   
(In Thousands)   March 31, 2009   December 31, 2008
REO   $ 18,926     $ 19,264  
Fixed assets and leasehold improvements     4,732       5,103  
Principal receivable     633       1,647  
Income tax receivables     3,452       4,225  
Prepaid expenses     1,361       9,119  
Other     3,150       4,584  
Total Other Assets   $ 32,254     $ 43,942  

REO consists of foreclosed properties received in full satisfaction of defaulted real estate loans. The carrying value of REO at March 31, 2009, was $19 million, of which $9 million related to transfers into REO in the first quarter of 2009, offset by $8 million of REO liquidations, and $1 million of negative market valuation adjustments during this same period. The carrying value of REO as of December 31, 2008 was $19 million, of which $38 million related to transfers into REO during 2008, offset by $21 million of REO liquidations, $8 million of negative valuation changes, and $5 million of REO derecognized as a result of our deconsolidations of certain Sequoia entities.

At March 31, 2009, there were 95 single-family properties recorded on our balance sheet, of which, 92 were owned at Sequoia and 3 were owned at Redwood. At December 31, 2008, there were 93 single-family properties recorded on our balance sheet, of which, 90 were owned at Sequoia and 3 were owned at Redwood. The states of California, Ohio, Georgia, and Michigan accounted for 60% of our REO balance at March 31, 2009.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO FINANCIAL STATEMENTS
March 31, 2009
(Unaudited)

Note 12. Asset-Backed Securities Issued

The Sequoia and Acacia securitization entities that we sponsor issue ABS to acquire assets from us and from third parties. Each series of ABS issued consists of various classes that pay interest on a monthly or quarterly basis. Substantially all ABS issued pay variable rates of interest, which are indexed to one, three, or six-month LIBOR. Some ABS issued pay fixed rates of interest or pay hybrid rates, which are fixed rates that subsequently adjust to variable rates. ABS issued also include some interest-only classes with coupons set at a fixed-rate or a fixed spread, or set at a spread to the interest rates earned on the assets, less the interest rates paid on the liabilities of a securitization entity.

The components of ABS issued by consolidated securitization entities we sponsor as of March 31, 2009 and December 31, 2008, along with other selected information, are summarized in the following table.

Asset-Backed Securities Issued

           
  March 31, 2009   December 31, 2008
(In Thousands)   Sequoia   Acacia   Total   Sequoia   Acacia   Total
Certificates with principal value   $ 4,396,893     $ 3,108,914