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, 2010

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o

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

     
Large accelerated filer x   Accelerated filer o   Non-accelerated filer o   Smaller reporting company o

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

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

Common Stock, $0.01 par value per share           77,897,360 shares outstanding as of May 4, 2010

 

 


 
 

TABLE OF CONTENTS

REDWOOD TRUST, INC.
  
2010 FORM 10-Q REPORT
  
TABLE OF CONTENTS

 
  Page
PART I
 

Item 1.

Financial Statements

    1  
Consolidated Balance Sheets at March 31, 2010 (Unaudited) and December 31, 2009     1  
Consolidated Statements of Income (Loss) for the Three Months Ended March 31, 2010 and 2009 (Unaudited)     2  
Consolidated Statements of Equity and Comprehensive Income (Loss) for the Three Months Ended March 31, 2010 and 2009 (Unaudited)     3  
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2010 and 2009 (Unaudited)     4  
Notes to Consolidated Financial Statements     5  

Item 2.

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

    44  

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

    83  

Item 4.

Controls and Procedures

    83  
PART II
 

Item 1.

Legal Proceedings

    84  

Item 1A.

Risk Factors

    84  

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

    84  

Item 3.

Defaults Upon Senior Securities

    84  

Item 4.

(Removed and Reserved)

    84  

Item 5.

Other Information

    84  

Item 6.

Exhibits

    85  

Signatures

 

    86  

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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,
2010
  December 31,
2009
ASSETS
                 
Real estate loans   $ 3,662,283     $ 3,739,254  
Real estate securities, at fair value:
                 
Trading securities     288,820       277,274  
Available-for-sale securities     846,642       810,471  
Total real estate securities     1,135,462       1,087,745  
Other investments     10,762       20,371  
Cash and cash equivalents     241,753       242,818  
Total earning assets     5,050,260       5,090,188  
Restricted cash     87,600       94,306  
Accrued interest receivable     14,665       18,193  
Derivative assets     5,520       12,372  
Deferred tax asset     3,631       4,810  
Deferred asset-backed securities issuance costs     6,014       6,639  
Other assets     27,576       26,142  
Total Assets(1)   $ 5,195,266     $ 5,252,650  
LIABILITIES AND EQUITY
                 
Liabilities
                 
Short-term debt   $     $  
Accrued interest payable     5,390       5,968  
Derivative liabilities     79,486       83,800  
Accrued expenses and other liabilities     103,617       71,828  
Dividends payable     19,438       19,434  
Asset-backed securities issued – Sequoia     3,557,669       3,644,933  
Asset-backed securities issued – Acacia     279,471       297,596  
Long-term debt     140,000       140,000  
Total liabilities(2)     4,185,071       4,263,559  
Equity
                 
Common stock, par value $0.01 per share, 100,000,000 shares authorized; 77,750,697 and 77,737,130 issued and outstanding     778       777  
Additional paid-in capital     1,680,565       1,674,367  
Accumulated other comprehensive income     57,597       64,860  
Cumulative earnings     411,731       364,888  
Cumulative distributions to stockholders     (1,153,065 )      (1,133,171 ) 
Total stockholders’ equity     997,606       971,721  
Noncontrolling interest     12,589       17,370  
Total equity     1,010,195       989,091  
Total Liabilities and Equity   $ 5,195,266     $ 5,252,650  

(1) Assets in our consolidated balance sheets include assets of consolidated variable interest entities (VIEs) that can only be used to settle obligations of these VIEs. At March 31, 2010, these assets totaled $4,074,108.
(2) Liabilities in our consolidated balance sheets include liabilities of consolidated VIEs for which creditors do not have recourse to the primary beneficiary (Redwood Trust, Inc.). At March 31, 2010, these liabilities totaled $3,981,885.

 
 
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 INCOME (LOSS)

   
(In Thousands, Except Share Data)
(Unaudited)
  Three Months Ended
March 31,
  2010   2009
Interest Income
                 
Real estate loans   $ 14,791     $ 33,969  
Real estate securities     43,899       47,263  
Other investments     9       76  
Cash and cash equivalents     17       130  
Total interest income     58,716       81,438  
Interest Expense
                 
Short-term debt            
Asset-backed securities issued     (17,066 )      (45,834 ) 
Long-term debt     (1,116 )      (1,808 ) 
Total interest expense     (18,182 )      (47,642 ) 
Net Interest Income     40,534       33,796  
Provision for loan losses     (9,475 )      (16,032 ) 
Market valuation adjustments on trading instruments     (9,291 )      (14,207 ) 
Other-than-temporary impairments(1)     (1,946 )      (29,035 ) 
Market valuation adjustments, net     (11,237 )      (43,242 ) 
Net Interest Income (Loss) After Provision and Market Valuation Adjustments     19,822       (25,478 ) 
Operating expenses     (17,306 )      (10,539 ) 
Realized gains, net     44,338       462  
Net income (loss) before provision for income taxes     46,854       (35,555 ) 
Provision for income taxes     (26 )      (105 ) 
Net income (loss)     46,828       (35,660 ) 
Less: Net loss attributable to noncontrolling interest     (15 )      (716 ) 
Net Income (Loss) Attributable to Redwood Trust, Inc.   $ 46,843     $ (34,944 ) 
Basic earnings (loss) per common share:   $ 0.59     $ (0.65 ) 
Diluted earnings (loss) per common share:   $ 0.58     $ (0.65 ) 
Regular dividends declared per common share   $ 0.25     $ 0.25  
Special dividends declared per common share   $     $  
Total dividends declared per common share   $ 0.25     $ 0.25  
Basic weighted average shares outstanding     77,677,235       53,632,132  
Diluted weighted average shares outstanding     78,542,299       53,632,132  

(1) For the three months ended March 31, 2010, total other-than-temporary impairments were $3,615 of which $1,669 were recognized in Accumulated Other Comprehensive Income (Loss).

 
 
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 INCOME (LOSS)

For the Three Months Ended March 31, 2010

               
               
(In Thousands, Except Share Data)
(Unaudited)
   
Common Stock
  Additional
Paid-In
Capital
  Accumulated
Other
Comprehensive
Income (Loss)
  Cumulative
Earnings
(Losses)
  Cumulative
Distributions
to Stockholders
  Noncontrolling
Interest
  Total
  Shares   Amount
December 31, 2009     77,737,130     $ 777     $ 1,674,367     $ 64,860     $ 364,888     $ (1,133,171 )    $ 17,370     $ 989,091  
Net income (loss)                             46,843             (15 )      46,828  
Net unrealized (loss) gain on available-for-sale securities                       (8,940 )                  2,138       (6,802 ) 
Reclassification of other-than-temporary impairments to net income (loss)                       1,594                         1,594  
Reclassification of unrealized loss on interest rate agreements to net income (loss)                       83                         83  
Total other comprehensive loss                       (7,263 )                            
Total comprehensive income                                               41,703  
Issuance of common stock:
                                                                       
Secondary offerings                                                
Dividend reinvestment & stock purchase plans     8,687       1       128                               129  
Employee stock purchase and incentive plans     4,880             (16 )                              (16 ) 
Non-cash equity award compensation                 6,086                               6,086  
Distributions to noncontrolling interests, net                                         (6,904 )      (6,904 ) 
Common dividends declared                                   (19,894 )            (19,894 ) 
March 31, 2010     77,750,697     $ 778     $ 1,680,565     $ 57,597     $ 411,731     $ (1,153,065 )    $ 12,589     $ 1,010,195  

For the Three Months Ended March 31, 2009

               
               
(In Thousands, Except Share Data)
(Unaudited)
   
