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, 2011

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 x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See 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		78,548,044 shares outstanding as of May 4, 2011

TABLE OF CONTENTS

REDWOOD TRUST, INC.
2011 FORM 10-Q REPORT
  
TABLE OF CONTENTS

		Page
PART I
Item 1. Financial Statements			1
Consolidated Balance Sheets at March 31, 2011 (Unaudited) and December 31, 2010			1
Consolidated Statements of Income for the Three Months Ended March 31, 2011 and 2010 (Unaudited)			2
Consolidated Statements of Equity and Comprehensive Income for the Three Months Ended March 31, 2011 and 2010 (Unaudited)			3
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2011 and 2010 (Unaudited)			4
Notes to Consolidated Financial Statements			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			45
Item 3. Quantitative and Qualitative Disclosures About Market Risk			86
Item 4. Controls and Procedures			86
PART II
Item 1. Legal Proceedings			87
Item 1A. Risk Factors			89
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			89
Item 3. Defaults Upon Senior Securities			89
Item 4. (Removed and Reserved)			89
Item 5. Other Information			89
Item 6. Exhibits			90
Signatures			91

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, 2011				December 31, 2010
ASSETS
Residential real estate loans		$	3,795,762			$	3,797,095
Commercial real estate loans			62,436				50,386
Real estate securities, at fair value:
Trading securities			321,820				329,717
Available-for-sale securities			781,992				825,119
Total real estate securities			1,103,812				1,154,836
Other investments			—				—
Cash and cash equivalents			220,276				46,937
Total earning assets			5,182,286				5,049,254
Restricted cash			34,983				24,524
Accrued interest receivable			13,569				13,782
Derivative assets			5,698				8,051
Deferred tax asset			3,487				3,487
Deferred securities issuance costs			7,052				5,928
Other assets			36,231				38,662
Total Assets(1)		$	5,283,306			$	5,143,688
LIABILITIES AND EQUITY
Liabilities
Short-term debt		$	—			$	44,137
Accrued interest payable			6,611				5,930
Derivative liabilities			70,157				83,115
Accrued expenses and other liabilities			8,358				14,305
Dividends payable			19,535				19,531
Asset-backed securities issued – Sequoia			3,646,342				3,458,501
Asset-backed securities issued – Acacia			310,952				303,077
Long-term debt			139,500				139,500
Total liabilities(2)			4,201,455				4,068,096
Equity
Common stock, par value $0.01 per share, 100,000,000 shares authorized; 78,138,724 and 78,124,668 issued and outstanding			781				781
Additional paid-in capital			1,692,095				1,689,851
Accumulated other comprehensive income			122,112				112,339
Cumulative earnings			493,105				474,940
Cumulative distributions to stockholders			(1,233,282	)			(1,213,158	)
Total stockholders’ equity			1,074,811				1,064,753
Noncontrolling interest			7,040				10,839
Total equity			1,081,851				1,075,592
Total Liabilities and Equity		$	5,283,306			$	5,143,688

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

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME

(In Thousands, Except Share Data) (Unaudited)		Three Months Ended March 31,
		2011				2010
Interest Income
Residential real estate loans		$	18,469			$	14,488
Commercial real estate loans			1,225				303
Real estate securities			34,624				43,899
Other investments			—				9
Cash and cash equivalents			15				17
Total interest income			54,333				58,716
Interest Expense
Short-term debt			(182	)			—
Asset-backed securities issued			(19,423	)			(17,066	)
Long-term debt			(2,367	)			(1,116	)
Total interest expense			(21,972	)			(18,182	)
Net Interest Income			32,361				40,534
Provision for loan losses			(2,807	)			(9,475	)
Market valuation adjustments			(3,118	)			(9,291	)
Other-than-temporary impairments(1)			(2,622	)			(1,946	)
Market valuation adjustments, net			(5,740	)			(11,237	)
Net Interest Income After Provision and Market Valuation Adjustments			23,814				19,822
Operating expenses			(11,514	)			(17,306	)
Realized gains on sales and calls, net			3,864				44,338
Net income before provision for income taxes			16,164				46,854
Provision for income taxes			(14	)			(26	)
Net income			16,150				46,828
Less: Net loss attributable to noncontrolling interest			(2,015	)			(15	)
Net Income Attributable to Redwood Trust, Inc.		$	18,165			$	46,843
Basic earnings per common share		$	0.23			$	0.59
Diluted earnings per common share		$	0.22			$	0.58
Regular dividends declared per common share		$	0.25			$	0.25
Basic weighted average shares outstanding			78,027,840				77,677,235
Diluted weighted average shares outstanding			79,371,776				78,542,299

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

TABLE OF CONTENTS

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

For the Three Months Ended March 31, 2011

(In Thousands, Except Share Data) (Unaudited)		Common Stock								Additional Paid-In Capital				Accumulated Other Comprehensive Income				Cumulative Earnings				Cumulative Distributions to Stockholders				Noncontrolling Interest				Total
		Shares				Amount
December 31, 2010			78,124,668			$	781			$	1,689,851			$	112,339			$	474,940			$	(1,213,158	)		$	10,839			$	1,075,592
Net income (loss)			—				—				—				—				18,165				—				(2,015	)			16,150
Net unrealized gain on available-for-sale securities			—				—				—				3,049				—				—				4,539				7,588
Reclassification of other-than-temporary impairments to net income			—				—				—				1,770				—				—				—				1,770
Net unrealized gain on interest rate agreements			—				—				—				3,890				—				—				—				3,890
Reclassification of unrealized loss on interest rate agreements to net income			—				—				—				1,064				—				—				—				1,064
Total other comprehensive gain															9,773
Total comprehensive income																															30,462
Issuance of common stock:
Dividend reinvestment & stock purchase plans			13,304				—				196				—				—				—				—				196
Employee stock purchase and incentive plans			752				—				(26	)			—				—				—				—				(26	)
Non-cash equity award compensation			—				—				2,074				—				—				—				—				2,074
Distributions to noncontrolling interest, net			—				—				—				—				—				—				(6,323	)			(6,323	)
Common dividends declared			—				—				—				—				—				(20,124	)			—				(20,124	)
March 31, 2011			78,138,724			$	781			$	1,692,095			$	122,112			$	493,105			$	(1,233,282	)		$	7,040			$	1,081,851

For the Three Months Ended March 31, 2010

(In Thousands, Except Share Data) (Unaudited)		Common Stock								Additional Paid-In Capital				Accumulated Other Comprehensive Income				Cumulative Earnings				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 gain (loss) on available-for-sale securities			—				—				—				(8,940	)			—				—				2,138				(6,802	)
Reclassification of other-than-temporary impairments to net income			—				—				—				1,594				—				—				—				1,594
Reclassification of unrealized loss on interest rate agreements to net income			—				—				—				83				—				—				—				83
Total other comprehensive loss															(7,263	)
Total comprehensive gain																															41,703
Issuance of common stock:
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
Share repurchases			—				—				—				—				—				—				—				—
Distributions to noncontrolling interest, 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

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

TABLE OF CONTENTS

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

(In Thousands, Except Share Data) (Unaudited)		Three Months Ended March 31,
		2011				2010
Cash Flows From Operating Activities:
Net income attributable to Redwood Trust, Inc.		$	18,165			$	46,843
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of premiums, discounts, and debt issuance costs, net			(9,520	)			(8,220	)
Depreciation and amortization of non-financial assets			257				240
Provision for loan losses			2,807				9,475
Non-cash equity award compensation			2,074				6,086
Market valuation adjustments, net			5,740				11,237
Realized gains on sales and calls, net			(3,864	)			(44,338	)
Net change in:
Accrued interest receivable			76				3,349
Deferred tax asset			—				1,179
Other assets			3,529				1,976
Accrued interest payable			3,892				2,026
Accrued expenses and other liabilities			(5,947	)			31,789
Net cash provided by operating activities			17,209				61,642
Cash Flows From Investing Activities:
Purchases of real estate loans held-for-investment			(112,742	)			—
Principal payments on real estate loans held-for-investment			93,292				65,647
Proceeds from sales of real estate loans held-for-sale			1,857				—
Purchases of available-for-sale securities			(13,223	)			(162,772	)
Proceeds from sales of available-for-sale securities			48,072				134,025
Principal payments on available-for-sale securities			31,234				33,458
Purchases of real estate securities trading			—				(17,137	)
Proceeds from sales of trading securities			12,841				3,603
Principal payments on trading securities			15,080				14,290
Principal payments on other investments			—				3,766
Net (increase) decrease in restricted cash			(10,459	)			6,706
Net cash provided by investing activities			65,952				81,586
Cash Flows From Financing Activities:
Net repayments on short-term debt			(44,137	)			—
Proceeds from issuance of asset-backed securities			280,111				—
Repurchase of asset-backed securities			—				(8,639	)
Deferred securities issuance costs			(1,695	)			—
Repayments on asset-backed securities			(110,896	)			(96,568	)
Net settlements of derivatives			(4,916	)			(12,390	)
Net proceeds from issuance of common stock			170				113
Dividends paid			(20,121	)			(19,890	)
Change in noncontrolling interests			(8,338	)			(6,919	)
Net cash provided by (used in) financing activities			90,178				(144,293	)
Net increase (decrease) in cash and cash equivalents			173,339				(1,065	)
Cash and cash equivalents at beginning of period		$	46,937			$	242,818
Cash and cash equivalents at end of period		$	220,276			$	241,753
Supplemental Disclosures:
Cash paid for interest		$	16,833			$	16,156
Cash paid for taxes		$	18			$	4
Dividends declared but not paid at end of period		$	19,535			$	19,438
Transfers from real estate loans to real estate owned		$	2,396			$	3,707

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

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(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, 2011 and December 31, 2010, and for the three months ended March 31, 2011 and 2010. These consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) in the United States of America — as prescribed by the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) — and using the Securities and Exchange Commission’s (SEC) instructions to Form 10-Q. All amounts presented herein, except share data, are shown in thousands.

Organization

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

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

Principles of Consolidation

We apply FASB guidance to determine whether we must consolidate transferred financial assets and variable interest entities (VIEs) for financial reporting purposes. 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 a continuing involvement.

For financial reporting purposes, the underlying loans and securities owned at Sequoia and Acacia entities are shown on our consolidated balance sheets under real estate loans and real estate securities and the asset-backed securities (ABS) issued to third-parties by these entities are shown under ABS issued. In our consolidated statements of income, we record interest income on the loans and securities owned by consolidated Sequoia and Acacia entities and interest expense on the ABS issued by these entities. 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, 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.

See Note 4 for further discussion on principles of consolidation.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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 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:

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 5 for further discussion on fair value measurements.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

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 our consolidated statements of income.

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 accounted for in a manner consistent with the associated liabilities. 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.

See Note 5 for further discussion on the fair value option.

Real Estate Loans

Residential and Commercial Real Estate Loans — Fair Value

Residential and commercial real estate loans at fair value include 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 in market valuation adjustments, net.

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

Residential and commercial real estate loans held-for-sale include 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. 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.