Common Stock
  Additional
Paid-In Capital
  Accumulated
Other
Comprehensive
Income (Loss)
  Cumulative
Earnings
(Losses)
  Cumulative
Distributions
to Stockholders
  Noncontrolling
Interest
  Total
  Shares   Amount
December 31, 2008     33,470,557     $ 335     $ 1,149,393     $ (56,865 )    $ 266,059     $ (1,057,070 )    $ 22,611     $ 324,463  
Net (loss) income                             (34,944 )            (716 )      (35,660 ) 
Net unrealized loss on available-for-sale securities                       (44,112 )                  (1,943 )      (46,055 ) 
Reclassification of other-than-temporary impairments to net (loss) income                       14,411                         14,411  
Reclassification of unrealized loss on interest rate agreements to net (loss) income                       1,099                         1,099  
Total other comprehensive loss                       (28,602 )                            
Total comprehensive loss                                               (66,205 ) 
Issuance of common stock:
                                                                       
Secondary offerings     26,450,000       265       282,141                               282,406  
Dividend reinvestment & stock purchase plans     132,406       1       1,462                               1,463  
Employee stock purchase and incentive plans     175,095       1       (1,105 )                              (1,104 ) 
Non-cash equity award compensation                 1,794                               1,794  
Contributions from noncontrolling interests, net                                         (1,854 )      (1,854 ) 
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  

 
 
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 CASH FLOWS

   
(In Thousands, Except Share Data)
(Unaudited)
  Three Months Ended
March 31,
  2010   2009
Cash Flows From Operating Activities:
                 
Net income (loss)   $ 46,843     $ (34,944 ) 
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
                 
Amortization of premiums, discounts, and debt issuance costs, net     (8,220 )      2,965  
Depreciation and amortization of non-financial assets     240       273  
Provision for loan losses     9,475       16,032  
Non-cash equity award compensation     6,086       1,794  
Market valuation adjustments, net     11,237       43,242  
Realized gains, net     (44,338 )      (462 ) 
Net change in:
                 
Accrued interest receivable     3,349       6,244  
Deferred tax asset     1,179       869  
Other assets     1,976       20,087  
Accrued interest payable     2,026       (10,483 ) 
Accrued expenses and other liabilities     31,789       (8,499 ) 
Net cash provided by operating activities     61,642       37,118  
Cash Flows From Investing Activities:
                 
Principal payments on real estate loans held-for-investment     65,647       83,866  
Purchases of real estate securities available-for-sale     (162,772 )      (97,551 ) 
Proceeds from sales of real estate securities available-for-sale     134,025       711  
Principal payments on real estate securities available-for-sale     33,458       18,588  
Purchases of real estate securities trading     (17,137 )       
Proceeds from sales of real estate securities trading     3,603        
Principal payments on real estate securities trading     14,290       28,571  
Principal payments on other investments     3,766       3,942  
Net decrease in restricted cash     6,706       2,237  
Net cash provided by investing activities     81,586       40,364  
Cash Flows From Financing Activities:
                 
Repurchase of asset-backed securities     (8,639 )       
Repayments on asset-backed securities     (96,568 )      (117,142 ) 
Net settlements of derivatives     (12,390 )      (7,223 ) 
Net proceeds from issuance of common stock     113       282,765  
Dividends paid     (19,890 )      (26,639 ) 
Change in noncontrolling interests     (6,919 )      (2,570 ) 
Net cash (used in) provided by financing activities     (144,293 )      129,191  
Net (decrease) increase in cash and cash equivalents     (1,065 )      206,673  
Cash and cash equivalents at beginning of period   $ 242,818     $ 126,480  
Cash and cash equivalents at end of period   $ 241,753     $ 333,153  
Supplemental Disclosures:
                 
Cash paid for interest   $ 16,156     $ 62,362  
Cash paid (received) for taxes   $     $ (806 ) 
Dividends declared but not paid at end of period   $ 19,438     $ 15,057  

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

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TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(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, 2010 and December 31, 2009, and for the three months ended March 31, 2010 and 2009. These consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) in the United States 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, 2010, may not necessarily be indicative of the results for the year ending December 31, 2010. These unaudited interim consolidated financial statements 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, 2009. All amounts presented herein, except per share data, are shown in thousands.

We recognize the Financial Accounting Standards Board’s (FASB) Statement of Financial Accounting Standards No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles — a replacement of FASB Statement No. 162 (FAS 168), which establishes the Accounting Standards Codification (ASC) as the single source of authoritative GAAP in the United States.

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.

We do not service any assets, including assets owned by the Fund, Sequoia, or Acacia.

Principles of Consolidation

We apply ASC 860 and ASC 810-10 to determine whether we must consolidate transferred financial assets and variable interest entities (VIEs) for financial reporting purposes. These standards became effective for our interests in all VIEs as of January 1, 2010, except for the Fund, as a result of the FASB’s decision to delay the applicability of ASC 810-10 for private equity funds. Our determination of whether we must consolidate the Fund was made in accordance with FASB Interpretation No. 46 (revised), Consolidation of Variable Interest Entities (FIN 46(R)); at the time we acquired our interests in the Fund.

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TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 2. Basis of Presentation  – (continued)

We currently consolidate the assets, liabilities, and noncontrolling interests of the Fund, as well as the assets and liabilities of the Sequoia and the Acacia securitization entities where we maintain continuing involvement. For financial reporting purposes, the real estate securities owned at the Fund are shown on our consolidated balance sheets under real estate securities and the portion of the Fund owned by third parties is shown under noncontrolling interest. In our consolidated statements of income (loss), we record interest income on the securities owned at the Fund. Since the Fund is currently funded with equity, there is no associated interest expense. 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 income (loss), we record interest income on the loans and securities owned by Sequoia and Acacia entities and interest expense on the ABS issued by these consolidated securitization entities.

See Note 4 for further discussion on principles of consolidation.

Note 3. Summary of Significant Accounting Policies

Use of Estimates

The preparation of financial statements 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, 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

We have the option to measure eligible financial assets, financial liabilities, and commitments at fair value on an instrument-by-instrument basis. This option is available when we first recognize a financial asset or financial liability or enter into a firm commitment. Subsequent changes in the fair value of assets, liabilities, and commitments where we have elected the fair value option are recorded in the consolidated statements of income (loss).

Our decision to apply the fair value option 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. 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 measured using the fair value option along with the corresponding liabilities. Additionally, we may elect the fair value option for nontraditional real estate investments or for a variety of other reasons.

See Note 5 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 in accordance with GAAP. A fair value measurement represents the price at which an orderly transaction would occur between willing market participants 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:

Quoted prices for the same or similar securities;

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

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

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 many of 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 market conditions, 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 might not be 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) is also evaluated.

In circumstances where relevant market inputs cannot be obtained, increased analysis and management judgment are required to estimate fair value. This generally requires us to establish 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 6 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. 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 are recurring and are reported through our consolidated statements of income (loss) 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 third parties. These loans are carried at the lower of their cost or fair value, as measured on an individual basis. If the fair value of a loan held-for-sale is lower than its amortized cost basis, this difference is reported as a negative market valuation adjustment through our consolidated statements of income (loss). Coupon interest for loans held-for-sale is recognized as revenue when earned and deemed collectible or until a loan becomes more than 90 days past due. Gains or losses on the sale of real estate loans are based on the specific identification method.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(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 for loans that have become greater than 90 days past due is reserved for 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.

We use the interest method to determine an effective yield 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 periodic amortization. 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 determine periodic amortization.

We reclassify loans held-for-investment to loans held-for-sale if we determine that these loans will be sold to third parties. This may occur, for example, if we exercise our right to call ABS issued by a Sequoia securitization trust and decide to subsequently sell the underlying loans to third parties.

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 at 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 consider the following factors in setting the allowance for loan losses:

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.

Once we determine the amount of defaults, the timing of the defaults, and severity of losses upon the 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 appropriate 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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

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

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 at least quarterly.

As part of the loss mitigation efforts undertaken by servicers of residential loans owned by Sequoia securitization entities, a growing number of loan modifications have been completed to help make mortgage loans more affordable for certain borrowers. Loan modifications may include, but are not limited to: (i) conversion of a floating rate mortgage loan into a fixed rate mortgage loan; (ii) reduction in the contractual interest rate of a mortgage loan; (iii) forgiveness of a portion of the contractual interest and/or principal amounts owed on a mortgage loan; and, (iv) extension of the contractual maturity of a mortgage loan. We evaluate all loan modifications performed by servicers to determine if they constitute troubled debt restructurings according to GAAP. If a loan is determined to be a troubled debt restructuring, it is removed from the general loan pools used for calculating allowances for loan losses and assessed for impairment on an individual basis based upon any adverse change in the expected future cash flows resulting from the modification. This difference is recorded to the provision for loan losses in the consolidated statements of income (loss).

See Note 8 for further discussion on the allowance for loan losses.

We do not currently maintain a loan repurchase reserve. We do not originate real estate loans and we believe that risk of loss due to loan repurchases (i.e., due to breach of representations and warranties) would generally be a contingency to the companies from whom we acquired the loans and therefore would be covered by our recourse to those companies. In addition, management is not aware of any outstanding repurchase claims against Redwood that would require the establishment of a loan repurchase reserve.

Real Estate Securities, at Fair Value

Trading Securities

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

We primarily denote trading securities as those securities where we have adopted the fair value option. We currently account for certain securities at Redwood and all securities at Acacia entities as trading securities.

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 income (loss) in our consolidated statements of equity. 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 security and make assumptions with regards to interest rates, prepayment rates, the timing and amount of credit losses, and other factors. We review 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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

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

For an AFS security where its fair value has declined below its amortized cost basis, we evaluate the security for other-than-temporary impairment (OTTI). If we either — (i) intend to sell the impaired security; (ii) will more likely than not be required to the sell the impaired security before it recovers in value; or, (iii) do not expect to recover the impaired security’s amortized cost basis even if we do not intend to sell the security — the impairment is deemed an OTTI and we record the entire difference between the security’s fair value and its amortized cost in our consolidated statements of income (loss). Conversely, if none of these three conditions are met, we analyze the expected cash flows, or cost recovery of the security, to determine what, if any, OTTI is recognized through our consolidated statements of income (loss). This analysis includes an assessment of any changes in the regulatory and/or economic environment that might affect the performance of the security.

If we conclude through our analysis that there has been no significant adverse change in our cash flow assumptions for the security, then the impairment is deemed temporary in nature and the associated difference between the security’s fair value and its amortized cost basis is recorded as an unrealized loss through accumulated other comprehensive income (loss), a component of stockholders’ equity. Alternatively, if we conclude that there has been a significant adverse change in our cash flow assumptions for the security, then the impairment is deemed an OTTI and we perform an additional analysis to determine what portion of OTTI, if any, should be recorded through our consolidated statements of income (loss). This analysis entails discounting the security’s cash flows to a present value using the prior period yield for the security to determine an “expected recoverable value.” The difference between this expected recoverable value and the amortized cost basis of the security is deemed to be the “credit” component of the OTTI that is recorded in our consolidated statements of income (loss). The amortized cost of the security is then adjusted to the expected recoverable value, and the difference between this expected recoverable value and the fair value is deemed to be the “non-credit” component of the OTTI that is recorded to accumulated other comprehensive income (loss). Future amortization and accretion for the security is computed based upon its new amortized cost basis.

In the second quarter of 2009, as part of our adoption of new authoritative GAAP guidance that we currently use to evaluate impairments on AFS securities, we evaluated $450 million of previously recorded OTTI on securities still held at April 1, 2009. We determined that $224 million of these OTTI related to securities where we either had the intent to sell or the OTTI did not include a non-credit component. The remaining $226 million of these OTTI related to securities that included a $165 million aggregate credit component and a $61 million aggregate non-credit component (of which, $60 million related to Redwood’s interest and $1 million related to noncontrolling interest at the Fund). In accordance with the guidance, we recorded a $61 million one-time cumulative-effect adjustment, net of any related tax effects, to reclassify the non-credit component of these OTTI previously recorded through our consolidated statements of income (loss), as was prescribed under previous GAAP. This reclassification increased retained earnings and decreased other comprehensive income (OCI), resulting in zero net impact to reported stockholders’ equity and noncontrolling interest.

See Note 9 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 statement purposes. We account for this investment under the fair value option. Changes in fair value are reported through our consolidated statements of income (loss) through market valuation adjustments, net. Interest income is reported through our consolidated statements of income (loss) through interest income, other investments.

See Note 10 for further discussion on other investments.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

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

Cash and Cash Equivalents

Cash and cash equivalents include non-restricted cash and highly liquid investments with original maturities of three months or less. At March 31, 2010, we had minimal concentrations of credit risk arising from cash deposits as more than 98% of our cash and cash equivalents were invested in U.S. Government Treasury Bills or FDIC-insured bank products.

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. At March 31, 2010, we did not have any significant concentrations of credit risk arising from restricted cash deposits as more than 98% of our restricted cash was held in custodial accounts, invested in U.S. Government Treasury Bills, or held in FDIC-insured bank products.

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, the associated accrued interest on these assets is measured at fair value. For financial assets where we have not elected the fair value option, 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 in accordance with derivative accounting guidance. 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 income (loss) through market valuation adjustments, net.

Interest Rate Agreements

We maintain an overall interest rate risk management strategy that incorporates the use of interest rate agreements. We enter into interest rate agreements for a variety of reasons, including minimizing significant fluctuations in earnings or market values on certain assets or liabilities that may be caused by interest rate volatility. Interest rate agreements that we use as part of our interest rate risk management strategy may include interest rate options, swaps, options on swaps, futures contracts, options on futures contracts, and options on forward purchases. We designate these interest rate agreements as either (i) a hedge of the fair market value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge); (ii) a hedge of a forecasted transaction or of the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge); or, (iii) a trading instrument (no designation).

In 2010, we began using interest rate swaps to hedge our interest rate exposure related to our long-term debt. We account for these swaps as cash flow hedges, as we structured their critical terms to substantially match the payment terms of our floating-rate long-term debt. Specifically, (i) the swaps and long-term debt use the same interest rate index for variable cash flows, (ii) the interest rate resets for variable rate cash flows are the same for both the swaps and long-term debt, and (iii) the hedging relationship does not contain any other basis differences.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

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

We expect these cash flow hedges to be highly effective in reducing our exposure to changes in the benchmark LIBOR interest rates used to determine our quarterly interest payment obligations on long-term debt. We measure the effective portion of these cash flow hedges by comparing the change in fair value of the expected future variable cash flows of the swaps with the change in fair value of the expected future variable cash flows of our long-term debt. To the extent these cash flow hedges are effective, we record interest income or expense as a component of net interest income and all other changes in fair value of the swaps are recorded in accumulated other comprehensive income (loss), a component of stockholders’ equity. We currently do not anticipate recording any ineffectiveness pertaining to these cash flow hedges and any unrealized gains or losses resulting from changes in the fair values of the swaps would only be reclassified into earnings to the extent the hedging relationships are terminated prior to the derivative contracts expiring.

We will discontinue cash flow hedge accounting if (i) we determine that the derivative is no longer expected to be effective in offsetting changes in the cash flows of the designated hedged item; (ii) the derivative expires or is sold, terminated, or exercised; (iii) the derivative is de-designated as a cash flow hedge; or (iv) it is probable that a forecasted transaction will not occur by the end of the originally specified time period. To the extent we de-designate cash flow hedges but 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 income (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 included in net settlements of derivatives, which are classified as financing activities within our consolidated statements of cash flows.