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 residential 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 or when a loan has been individually impaired, at which point the loan is placed on nonaccrual status. Interest previously accrued for loans that have become greater than 90 days past due or individually impaired is reserved for in the allowance for loan losses. Loans delinquent more than 90 days or in foreclosure are characterized as seriously delinquent. Cash principal and interest that is advanced from servicers subsequent to a loan becoming greater than 90 days past due or individually impaired is used to reduce the outstanding loan principal balance. When a seriously delinquent loan previously placed on nonaccrual status has cured, meaning all delinquent principal and interest have been remitted by the borrower, the loan is placed back on accrual status. Loans that have been individually impaired are placed back on accrual status once the loan is considered reperforming.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

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 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, if any, 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.

See Note 6 for further discussion on real estate loans.

Residential Real Estate Loans — Allowance for Loan Losses

For residential 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 pools of loans.

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

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 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 at the reported date of the financial statements. We re-evaluate the adequacy of our allowance for loan losses 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

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

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 (TDR), 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 our consolidated statements of income.

When foreclosed property is received 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. Foreclosed property is subsequently recorded as real estate owned (REO), a component of other assets on our consolidated balance sheets. Actual losses incurred on loans liquidated through a short-sale are also charged against the allowance for loan losses.

Commercial Real Estate Loans — Allowance for Loan Losses

For commercial real estate loans classified as held-for-investment, we establish and maintain an allowance for loan losses on an individual basis for those loans we have determined to be impaired as of the reporting date. To calculate the allowance for loan losses, we assess each loan for indications of adverse credit conditions such as delinquencies or changes in expected future cash flows. Upon identification of an adverse credit conditions, the loans are evaluated for impairment and any resulting impairment is recorded in the provision for loan losses in our consolidated statements of income. We re-evaluate the adequacy of our allowance for loan losses for commercial loans held-for-investment at least quarterly.

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

Repurchase Reserves

We do not currently maintain a loan repurchase reserve and management is not aware of any outstanding repurchase claims against Redwood that would require the establishment of such a reserve. We do not originate residential loans and 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 circumstances where we believe that there is a risk of loss due to a loan repurchase demand (i.e., due to an allegation of a breach of representations and warranties) and we do not believe that full recourse to the company from whom we acquired the loan exists or is enforceable, we will review the need for any loan repurchase reserve in accordance with FASB guidance on accounting for contingencies and establish reserves when, in the opinion of management, it is probable that a matter would result in a liability and the amount of loss, if any, can be reasonably estimated.

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 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, at fair value.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

Available-for-Sale (AFS) 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 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.

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. Conversely, if none of these three conditions is 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. 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, a component of 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. 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. 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. Future amortization and accretion for the security is computed based upon the new amortized cost basis.

See Note 8 for further discussion on real estate securities.

Other Investments

Other investments included a guaranteed investment contract (GIC) entered into by an Acacia securitization entity that we consolidate for financial statement purposes. At December 31, 2010, the GIC had been drawn down completely to cover credit losses and principal reductions on the referenced securities. We accounted for this investment under the fair value option. Changes in fair value were reported through our consolidated statements of income through market valuation adjustments, net. Interest income was reported through our consolidated statements of income through interest income, other investments. This GIC represented a deposit certificate issued by a rated investment bank and serves as collateral to cover realized losses on credit default swaps (CDS) entered into by this same Acacia entity.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(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, 2011, we did not have any significant concentrations of credit risk arising from cash deposits as all of our cash and cash equivalents were invested in 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 by consolidated securitization entities. Restricted cash may also include cash retained in Acacia or Sequoia securitization entities prior to the payments on or redemptions of outstanding ABS issued, or in the Fund prior to distributions to limited partners. At March 31, 2011, we did not have any significant concentrations of credit risk arising from restricted cash deposits as all of our restricted cash was held in custodial accounts or FDIC-insured bank products.

Accrued Interest Receivable

Accrued interest receivable includes 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 risk management derivatives — namely interest rate agreements — and credit derivatives. All derivative financial instruments are recorded at fair value in our consolidated balance sheets. Derivatives with a positive fair value to us are reported as an asset and derivatives with a negative fair value to us are reported as a liability. We classify each of our derivative financial instruments as either (i) a trading instrument (no hedging designation) or (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).

Changes in fair value of derivatives accounted for as trading instruments, including any associated interest income or expense, are recorded in our consolidated statements of income through market valuation adjustments, net. Changes in the fair value of derivatives accounted for as cash flow hedges, to the extent they are effective, are recorded in accumulated other comprehensive income, a component of equity. Interest income or expense and any ineffectiveness associated with these hedging derivatives are recorded as a component of net interest income in our consolidated statements of income. We measure the effective portion of cash flow hedges by comparing the change in fair value of the expected future variable cash flows of the derivative hedging instruments with the change in fair value of the expected future variable cash flows of the hedged liabilities.

We will discontinue cash flow hedge accounting if (i) we determine that the hedging 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 associated with the hedged item will not occur by the end of the originally specified time period. To the extent we de-designate a cash flow hedging relationship but the associated hedged item continues to exist, the fair value of the cash flow hedge at the time of de-designation remains in accumulated other comprehensive income and is amortized using the straight-line method through interest expense over the remaining life of the hedged liability.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

Risk Management Derivatives

Risk management derivatives that we currently utilize include interest rate swaps and caps. Interest rate swaps are derivative contracts in which (i) one party exchanges a stream of fixed interest payments for another party’s stream of variable interest cash flows or (ii) each party exchanges variable interest cash flows that are referenced to different indices. Interest rate caps are derivative contracts in which the buyer receives payments at the end of each period in which the interest rate exceeds an agreed upon strike price. We enter into interest rate swaps and caps primarily to reduce significant changes in our income or equity caused by interest rate volatility. Certain of these interest rate agreements may be designated as cash flow hedges.