Credit Derivatives

A credit default swap (CDS) is an agreement to provide (receive) credit event protection based on a financial index or specific security in exchange for receiving (paying) a fixed-rate fee or premium over the term of the contract. These instruments enable us to synthetically assume the credit risk of a reference security or index of securities. All of our existing CDS contracts were initiated during 2007 by one of the Acacia entities that we consolidate for financial reporting purposes. Net purchases and proceeds from CDS are included in net settlements of derivatives, which are classified as financing activities within our consolidated statements of cash flows.

See Note 11 for further discussion on derivative financial instruments.

Deferred Tax Assets

Our deferred tax assets are generated by differences in GAAP and taxable income at our taxable subsidiaries. Income and expense recognition for GAAP and tax differ in material respects. These differences generally 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 and an associated deferred tax benefit for GAAP. As the income is subsequently realized in future periods under GAAP, the deferred tax asset is recognized as an expense.

Deferred Asset-Backed Securities Issuance Costs

ABS issuance costs are expenses associated with the issuance of ABS from the Sequoia securitization entities we sponsor. These expenses 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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

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

to interest expense using the interest method, based upon the actual and estimated repayment schedules of the related ABS issued under the principle guidance for interest on receivables and payables.

Other Assets

Other assets on our consolidated balance sheets include real estate owned (REO), fixed assets, principal receivable, and other prepaid expenses. REO is reported at the lower of cost or fair value. Subsequent declines in the value of an REO property are recorded in our consolidated statements of income (loss) as a component of market valuation adjustments, net. All other assets are reported at cost.

See Note 12 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 November 2008, we have had no short-term debt outstanding.

Accrued Interest Payable

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

Acacia ABS issued are accounted for under the fair value option and carried at their estimated fair values. Changes in fair value (gains or losses) are reported in our consolidated statements of income (loss) through market valuation adjustments, net.

See Note 13 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.

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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

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

Equity

Earnings (Loss) Per Common Share

Basic earnings (loss) per share (EPS) is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted EPS is computed by dividing net income (loss) 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 earnings per common share guidance, if there is a loss from continuing operations, the common stock equivalents are deemed antidilutive and diluted income (loss) per share is calculated in the same manner as basic income (loss) per share.

Effective January 1, 2009, the authoritative GAAP states that unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents are “participating securities” and therefore should be included in computing EPS using the two-class method. Our adoption of this guidance required us to recast previously reported EPS and did not have a significant impact on EPS.

Other Comprehensive Income (Loss)

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

Noncontrolling Interest

Noncontrolling interest represents the aggregate limited partnership interests in the Fund held by third parties. In accordance with FASB noncontrolling interest guidance, the noncontrolling interest of the Fund is shown as a component of equity on our consolidated balance sheets, and the portion of income (loss) allocable to third parties is shown as net income (loss) attributable to noncontrolling interest in our consolidated statements of income (loss). A reconciliation of equity attributable to noncontrolling interest is disclosed in our consolidated statements of equity and comprehensive income (loss).

Equity Compensation Plans

Incentive Plan

In May 2008, our shareholders approved an amendment to our previously amended 2002 Redwood Trust, Inc. Incentive Plan (Incentive Plan) for executive officers, employees, and non-employee directors. 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, performance units (including cash), stock appreciation rights, limited stock appreciation rights (awards), and dividend equivalent rights (DERs) to eligible recipients other than non-employee directors. These awards generally vest over a four-year period. Non-employee directors are also provided annual awards under the Incentive Plan that generally vest immediately.

The cost of equity awards is determined in accordance with share-based payment accounting guidance and amortized over the vesting term using an accelerated method for equity awards granted prior to December 1, 2008. For equity awards granted after December 1, 2008, the cost of the awards is amortized over the vesting period on a straight-line basis. Timing differences between the accelerated and straight-line method of amortization were determined to not be material to our financial statements.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

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

Employee Stock Purchase Plan

In May 2009, our stockholders approved an amendment to our 2002 Redwood Trust, Inc. Employee Stock Purchase Plan (ESPP), to increase the number of shares available under the ESPP. 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 17 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 related to assets, income, and stock ownership. We assess our tax positions for all open tax years and determine whether we have any material unrecognized liabilities in accordance with FASB guidance on accounting for uncertainty in income taxes. 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 income (loss).

See Note 19 for further discussion on taxes.

Recent Accounting Pronouncements

In March 2010, the FASB issued Accounting Standards Update (ASU) 2010-11, Scope Exception Related to Embedded Credit Derivatives, to address questions that have been raised in practice about the intended breadth of the embedded credit derivative scope exception in ASC 815, Derivatives and Hedging. The amended guidance clarifies that the scope exception applies to contracts that contain an embedded credit derivative that is only in the form of subordination of one financial instrument to another. The amended guidance is effective at the beginning of an entity’s first fiscal quarter beginning after June 15, 2010, although early adoption is permitted as of the first day of an entity’s first fiscal quarter beginning after the ASU’s issuance date of March 5, 2010. Upon adoption of the amended guidance, entities are permitted to elect the fair value option for beneficial interests in securitized financial assets on an instrument-by-instrument basis. Entities that elect the fair value option must prepare supporting documentation by the beginning of the period of adoption, and perform impairment analyses of applicable investments before adoption. We are currently evaluating the impact of ASU 2010-11 on our financial statements.

On February 26, 2010, the FASB issued Accounting Standards Update (ASU) 2010-10, Amendments for Certain Investment Funds. The ASU defers the effective date of Statement 167, Amendments to FASB Interpretation 46(R) (included in ASC 810-10) for a reporting enterprise’s interest in certain entities and for certain money market mutual funds. It addresses concerns that the joint consolidation model under

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

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

development by the FASB and the International Accounting Standards Board (IASB) may result in a different consolidation conclusion for asset managers and that an asset manager consolidating certain funds would not provide useful information to investors. The ASU also amends certain provisions of current guidance to change how a decision maker or service provider determines whether its fee is a variable interest. The amended guidance in ASU 2010-10 is effective for fiscal years beginning after November 15, 2009, and for interim periods within those years. The adoption of ASU 2010-10 did not impact our financial statements.

Note 4. Principles of Consolidation

We apply ASC 860 and ASC 810-10 to determine whether we must consolidate transferred financial assets and variable interest entities (VIEs) for financial reporting purposes. ASC 860 considers whether securitizations and other transfers of financial assets are treated as sales or financings. Additionally, ASC 810-10 addresses whether VIEs (e.g., certain legal entities often used in securitization and other structured finance transactions) should be included in the consolidated financial statements of any particular interested party. These standards became effective for our interests in all VIEs as of January 1, 2010, except for the Fund, as a result of the FASB’s decision to delay the applicability of ASC 810-10 for private equity funds. Our determination of whether we must consolidate the Fund was performed in accordance with FASB Interpretation No. 46 (revised), Consolidation of Variable Interest Entities (FIN 46(R)) at the time we acquired our interests in the Fund.

To provide information on the application of these principles, we provide our analysis of consolidated and unconsolidated VIEs below. We also note that these principles of consolidation require reassessment every quarter. Our future assessments of whether we are required to consolidate a VIE may change based upon the facts and circumstances pertaining to each VIE. This could result in a material impact to our financial statements during subsequent reporting periods.

Analysis of Consolidated VIEs

The VIEs we are required to consolidate include the Fund, certain Sequoia securitization entities, and the Acacia entities. The following table presents a summary of the assets and liabilities of these VIEs.

Assets and Liabilities of Consolidated VIEs at March 31, 2010

       
(In Thousands, Except VIE Data)   The Fund   Sequoia
Entities
  Acacia
Entities
  Total
Real estate loans   $     $ 3,643,143     $ 16,670     $ 3,659,813  
Real estate securities     26,969             268,830       295,799  
Other investments                 10,762       10,762  
Other assets     2,779       24,588       94,540       121,907  
Total Assets     29,748       3,667,731       390,802       4,088,281  
Asset-backed securities           3,557,669       279,471       3,837,140  
Other liabilities     1,331       2,064       141,350       144,745  
Total Liabilities     1,331       3,559,733       420,821       3,981,885  
Noncontrolling interest     12,589                   12,589  
Number of VIEs     1       36       10       47  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 4. Principles of Consolidation  – (continued)

As noted above, we looked to FIN 46(R) to determine whether to consolidate the assets, liabilities, and noncontrolling interest of the Fund. We determined that we are the primary beneficiary of the Fund as our ongoing asset management responsibilities provide us with the power to direct the activities that most significantly impact the economic performance of the Fund, and our significant general and limited partnership interests provide us with the obligation to absorb losses or the right to receive benefits that are significant.

Pursuant to the guidance in ASC 860, we consolidate the assets and liabilities of certain Sequoia securitization entities, as we did not meet the sale criteria at the time we transferred financial assets to these entities. Had we not been the transferor and depositor of these securitizations; however, we would likely not have consolidated them as we determined that we are not the primary beneficiary of these entities in accordance with ASC 810-10. We note that future securitizations will be analyzed under these provisions and, although it is generally our intent to consolidate sponsored securitizations, the determination will be on a case by case basis.

We consolidate the assets and liabilities of the Acacia securitization entities, as we met the criteria for consolidation in both ASC 860 and ASC 810-10. That is, we determined that (i) we did not meet the sale criteria at the time we transferred financial assets to these entities; and (ii) we are the primary beneficiary of Acacia VIEs. Our ongoing asset management responsibilities and call options provide us with the power to direct the activities that most significantly impact the economic performance of these individual entities, and our equity investments in each entity provide us with the obligation to absorb losses or the right to receive benefits that are significant.

Analysis of Non-Consolidated VIEs

Third party VIEs are securitization entities that Redwood did not sponsor. We may own several securities from a third party VIE, and in those cases, the analysis is done in consideration of all of our interests in that VIE. In accordance with ASC 810-10, we determined that we are not the primary beneficiary of any third-party residential, commercial, re-REMIC, or CDO entities in any third party VIEs, as we do not have the required power to direct the activities that most significantly impact the economic performance of these entities. Specifically, we do not service or manage these entities or otherwise hold decision making powers that are significant. As a result of this assessment, we do not consolidate any of the underlying assets and liabilities of these VIEs — we only account for our specific interests in each.

The following table presents a summary of Redwood’s interest in third party VIEs at March 31, 2010, grouped by collateral type and ownership interest.

VIE Summary

   
March 31, 2010
(In Thousands, Except VIE Data)
  Fair Value   Number of
VIEs
Real estate securities at Redwood
                 
Residential
                 
Senior   $ 739,512       110  
Re-REMIC     66,913       10  
Subordinate     23,140       209  
Commercial     8,876       15  
CDO     1,222       10  
Total third-party real estate securities   $ 839,663       354  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 5. Fair Value Option

The fair value option 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. Subsequent changes in the fair value of these assets, liabilities, and commitments are recorded in the consolidated statements of income (loss).

Our decision to elect the fair value option for new financial instruments is generally based upon our funding strategy for the specific financial asset acquired. For example, securities that we anticipate funding with equity will generally be accounted for as AFS. Securities and loans that we anticipate funding with a combination of debt and equity or financed through securitization liabilities will generally be accounted for at cost or fair value and the corresponding liabilities will generally be accounted for in a similar manner. Additionally, we may elect to apply the fair value option for financial instruments that may not perform similarly to our traditional real estate investments or are particularly volatile or complex.

As of March 31, 2010, the loans at Acacia had an aggregate fair value of $17 million and an unpaid principal balance of $23 million, the securities had an aggregate fair value of $269 million and an unpaid principal balance of $2.0 billion, and asset-backed securities issued at Acacia had an aggregate fair value of $279 million and an unpaid principal balance of $3.0 billion.

We elected 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 and second quarter of 2009. These ABS issued had been previously eliminated as intercompany assets for financial reporting purposes. During the first quarter of 2010, we elected the fair value option for $13 million of residential senior securities that we acquired.

Note 6. Fair Value of Financial Instruments

The FASB fair value guidance defines fair value, establishes a hierarchy of information used in measuring fair value, and enhances the disclosure of information about fair value measurements. Further, it 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. Additionally, relevant market data, to the extent available, and not internally generated or entity specific information should be used to determine fair value. The financial impact on Redwood from the adoption of this guidance was not significant since our valuation methodology used in prior periods did not need to be revised to comply with the new standard.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 6. 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, 2010 and December 31, 2009.

       
  March 31, 2010   December 31, 2009
(In Thousands)   Carrying
Value
  Fair Value   Carrying
Value
  Fair Value
Assets
                                   
Real estate loans (held-for-investment)   $ 3,643,386     $ 2,958,370     $ 3,724,791     $ 3,000,496  
Real estate loans (held-for-sale)     2,227       2,227       2,374       2,374  
Real estate loans (fair value)     16,670       16,670       12,089       12,089  
Trading securities     288,820       288,820       277,274       277,274  
Available-for-sale securities     846,642       846,642       810,471       810,471  
Other investments     10,762       10,762       20,371       20,371  
Cash and equivalents     241,753       241,753       242,818       242,818  
Derivative assets     5,520       5,520       12,372       12,372  
Restricted cash     87,600       87,600       94,306       94,306  
Accrued interest receivable     14,665       14,665       18,193       18,193  
REO (included in other assets)     14,289       14,289       17,421       17,421  
Liabilities
                                   
Derivative liabilities     79,486       79,486       83,800       83,800  
Accrued interest payable     5,390       5,390       5,968       5,968  
ABS Issued
                                   
ABS issued – Sequoia     3,557,669       2,912,559       3,644,933       2,909,032  
ABS issued – Acacia     279,471       279,471       297,596       297,596  
Total ABS issued     3,837,140       3,192,030       3,942,529       3,206,628  
Long-term debt     140,000       72,800       140,000       68,600  

For financial reporting purposes, we follow a fair value hierarchy established under GAAP that is used to measure the fair value of the assets and liabilities in the table above. This hierarchy prioritizes relevant market inputs in order to determine an “exit price”, or 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 date of measurement. Level 1 inputs are observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 inputs are observable inputs other than quoted prices for an asset or liability that are obtained through corroboration with observable market data. Level 3 inputs are unobservable inputs (e.g., our own data or assumptions) that are used when there is little, if any, relevant market activity for the asset or liability being measured at fair value.

In certain cases, 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 CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 6. 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, 2010

       
(In Thousands)   Carrying
Value
  Fair Value Measurements Using
  Level 1   Level 2   Level 3
Assets
                                   
Real estate loans   $ 16,670     $     $     $ 16,670  
Trading securities     288,820                   288,820  
Available-for-sale securities     846,642                   846,642  
Other investments     10,762             10,762        
Derivative assets     5,520             5,498       22  
Liabilities
                                   
ABS issued – Acacia     279,471                   279,471  
Derivative liabilities     79,486             68,763       10,723  

Assets and Liabilities Measured at Fair Value on a Recurring Basis as of December 31, 2009

       
(In Thousands)   Carrying
Value
  Fair Value Measurements Using
  Level 1   Level 2   Level 3
Assets
                                   
Real estate loans   $ 12,089     $     $     $ 12,089  
Trading securities     277,274                   277,274  
Available-for-sale securities     810,471                   810,471  
Other investments     20,371             20,371        
Derivative assets     12,372             12,326       46  
Liabilities
                                   
ABS issued – Acacia     297,596                   297,596  
Derivative liabilities     83,800             63,499       20,301  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 6. Fair Value of Financial Instruments  – (continued)

The following table presents additional information about Level 3 assets and liabilities during the three months ended March 31, 2010.