Other risk management derivatives we currently utilize include “To Be Announced” (TBA) contracts and financial futures contracts such as Eurodollar futures and Treasury futures. TBA contracts are forward commitments to purchase agency mortgage-backed securities to be issued in the future. Financial futures are futures contracts on short-term interest rates. We purchase or sell these hedging instruments to offset — to varying degrees — changes in the value of mortgage products in which we have exposure.

Credit Derivatives

Credit derivatives that we have historically utilized include CDS, which are agreements 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, or our consolidated securitization entities, to synthetically assume the credit risk of a reference security or index of securities. The estimated fair values of these contracts fluctuate for a variety of reasons, such as the likelihood or occurrence of a qualifying credit event (e.g., an interest shortfall, a failure to pay principal, or a distressed rating downgrade), the market perception of default risk and counterparty risk, and supply and demand changes. We do not designate any credit derivatives as cash flow hedges.

See Note 9 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. 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 for GAAP. As the income is subsequently realized in future periods under GAAP, the deferred tax asset is reduced.

Deferred Securities Issuance Costs

Securities issuance costs are expenses associated with the issuance of long-term debt and 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 (an asset) and are amortized as an adjustment to interest expense using the interest method, based upon the actual and estimated repayment schedules of the related debt and ABS issued.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

Other Assets

Other assets include REO, derivative margin receivables, fixed assets, principal receivable and other prepaid expenses. REO property acquired through, or in lieu of, loan foreclosure is initially recorded at fair value, and subsequently reported at the lower of carrying amount or fair value (less estimated cost to sell). Changes in the fair value of an REO property that has a fair value at or below its carrying amount are recorded in our consolidated statements of income as a component of market valuation adjustments, net. Derivative margin receivables reflect cash collateral Redwood has posted with our various hedge counterparties as required to satisfy the minimum margin requirements.

See Note 10 for further discussion on other assets.

Short-Term Debt

Short-term debt includes master repurchase agreements, bank borrowings, and other forms of collateralized borrowings that expire within one year with various commercial banks and investment banks. These facilities may be unsecured or collateralized by cash, loans, or securities. There was no short-term debt outstanding at March 31, 2011. At December 31, 2010, we had short-term debt outstanding of $44 million, which matured in the first quarter of 2011.

Accrued Interest Payable

Accrued interest payable includes 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 entities sponsored by Redwood. Sequoia and Acacia assets are held in the custody of securitization 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.

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 through market valuation adjustments, net.

See Note 11 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. Our long-term debt is unsecured with quarterly interest payments determined based upon a floating rate equal to the three-month London Interbank Offered Rate (LIBOR) plus a margin until it is redeemed in whole or matures at a future date.

See Note 12 for further discussion on long-term debt.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

Equity

Accumulated Other Comprehensive Income

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

Noncontrolling Interest

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

Earnings Per Common Share

Basic earnings per common share (EPS) is computed by dividing net income allocated to common shareholders by the weighted average common shares outstanding. Net income allocated to common shareholders represents net income applicable to common shareholders, less income allocated to participating securities (as described below). Diluted earnings per common share is computed by dividing income allocated to common shareholders by the weighted average common shares outstanding plus amounts representing the dilutive effect of equity awards.

Accounting guidance on EPS defines unvested share-based payment awards containing nonforfeitable rights to dividends as participating securities that are included in computing EPS using the two-class method. The two-class method is an earnings allocation formula under which EPS is calculated for common stock and participating securities according to dividends declared and participating rights in undistributed earnings. Under this method, all earnings (distributed and undistributed) are allocated to participating securities and common shares based on their respective rights to receive dividends.

See Note 14 for further discussion on equity.

Incentive Plans

In May 2010, 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 amendment provided for an increase in the number of shares available for distribution under the plan. 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), performance stock units (PSUs), 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 three- or four-year period. Non-employee directors are also provided annual awards under the Incentive Plan that generally vest immediately.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

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 methods of amortization were determined to not be material to our financial statements.

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 the Company 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. The Company matches some deferrals. Compensation deferred under the EDCP is recorded as an asset on our consolidated balance sheet and subject to the claims of our general creditors. The EDCP allows for the investment of deferrals in either an interest crediting account or DSUs.

401(k) Plan

We offer a tax-qualified 401(k) Plan to all employees for retirement savings. Under this Plan, employees are allowed to defer and invest up to 100% of their cash earnings, subject to the maximum 401(k) contribution amount. We match some employee contributions to encourage participation and to provide a retirement planning benefit to employees. Vesting of the 401(k) Plan matching contributions is based on the employee’s tenure at the Company, and over time, an employee becomes increasingly vested in both prior and new matching contributions.

See Note 15 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.

See Note 17 for further discussion on taxes.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

Recent Accounting Pronouncements

In April 2011, the FASB issued Accounting Standards Update (ASU) 2011-02, A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring, which provides additional guidance to creditors for evaluating troubled debt restructurings. The amendments clarify the guidance in ASC 310-40, Receivables: Troubled Debt Restructurings by Creditors, which requires a creditor to classify a restructuring as a TDR if (1) the restructuring includes a concession by the creditor to the borrower and (2) the borrower is experiencing financial difficulties. The amended guidance requires a creditor to consider all aspects of the restructuring to determine whether it has granted a concession, and includes additional guidance to identify concessions, as well as indicators for determining whether the debtor is facing financial difficulties. The effective date of the amended guidance for public companies is the first interim or annual period beginning on or after June 15, 2011, and it requires companies to retrospectively evaluate all restructurings occurring on or after the beginning of the fiscal year of adoption to determine if the restructuring is a TDR.