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

           
(In Thousands)   Assets   Liabilities
  Real Estate
Loans
  Trading
Securities
  AFS
Securities
  Derivative
Assets
  ABS
Issued – Acacia
  Derivative
Liabilities
Beginning balance – December 31, 2009   $ 12,089     $ 277,274     $ 810,471     $ 46     $ 297,596     $ 20,301  
Principal paydowns     215       (14,290 )      (33,458 )            (25,982 )       
Gains / losses in net income, net     4,366       12,149       8,684       (20 )      5,253       (186 ) 
Gains / losses in OCI, net                 (5,207 )                   
Acquisitions           17,137       162,772                    
Sales           (3,603 )      (96,646 )                   
Other settlements, net           153       26       (4 )      2,604       (9,392 ) 
Ending Balance – March 31, 2010   $ 16,670     $ 288,820     $ 846,642     $ 22     $ 279,471     $ 10,723  

The following table presents the portion of gains or losses included in our consolidated statement of income (loss) that were attributable to Level 3 assets and liabilities recorded at fair value on a recurring basis and still held at March 31, 2010 and 2009. Gains or losses incurred on assets or liabilities sold or otherwise disposed of during the three months ended March 31, 2010 and 2009 are not included in this presentation.

Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at March 31, 2010 and 2009 Included in Net Income (Loss)

   
  Included in Net Income (Loss)
     Three Months Ended March 31,
(In Thousands)   2010   2009
Assets
                 
Real estate loans   $ 4,366     $ (2,246 ) 
Trading securities     12,281       (46,471 ) 
Available-for-sale securities     (1,946 )      (29,035 ) 
Derivative assets     (20 )      160  
Liabilities
                 
ABS issued – Acacia     (5,253 )      31,689  
Derivative liabilities     186       271  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 6. Fair Value of Financial Instruments  – (continued)

The following table presents information on assets and liabilities recorded at fair value on a non-recurring basis at March 31, 2010 and December 31, 2009.

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis as of March 31, 2010

         
(In Thousands)   Carrying
Value
  Fair Value Measurements Using   Gain (Loss)
  Three Months
Ended
March 31,
2010
  Level 1   Level 2   Level 3
Assets
                                            
Real estate loans (held-for-sale)   $ 2,227     $     $     $ 2,227     $ (120 ) 
REO     14,289                   14,289       (74 ) 

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis as of December 31, 2009

         
(In Thousands)   Carrying
Value
  Fair Value Measurements Using   Gain (Loss)
  Three Months
Ended
March 31,
2009
  Level 1   Level 2   Level 3
Assets
                                            
Real estate loans (held-for-sale)   $ 2,374     $     $     $ 2,374     $ (21 ) 
REO     17,421                   17,421       (765 ) 

The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of income (loss) for the three months ended March 31, 2010 and 2009.

Market Valuation Adjustments, Net

   
  Three Months Ended March 31,
(In Thousands)   2010   2009
Assets
                 
Real estate loans (fair value)   $ 4,366     $ (2,246 ) 
Real estate loans (held-for-sale)     (120 )      (21 ) 
REO     (74 )      (765 ) 
Trading securities     12,149       (46,425 ) 
Impairments on AFS securities     (1,946 )      (29,035 ) 
Liabilities
                 
ABS issued – Acacia     (5,253 )      31,689  
Derivative instruments, net     (20,359 )      3,561  
Market Valuation Adjustments, Net   $ (11,237 )    $ (43,242 ) 

A description of the instruments measured at fair value as well as the general classification of such instruments pursuant to the Level 1, Level 2, and Level 3 valuation hierarchy 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).

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 6. Fair Value of Financial Instruments  – (continued)

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).
We request and consider indications of value (marks) from third-party dealers to assist us in our valuation process. The availability of third-party marks continues to decline, in part because some dealers no longer exist and others have ceased providing client valuation services. For March 31, 2010, we received dealer marks on 81% of our securities. In the aggregate, our internal valuations of the securities on which we received dealer marks were 4% lower (i.e., more conservative) than the aggregate dealer marks.
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 generally be verified and model selection does not involve significant management judgment (Level 2). For other derivatives, such as certain CDS, 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.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 6. Fair Value of Financial Instruments  – (continued)

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).
We request and consider indications of value (marks) from third-party dealers to assist us in our valuation process. The availability of third-party marks continues to decline, in part because some dealers no longer exist and others have ceased providing client valuation services. For March 31, 2010, we received dealer marks on 92% of our ABS issued. Our internal valuations of our ABS issued on which we received dealer marks were 9% higher (i.e., more conservative) than the aggregate dealer marks.
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).
Real Estate Owned (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 CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 7. 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 or long-term debt.

The following table summarizes the classifications and carrying value of the residential and commercial real estate loans recorded on our consolidated balance sheets at March 31, 2010 and December 31, 2009.

   
(In Thousands)   March 31,
2010
  December 31,
2009
Residential real estate loans (held-for-sale)   $ 2,227     $ 2,374  
Residential real estate loans (held-for-investment)     3,643,143       3,724,546  
Commercial real estate loans (fair value)     16,670       12,089  
Commercial real estate loans (held-for-investment)     243       245  
Total Real Estate Loans   $ 3,662,283     $ 3,739,254  

Residential Real Estate Loans Held-for-Sale

Residential real estate loans held-for-sale are owned at Redwood and financed with equity. At both March 31, 2010 and December 31, 2009, there were 14 residential loans held-for-sale with $4 million in outstanding principal value and a lower of cost or fair value of $2 million.

Residential Real Estate Loans Held-for-Investment

Residential real estate loans held-for-investment are owned at the consolidated Sequoia securitization entities. The following table provides additional information on residential real estate loans held-for-investment at March 31, 2010 and December 31, 2009.

   
(In Thousands)   March 31,
2010
  December 31,
2009
Principal value   $ 3,656,655     $ 3,728,738  
Unamortized premium, net     47,657       50,028  
Allowance for loan losses     (61,169 )      (54,220 ) 
Carrying Value   $ 3,643,143     $ 3,724,546  

Of the $3.7 billion of principal face and $48 million of unamortized premium on these loans at March 31, 2010, $1.8 billion of principal face and $31 million of unamortized premium relates to residential loans acquired prior to July 1, 2004. During the first quarter of 2010, 2% of these residential loans prepaid and we amortized 6% of the premium based upon the accounting elections we apply. For residential loans acquired after July 1, 2004, the principal face was $1.9 billion and the unamortized premium was $17 million at March 31, 2010. During the first quarter of 2010, 2% of these residential loans prepaid and we amortized 3% of the premium.

Of the $3.7 billion of principal face and $50 million of unamortized premium on these loans at December 31, 2009, $1.8 billion of principal face and $33 million of unamortized premium relates to residential loans acquired prior to July 1, 2004. During the fourth quarter of 2009, 2% of these residential loans prepaid and we amortized 7% of the premium based upon the accounting elections we apply. For residential loans acquired after July 1, 2004, the principal face was $1.9 billion and the unamortized premium was $17 million at December 31, 2009. During the fourth quarter of 2009, 2% of these residential loans prepaid and we amortized 4% of the premium.

Commercial Real Estate Loans

Commercial real estate loans at fair value are owned at the consolidated Acacia securitization entities. At March 31, 2010, there were four commercial loans at fair value with an aggregate outstanding principal value

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 7. Real Estate Loans  – (continued)

of $23 million and an aggregate fair value of $17 million, one of which has been delinquent since May 2009 with an outstanding principal balance of $4 million and a fair value of $3 million. At December 31, 2009, there were four commercial loans at fair value, with an outstanding principal of $23 million and a fair value of $12 million. The fair value of our commercial loans increased by $5 million during the first quarter as there was increased clarity regarding a bankruptcy and the resumption of payments in the near future.

At March 31, 2010, there was one commercial loan held-for-investment with $0.5 million in outstanding principal value and a carrying value of $0.2 million. During the first quarter of 2010, we charged off a $10 million commercial mezzanine loan with no impact to our consolidated statements of income (loss), as we had fully reserved for this loan in 2007. At December 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.

Note 8. 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, 2010 and December 31, 2009, 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 for the three months ended March 31, 2010 and 2009.

   
  Three Months Ended
March 31,
(In Thousands)   2010   2009
Balance at Beginning of Period   $ 54,220     $ 35,713  
Charge-offs, net     (2,526 )      (3,798 ) 
Provision for loan losses     9,475       16,032  
Balance at End of Period   $ 61,169     $ 47,947  

Serious delinquencies on consolidated Sequoia loans were $158 million and $155 million as of March 31, 2010 and 2009, respectively. Serious delinquencies include loans delinquent more than 90 days and in foreclosure. As a percentage of current loan balances, serious delinquencies were 4.32% and 3.43% at March 31, 2010 and 2009, respectively.

When we pursue foreclosure in full satisfaction for a defaulted loan, we estimate the specific loan loss, if any, based on estimated net proceeds from the sale of the property (including accrued but unpaid interest and other costs), and charge this specific estimated loss against the allowance for loan losses. During the first quarter of 2010, there were $3 million of charge-offs that reduced our allowance for loan losses. These charge-offs arose from $9 million of defaulted loan principal. Foreclosed property is subsequently recorded as REO, a component of other assets.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 9. 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, 2010 and December 31, 2009.

       
March 31, 2010
(In Thousands)
  Redwood   The Fund   Acacia   Total
Securities
Residential   $ 829,565     $ 22,874     $ 201,388     $ 1,053,827  
Commercial     8,876             54,542       63,418  
CDO     1,222       4,095       12,900       18,217  
Total Real Estate Securities   $ 839,663     $ 26,969     $ 268,830     $ 1,135,462  

       
December 31, 2009
(In Thousands)
  Redwood   The Fund   Acacia   Total
Securities
Residential   $ 770,916     $ 32,884     $ 201,367     $ 1,005,167  
Commercial     9,200             54,206       63,406  
CDO     1,247       4,067       13,858       19,172  
Total Real Estate Securities   $ 781,363     $ 36,951     $ 269,431     $ 1,087,745  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 9. Real Estate Securities  – (continued)

The following table presents our securities by trading and AFS, collateral type, and entity as of March 31, 2010 and December 31, 2009.

           
March 31, 2010
(In Thousands)
  Trading   AFS
  Redwood   Acacia   Total   Redwood   The Fund   Total
Senior Securities
                                                     
Residential prime   $     $ 5,031     $ 5,031     $ 372,140     $     $ 372,140  
Residential non-prime     18,231       102,491       120,722       349,141       16,560       365,701  
Commercial           10,220       10,220                    
Total Senior Securities     18,231       117,742       135,973       721,281       16,560       737,841  
Re-REMIC Securities                       66,913             66,913  
Subordinate Securities
                                                     
Residential prime     346       24,642       24,988       16,250             16,250  
Residential non-prime     191       69,224       69,415       6,353       6,314       12,667  
Commercial           44,322       44,322       8,876             8,876  
CDO     1,222       12,900       14,122             4,095       4,095  
Total Subordinate Securities     1,759       151,088       152,847       31,479       10,409       41,888  
Total Real Estate Securities   $ 19,990     $ 268,830     $ 288,820     $ 819,673     $ 26,969     $ 846,642  

           
December 31, 2009
(In Thousands)
  Trading   AFS
  Redwood   Acacia   Total   Redwood   The Fund   Total
Senior Securities
                                                     
Residential prime   $     $ 4,826     $ 4,826     $ 329,208     $     $ 329,208  
Residential non-prime     6,084       100,397       106,481       308,868       26,735       335,603  
Commercial           9,508       9,508                    
Total Senior Securities     6,084       114,731       120,815       638,076       26,735       664,811  
Re-REMIC Securities                       105,951             105,951  
Subordinate Securities
                                                     
Residential prime     319       27,380       27,699       19,191             19,191  
Residential non-prime     218       68,764       68,982       1,077       6,149       7,226  
Commercial           44,698       44,698       9,200             9,200  
CDO     1,222       13,858       15,080       25       4,067       4,092  
Total Subordinate Securities     1,759       154,700       156,459       29,493       10,216       39,709  
Total Real Estate Securities   $ 7,843     $ 269,431     $ 277,274     $ 773,520     $ 36,951     $ 810,471  

Senior securities are those interests in a securitization that have the first right to cash flows and are last in line to absorb losses. Re-REMIC securities, as presented herein, were created through the resecuritization of certain senior interests to provide additional credit support to those interests. These re-REMIC securities are therefore subordinate to the remaining senior interest, but senior to any subordinate tranches of the securitization from which they were created. Subordinate securities are all interests below senior and re-REMIC interests. Prime residential securities are securities backed by prime residential loans that generally have low loan-to-value ratios (typically 75% LTV or less), are made to borrowers who have high FICO scores (typically 700 or higher), and typically have low concentrations of investor properties. Non-prime residential securities are generally backed by loans that have higher loan-to-value ratios, are made to borrowers who have lower credit scores or impaired credit histories (but exhibit the ability to repay their loans), and may have

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TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 9. Real Estate Securities  – (continued)

higher concentrations of investor properties. At March 31, 2010, all of our real estate securities had contractual maturities over ten years, except for less than $1 million of residential securities that had contractual maturities greater than five years but less than ten years.

AFS Securities

We generally purchase AFS securities at a discount. To the extent we purchase an AFS security that has a likelihood of incurring credit loss, we generally will not amortize into income the portion of the purchase discount that, although we are entitled to earn, we 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. We designate the amount of principal face that we do not expect to receive and will not amortize into income as a credit reserve on the security, with any remaining net unamortized discounts or premiums amortized into income over time using the interest method.

The following table presents the components of carrying value (which equals fair value) of AFS securities as of March 31, 2010 and December 31, 2009.

       
March 31, 2010
(In Thousands)
  Residential   Commercial   CDO   Total
Current face   $ 1,495,304     $ 152,408     $ 89,397     $ 1,737,109  
Credit reserve     (388,078 )      (139,320 )      (87,103 )      (614,501 ) 
Net unamortized (discount) premium     (355,194 )      (5,660 )      9,379       (351,475 ) 
Amortized cost     752,032       7,428       11,673       771,133  
Gross unrealized gains     114,580       1,886             116,466  
Gross unrealized losses     (32,941 )      (438 )      (7,578 )      (40,957 ) 
Carrying Value   $ 833,671     $ 8,876     $ 4,095     $ 846,642  

       
December 31, 2009
(In Thousands)
  Residential   Commercial   CDO   Total
Current face   $ 1,581,692     $ 158,997     $ 89,371     $ 1,830,060  
Credit reserve     (469,273 )      (146,018 )      (87,017 )      (702,308 ) 
Net unamortized (discount) premium     (401,808 )      (5,130 )      8,941       (397,997 ) 
Amortized cost     710,611       7,849       11,295       729,755  
Gross unrealized gains     130,914       1,422       25       132,361  
Gross unrealized losses     (44,346 )      (71 )      (7,228 )      (51,645 ) 
Carrying Value   $ 797,179     $ 9,200     $ 4,092     $ 810,471  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 9. Real Estate Securities  – (continued)

The following table presents the changes for the three months ended March 31, 2010 of the unamortized discount and designated credit reserves on AFS securities.