In addition, ASU 2011-02 ended the public-entity deferral of TDR disclosures in ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. Public entities must begin providing TDR disclosures in the period they adopt ASU 2011-02. We are still evaluating the impact of ASU 2011-02 on our financial statements, but believe this will result in a larger percentage of our modified loans qualifying as TDRs. The increased disclosures required in ASU 2010-20 will not have an impact on our financial statements.

Note 4. Principles of Consolidation

We apply FASB guidance to determine whether we must consolidate transferred financial assets and VIEs for financial reporting purposes. Specifically, GAAP requires us to consider whether securitizations and other transfers of financial assets should be treated as sales or financings, as well as whether any VIEs (e.g., certain legal entities often used in securitization and other structured finance transactions) should be included in our consolidated financial statements.

The tables below present our analysis of VIEs where we maintain an interest, as distinguished by those we have consolidated for financial reporting purposes and those we have not. The principles of consolidation we apply require us to reassess our requirement to consolidate VIEs each quarter and therefore our determination may change based upon new facts and circumstances pertaining to each VIE. This could result in a material impact to our financial statements during subsequent reporting periods.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 4. Principles of Consolidation  – (continued)

Analysis of Consolidated VIEs

The VIEs we are required to consolidate include certain Sequoia securitization entities, the Acacia entities, and the Fund. The following table presents a summary of the assets and liabilities of these VIEs. Intercompany balances have been eliminated for purposes of this presentation.

Assets and Liabilities of Consolidated VIEs at March 31, 2011

(Dollars in thousands)		Sequoia Entities				Acacia Entities				The Fund				Total
Real estate loans		$	3,740,892			$	19,953			$	—			$	3,760,845
Real estate securities			—				301,119				15,285				316,404
Other investments			—				—				—				—
Other assets			24,077				37,842				4,955				66,874
Total Assets		$	3,764,969			$	358,914			$	20,240			$	4,144,123
Asset-backed securities		$	3,646,342			$	310,952			$	—			$	3,957,294
Other liabilities			3,605				64,477				2,417				70,499
Total Liabilities		$	3,649,947			$	375,429			$	2,417			$	4,027,793
Noncontrolling interest		$	—			$	—			$	7,040			$	7,040
Number of VIEs			38				10				1				49

We consolidate the assets and liabilities of certain Sequoia securitization entities issued prior to 2010, 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, 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. In April 2010 and March 2011, we sponsored residential prime jumbo mortgage securitizations through our Sequoia program of $238 million and $295 million, respectively. We recorded the assets and liabilities of these entities on our consolidated balance sheets, as we did not meet the sale criteria at the time we transferred financial assets to these entities. Additionally, we determined that we are the primary beneficiary of these VIEs as our ongoing loss mitigation and resolution responsibilities provide us with the power to direct the activities that most significantly impact the economic performance of these entities and our significant investment interests provide us with the obligation to absorb losses or the right to receive benefits that are significant.

We consolidate the assets and liabilities of the Acacia securitization entities, as we did not meet the sale criteria at the time we transferred financial assets to these entities and we are the primary beneficiary of these 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.

We consolidate the assets, liabilities, and noncontrolling interests of the Fund, as we determined that we are the primary beneficiary of this VIE. Our ongoing asset management responsibilities provide us with the power to direct the activities that most significantly impact the Fund’s economic performance, and our general and limited partnership interests provide us with the obligation to absorb losses or the right to receive benefits that are significant.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 4. Principles of Consolidation  – (continued)

Analysis of Non-Consolidated VIEs

Third-party VIEs are securitization entities in which we maintain an economic interest but do not sponsor. Our economic interest may include several securities from the same third-party VIE, and in those cases, the analysis is performed in consideration of all of our interests. The following table presents a summary of Redwood’s interest in third-party VIEs at March 31, 2011, grouped by collateral type and ownership interest.

Third-Party VIE Summary

March 31, 2011 (Dollars in Thousands)		Fair Value				Number of VIEs
Real estate securities at Redwood
Residential
Senior		$	622,818				93
Re-REMIC			85,497				7
Subordinate			71,435				185
Commercial			6,362				13
CDO			1,296				9
Total Third-party Real Estate Securities		$	787,408				307

We determined that we are not the primary beneficiary of any third-party residential, commercial, or CDO entities, 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 third-party VIEs — we only account for our specific interests in each.

Our assessments of whether we are required to consolidate a VIE may change in subsequent reporting periods based upon changing facts and circumstances pertaining to each VIE. Any related accounting changes could result in a material impact to our financial statements.

Note 5. Fair Value of Financial Instruments

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. 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, 2011
(Unaudited)

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

The following table presents the carrying values and estimated fair values of assets and liabilities that are required to be recorded or disclosed at fair value at March 31, 2011 and December 31, 2010.