Changes in Unamortized Discount and Designated Credit Reserves on AFS Securities

           
  Residential   Commercial   CDO
(In Thousands)   Credit
Reserve
  Unamortized
Discount Net
  Credit
Reserve
  Unamortized
Discount Net
  Credit
Reserve
  Unamortized
Discount Net
Beginning balance – December 31, 2009   $ 469,273     $ 401,808     $ 146,018     $ 5,130     $ 87,017     $ (8,941 ) 
Amortization of net discount           (10,596 )            319             (352 ) 
Realized credit losses     (43,194 )            (6,590 )                   
Acquisitions     8,966       43,388                          
Sales, calls, other     (52,335 )      (75,881 )                         
Impairments     1,843             103                    
Transfers to (release of) credit reserves     3,525       (3,525 )      (211 )      211       86       (86 ) 
Ending Balance – March 31, 2010   $ 388,078     $ 355,194     $ 139,320     $ 5,660     $ 87,103     $ (9,379 ) 

The loans underlying our residential subordinate securities totaled $64 billion at March 31, 2010. These loans are located nationwide with a large concentration in California (47%). Serious delinquencies (90+ days, in foreclosure or REO) at March 31, 2010 were 7.69% of current principal balances. The loans underlying our commercial subordinate securities totaled $25 billion at March 31, 2010, and consist primarily of office (37%), retail (33%), and multifamily (13%) loans. These loans are located nationwide with the highest concentration in California (13%). Serious delinquencies (60+ days, in foreclosure or REO) at March 31, 2010 were 3.70% of current principal balances.

AFS Securities with Unrealized Losses

The following table presents the components comprising the carrying value of AFS securities that were in an unrealized loss position as of March 31, 2010 and December, 31 2009.

           
March 31, 2010
(In Thousands)
  Less Than 12 Consecutive Months   12 Consecutive Months or Longer
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair
Value
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair
Value
Residential   $ 146,464     $ (3,977 )    $ 142,487     $ 66,296     $ (28,964 )    $ 37,331  
Commercial     2,909       (438 )      2,471                    
CDO     4,264       (2,309 )      1,955       7,409       (5,269 )      2,141  
Total Securities   $ 153,637     $ (6,724 )    $ 146,913     $ 73,705     $ (34,233 )    $ 39,472  

           
December 31, 2009
(In Thousands)
  Less Than 12 Consecutive Months   12 Consecutive Months or Longer
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair
Value
  Total
Amortized
Cost
  Gross
Unrealized
Losses
  Total
Fair
Value
Residential   $ 73,075     $ (30,520 )    $ 42,555     $ 42,368     $ (13,826 )    $ 28,542  
Commercial     2,719       (71 )      2,648                    
CDO     4,091       (2,136 )      1,955       7,204       (5,092 )      2,112  
Total Securities   $ 79,885     $ (32,727 )    $ 47,158     $ 49,572     $ (18,918 )    $ 30,654  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 9. Real Estate Securities  – (continued)

At March 31, 2010, after giving effect to purchases, sales, and extinguishments due to credit losses, our consolidated balance sheet included 552 AFS securities, of which 189 were in an unrealized loss position, of which 105 were in a continuous unrealized loss position for twelve consecutive months or longer. At December 31, 2009, our consolidated balance sheet included 554 AFS securities, of which 220 were in a continuous unrealized loss position and 72 were in a continuous unrealized loss position for twelve months or longer.

Of the total unrealized losses at March 31, 2010 and December 31, 2009, $10 million and $14 million, respectively, relate to securities owned at the Fund. The remaining unrealized losses relate to securities owned at Redwood.

Evaluating AFS Securities for Other-than-Temporary Impairments

When the fair value of an AFS security is below our cost basis, we evaluate the security for OTTI. Part of this evaluation is based upon significant adverse changes in the assumptions used to value the security. The table below summarizes the significant valuation assumptions we used for our AFS securities as of March 31, 2010.

Significant Valuation Assumptions

     
  Range for Securities
March 31, 2010   Prime   Non-prime   Commercial
Prepayment rates     2 – 15 %      1 – 12 %      N/A  
Loss severity(1)     13 – 64 %      21 – 63 %      34 – 50 % 
Projected losses(1)     0 – 20 %      1 – 55 %      2 – 11 % 

(1) Projected losses and severities are generally vintage specific, with the 2005 and later vintage securities having higher projected losses and severities and the 2004 and earlier vintages having the lower projected losses and severities.

During the three months ended March 31, 2010, we determined that $4 million of OTTI existed, of which $2 million was recognized in our consolidated statement of income (loss). We determined that $1 million of this $2 million related to securities with only credit-related OTTI and no corresponding non-credit component. The remaining $1 million was the aggregate credit component of OTTI for securities that also had an aggregate non-credit component of $2 million that was not recognized in our consolidated statements of income (loss).

The following table details the activity related to the credit component of OTTI (i.e., OTTI in either current earnings or retained earnings) for AFS securities that also had a non-credit component and were still held at March 31, 2010.

Activity of Credit Component of Other-than-Temporary Impairments

 
(In Thousands)   Three Months
Ended
March 31, 2010
Balance at beginning of period   $ 181,913  
Current period activity:
        
Additions related to AFS securities that were not previously impaired     90  
Additions related to AFS securities that were previously impaired     1,296  
Balance at End of Period   $ 183,299  

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 9. Real Estate Securities  – (continued)

Gross Realized Gains and Losses

Gains and losses from the sale of AFS securities are recorded as realized gains, net, in our consolidated statements of income (loss). The following table presents the gross realized gains and losses on sales of AFS securities for the three months ended March 31, 2010 and 2009.

   
  Three Months Ended
March 31,
(In Thousands)   2010   2009
Gross realized gains – sales   $ 38,854     $ 337  
Gross realized losses – sales     (1,475 )       
Total Realized Gains on Sales of AFS Securities, net   $ 37,379     $ 337  

Note 10. 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 reference residential mortgage-backed securities issued in 2006 that were initially A and BBB-rated and have subsequently been downgraded. The fair value of the GIC was $11 million as of March 31, 2010, which is equal to its carrying value. The GIC has been drawn down by $69 million since its acquisition to cover credit losses and principal reductions on the referenced securities.

Note 11. 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. Derivatives with a positive fair value are accounted for as assets while derivatives with a negative fair value are accounted for as liabilities. Redwood and the consolidated Acacia entities held derivative positions at March 31, 2010. Acacia’s derivative financial instruments are owned by Acacia securitization entities and are not the obligations of Redwood.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2010
(Unaudited)

Note 11. Derivative Financial Instruments  – (continued)

The following table shows the aggregate fair value and notional amount by entity of our derivative financial instruments as of March 31, 2010 and December 31, 2009.

           
March 31, 2010
(In Thousands)
  Redwood   Acacia   Total
  Fair
Value
  Notional
Amount
  Fair
Value
  Notional
Amount
  Fair
Value
  Notional
Amount
Assets Accounted for as Cash Flow Hedges
                                                     
Interest rate swaps   $ 281     $ 60,000     $     $     $ 281     $ 60,000  
Assets Accounted for as Trading Instruments
                                                     
Interest rate swaps                 757       73,536       757       73,536  
Interest rate caps purchased                 4,482       711,800       4,482       711,800  
Total Assets     281       60,000       5,239       785,336       5,520       845,336  
Liabilities Accounted for as Cash Flow Hedges
                                                     
Interest rate swaps     (693 )