		March 31, 2011								December 31, 2010
(In Thousands)		Carrying Value				Fair Value				Carrying Value				Fair Value
Assets
Real estate loans (held-for-investment)
Unsecuritized loans		$	95,508			$	95,627			$	283,618			$	283,939
Securitized loans			3,740,892				3,394,372				3,542,158				3,114,288
Real estate loans (held-for-sale)			1,845				1,845				1,855				1,855
Commercial real estate loans (fair value)			19,953				19,953				19,850				19,850
Trading securities			321,820				321,820				329,717				329,717
Available-for-sale securities			781,992				781,992				825,119				825,119
Other investments			—				—				—				—
Cash and cash equivalents			220,276				220,276				46,937				46,937
Derivative assets			5,698				5,698				8,051				8,051
Restricted cash			34,983				34,983				24,524				24,524
Accrued interest receivable			13,569				13,569				13,782				13,782
REO (included in other assets)			10,998				10,998				14,481				14,481
Liabilities
Short-term debt			—				—				44,137				44,137
Accrued interest payable			6,611				6,611				5,930				5,930
Derivative liabilities			70,157				70,157				83,115				83,115
ABS issued
ABS issued – Sequoia			3,646,342				3,187,566				3,458,501				2,959,997
ABS issued – Acacia			310,952				310,952				303,077				303,077
Total ABS issued			3,957,294				3,498,518				3,761,578				3,263,074
Long-term debt			139,500				80,910				139,500				75,330

We did not elect the fair value option for any financial instruments that we acquired in the first three months of 2011. We have elected the fair value option for all of the commercial loans, trading securities, and ABS issued at Acacia, as well as certain residential securities and CDOs at Redwood.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

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

Assets and Liabilities Measured at Fair Value on a Recurring Basis at March 31, 2011

March 31, 2011 (In Thousands)		Carrying Value				Fair Value Measurements Using
						Level 1				Level 2				Level 3
Assets
Commercial real estate loans		$	19,953			$	—			$	—			$	19,953
Trading securities			321,820				—				—				321,820
Available-for-sale securities			781,992				—				—				781,992
Derivative assets			5,698				22				5,676				—
Liabilities
Derivative liabilities			70,157				134				70,023				—
ABS issued – Acacia			310,952				—				—				310,952

The following table presents additional information about Level 3 assets and liabilities for the three months ended March 31, 2011.

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

		Assets																Liabilities
(In Thousands)		Commercial Real Estate Loans				Trading Securities				AFS Securities				Derivative Assets				ABS Issued  – Acacia
Beginning balance – December 31, 2010		$	19,850			$	329,717			$	825,119			$	1			$	303,077
Principal paydowns			(116	)			(15,080	)			(31,234	)			—				(19,473	)
Gains in net income, net			219				19,916				9,616				—				24,137
Gains in OCI, net			—				—				9,358				—				—
Acquisitions			—				—				13,223				—				—
Sales			—				(12,841	)			(44,116	)			—				—
Other settlements, net			—				108				26				(1	)			3,211
Ending Balance – March 31, 2011		$	19,953			$	321,820			$	781,992			$	—			$	310,952

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

The following table presents the portion of gains or losses included in our consolidated statements of income that were attributable to Level 3 assets and liabilities recorded at fair value on a recurring basis and still held at March 31, 2011 and 2010. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three months ended March 31, 2011 and 2010 are not included in this presentation.

Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at March 31, 2011 and 2010 Included in Net Income

		Included in Net Income Three Months Ended March 31,
(In Thousands)		2011				2010
Assets
Real estate loans		$	219			$	4,366
Trading securities			10,366				12,281
Available-for-sale securities			(2,622	)			(1,946	)
Derivative assets			—				(20	)
Liabilities
Derivative liabilities			—				186
ABS issued – Acacia			(24,137	)			(5,253	)

The following table presents information on assets and liabilities recorded at fair value on a non-recurring basis at March 31, 2011.

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at March 31, 2011

																		Gain (Loss)
March 31, 2011 (In Thousands)		Carrying Value				Fair Value Measurements Using												Three Months Ended March 31, 2011
					Level 1		Level 2				Level 3
Assets
Real estate loans (held-for-sale)		$	1,845			$	—			$	—			$	1,845			$	3
REO			10,998				—				—				10,998				(918	)

The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of income for the three months ended March 31, 2011 and 2010.

Market Valuation Adjustments, Net

		Three Months Ended March 31,
(In Thousands)		2011				2010
Assets
Real estate loans (fair value)		$	219			$	4,366
Real estate loans (held-for-sale)			3				(120	)
Trading securities			19,916				12,149
REO			(918	)			(74	)
Impairments on AFS securities			(2,622	)			(1,946	)
Liabilities
ABS issued – Acacia			(24,137	)			(5,253	)
Derivative instruments, net			1,799				(20,359	)
Market Valuation Adjustments, Net		$	(5,740	)		$	(11,237	)

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

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.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

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

Note 6. Real Estate Loans

We invest in residential real estate loans that we acquire from third-party originators and commercial loans that we originate or acquire from third-party originators. These loans are financed through the Sequoia and Acacia entities that we sponsor or with equity and long-term debt. We do not service any residential loans. Commercial loans originated by our subsidiary, Redwood Commercial Mortgage Company, in 2010 and 2011 and held-for-investment are currently serviced by us.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 6. Real Estate Loans  – (continued)

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, 2011 and December 31, 2010.

March 31, 2011 (In Thousands)		Redwood				Sequoia				Acacia				Total Loans
Residential real estate loans
Held-for-sale		$	1,845			$	—			$	—			$	1,845
Held-for-investment			53,025				3,740,892				—				3,793,917
Commercial real estate loans
Fair value			—				—				19,953				19,953
Held-for-investment			42,483				—				—				42,483
Total Real Estate Loans		$	97,353			$	3,740,892			$	19,953			$	3,858,198

December 31, 2010 (In Thousands)		Redwood				Sequoia				Acacia				Total Loans
Residential real estate loans
Held-for-sale		$	1,855			$	—			$	—			$	1,855
Held-for-investment			253,081				3,542,159				—				3,795,240
Commercial real estate loans
Fair value			—				—				19,850				19,850
Held-for-investment			30,536				—				—				30,536
Total Real Estate Loans		$	285,472			$	3,542,159			$	19,850			$	3,847,481

Residential Real Estate Loans Held-for-Sale

Residential real estate loans held-for-sale are owned at Redwood and financed with equity and long-term debt. At both March 31, 2011 and December 31, 2010, there were eleven residential loans held-for-sale with $3 million in outstanding principal value and a lower of cost or fair value of $2 million.

Residential Real Estate Loans Held-for-Investment

In March 2011, we sponsored a $295 million residential prime mortgage securitization through our Sequoia program. At March 31, 2011, the loans owned by this Sequoia entity had an outstanding principal value of $291 million. During the three months ended March 31, 2011, we purchased $101 million of prime quality residential loans in conjunction with our Sequoia securitization program.

The following table provides additional information on residential real estate loans held-for-investment at March 31, 2011 and December 31, 2010.

(In Thousands)		March 31, 2011				December 31, 2010
Principal value		$	3,816,321			$	3,815,273
Unamortized premium, net			40,518				42,399
Recorded investment			3,856,839				3,857,672
Allowance for loan losses			(62,922	)			(62,432	)
Carrying Value		$	3,793,917			$	3,795,240

Of the $3.8 billion of principal value and $41 million of unamortized premium on loans held-for-investment at March 31, 2011, $1.6 billion of principal value and $26 million of unamortized premium relates to residential loans acquired prior to July 1, 2004. During the first three months of 2011, 2% of these residential loans prepaid and we amortized 5% of the premium based upon the accounting elections

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 6. Real Estate Loans  – (continued)

we apply. For residential loans acquired after July 1, 2004, the principal value was $2.2 billion and the unamortized premium was $14 million. During the first three months of 2011, 3% of these loans prepaid and we amortized 3% of the premium.

Of the $3.8 billion of principal value and $42 million of unamortized premium on loans held-for-investment at December 31, 2010, $1.7 billion of principal value and $28 million of unamortized premium relates to residential loans acquired prior to July 1, 2004. For residential loans acquired after July 1, 2004, the principal value was $2.1 billion and the unamortized premium was $15 million.

Commercial Real Estate Loans at Fair Value

Commercial real estate loans at fair value are owned at the consolidated Acacia securitization entities. At both March 31, 2011 and December 31, 2010, there were four commercial real estate loans at fair value with an aggregate outstanding principal value of $23 million and an aggregate fair value of $20 million.

Commercial Real Estate Loans Held-for-Investment

During the three months ended March 31, 2011, we originated or acquired two commercial real estate loans with an outstanding principal balance of $12 million. At March 31, 2011, there were six commercial real estate loans held-for-investment (one of which was purchased prior to 2010) with an outstanding principal value of $43 million and a carrying value of $42 million. At December 31, 2010, there were four commercial real estate loans held-for-investment with an outstanding principal value and carrying value of $31 million.

Note 7. Allowance for Loan Losses

We establish an allowance for loan losses on our residential and commercial loans held-for-investment based on our estimate of losses incurred in these portfolios. The allowance includes a component for loans collectively evaluated for impairment that includes pools of residential loans owned at Sequoia securitization entities, and a component for loans individually evaluated for impairment that includes modified residential loans where it has been determined a concession has been granted, and commercial loans.

We collectively evaluate most of our residential loans for impairment based on the characteristics of the loan pools underlying the securitization entities that own the loans. These characteristics, which include loan product types, credit characteristics, and origination years, are what management primarily uses to establish the allowance for loan losses for residential loans. The collective analysis is further divided into two segments. The first segment reflects our estimate of losses on delinquent loans within each loan pool. These loss estimates are determined by applying the loss factors described in Note 3 to the delinquent loans, including our expectations of the timing of defaults and the loss severities we expect once defaults occur. The second segment relates to our estimate of losses incurred on nondelinquent loans within each loan pool. This estimate is based on losses we expect to realize over a 23 month loss confirmation period, which is based on our historical loss experience as well as consideration of the loss factors described in Note 3.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 7. Allowance for Loan Losses  – (continued)

Activity in the Allowance for Losses on Residential Loans

The following table summarizes the activity in the allowance for loan losses for the three months ended March 31, 2011 and 2010.

		Three Months Ended March 31,
(In Thousands)		2011				2010
Balance at beginning of period		$	62,432			$	54,220
Charge-offs, net			(2,317	)			(2,526	)
Provision for loan losses			2,807				9,475
Balance at End of Period		$	62,922			$	61,169

During the three months ended March 31, 2011 and 2010, there were $2 million and $3 million of charge-offs, respectively, in our residential loan portfolio that reduced our allowance for loan losses. These charge-offs arose from $8 million and $9 million of defaulted loan principal, respectively. As of March 31, 2011 and December 31, 2010, we did not record any interest income on individually impaired loans.

Loans Collectively Evaluated for Impairment

The following table summarizes the balances for loans collectively evaluated for impairment at March 31, 2011 and December 31, 2010.

(In Thousands)		March 31, 2011				December 31, 2010
Unpaid principal balance		$	3,803,837			$	3,801,921
Recorded investment			3,844,408				3,844,372
Related allowance			58,538				57,804

Residential Loans Collectively Evaluated for Impairment Past Due

The following table shows the recorded investment in residential loans collectively evaluated for impairment past due at March 31, 2011 and December 31, 2010.

(In Thousands)		30 – 59 Days Past Due				60 – 89 Days Past Due				90+ Days Past Due				Total Past Due				Current Loans				Total Loans
March 31, 2011		$	70,777			$	21,382			$	136,067			$	228,226			$	3,616,182			$	3,844,408
December 31, 2010			65,708				21,674				133,695				221,077				3,623,295				3,844,372

Loans Individually Evaluated for Impairment

The following table summarizes the balances for loans individually evaluated for impairment at March 31, 2011 and December 31, 2010. Individually impaired loans include TDRs where we have determined a concession has been granted.

(In Thousands)		March 31, 2011				December 31, 2010
Unpaid principal balance		$	12,484			$	13,352
Recorded investment			12,431				13,300
Related allowance			4,384				4,628
Average recorded investment for the three months ended			12,634				13,014

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 7. Allowance for Loan Losses  – (continued)

Residential Loans Individually Evaluated for Impairment Past Due

The following table shows the recorded investment in individually impaired loans past due at March 31, 2011 and December 31, 2010.

(In Thousands)		30 – 59 Days Past Due				60 – 89 Days Past Due				90+ Days Past Due				Total Past Due				Current Loans				Total Loans
March 31, 2011		$	2,278			$	—			$	808			$	3,086			$	9,345			$	12,431
December 31, 2010			2,604				—				1,046				3,650				9,650				13,300

Credit Quality of Residential Loans Held-for-Investment

We invest primarily in prime quality residential loans in conjunction with our Sequoia securitization program. As a percent of total recorded investment, 99% of residential loans held-for-investment on our balance sheet at March 31, 2011, were first lien, prime quality loans. The remaining 1% of loans at March 31, 2011 were second lien, prime quality, home equity lines of credit. The weighted average original loan-to-value (LTV) and weighted average original Fair Isaac Corporation (FICO) score for our residential loans held-for-investment outstanding at March 31, 2011, was 66% and 735, respectively. Due to the uniform product and credit characteristics of our residential loans, an indicator of credit performance is loan origination vintage.

The following table displays the recorded investment and year of origination for residential loans recorded on our consolidated balance sheets at March 31, 2011 and December 31, 2010.

(In Thousands)		March 31, 2011				December 31, 2010
2003 & Earlier		$	1,897,768			$	1,939,618
2004			1,100,306				1,116,358
2005			135,928				136,481
2006			190,153				191,945
2007			71,331				75,136
2008			—				—
2009			182,690				189,355
2010			263,178				208,779
2011			15,485				—
Total Principal		$	3,856,839			$	3,857,672

Allowance for Loan Losses on Commercial Loans

For commercial real estate loans classified as held-for-investment, we establish and maintain an allowance for loan losses on an individual basis for those loans we have determined to be impaired as of the reporting date. At March 31, 2011 and December 31, 2010, there were no commercial loans impaired.

Of the $42 million of recorded investment in commercial loans held-for-investment at March 31, 2011, 28% were originated during the first quarter of 2011, 71% were originated in the fourth quarter of 2010, and 1% were originated in 2004. Of the $31 million of recorded investment in commercial loans held-for-investment at December 31, 2010, 99% were originated in the fourth quarter of 2010 and 1% were originated in 2004.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 8. Real Estate Securities

We invest in third-party residential, commercial, and CDO securities. The following table presents the fair values of our real estate securities by collateral type and entity at March 31, 2011 and December 31, 2010.

March 31, 2011 (In Thousands)		Redwood				The Fund				Acacia				Total Securities
Residential		$	779,750			$	14,648			$	240,124			$	1,034,522
Commercial			6,362				—				44,557				50,919
CDO			1,296				637				16,438				18,371
Total Real Estate Securities		$	787,408			$	15,285			$	301,119			$	1,103,812

December 31, 2010 (In Thousands)		Redwood				The Fund				Acacia				Total Securities
Residential		$	814,683			$	19,011			$	248,494			$	1,082,188
Commercial			7,496				—				43,828				51,324
CDO			1,038				4,245				16,041				21,324
Total Real Estate Securities		$	823,217			$	23,256			$	308,363			$	1,154,836

At March 31, 2011, there were $3 million of residential securities that had contractual maturities greater than five years but less than ten years, and the remainder of our real estate securities had contractual maturities greater than ten years.

The following table presents our securities by accounting classification, collateral type, and ownership entity at March 31, 2011 and December 31, 2010.

March 31, 2011 (In Thousands)		Trading												AFS
		Redwood				Acacia				Total				Redwood				The Fund				Total
Senior Securities
Residential prime		$	—			$	4,259			$	4,259			$	306,192			$	—			$	306,192
Residential non-prime			18,868				115,427				134,295				297,758				11,683				309,441
Commercial			—				11,234				11,234				—				—				—
Total Senior Securities			18,868				130,920				149,788				603,950				11,683				615,633
Re-REMIC Securities			—				—				—				85,497				—				85,497
Subordinate Securities
Residential prime			369				47,387				47,756				58,870				—				58,870
Residential non-prime			168				73,051				73,219				12,028				2,965				14,993
Commercial			—				33,323				33,323				6,362				—				6,362
CDO			1,296				16,438				17,734				—				637				637
Total Subordinate Securities			1,833				170,199				172,032				77,260				3,602				80,862
Total Real Estate Securities		$	20,701			$	301,119			$	321,820			$	766,707			$	15,285			$	781,992

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 8. Real Estate Securities  – (continued)

December 31, 2010 (In Thousands)		Trading												AFS
		Redwood				Acacia				Total				Redwood				The Fund				Total
Senior Securities
Residential prime		$	—			$	4,412			$	4,412			$	315,891			$	—			$	315,891
Residential non-prime			19,742				117,623				137,365				326,365				12,915				339,280
Commercial			—				11,000				11,000				—				—				—
Total Senior Securities			19,742				133,035				152,777				642,256				12,915				655,171
Re-REMIC Securities			—				—				—				85,077				—				85,077
Subordinate Securities
Residential prime			386				49,620				50,006				53,846				—				53,846
Residential non-prime			188				76,839				77,027				13,188				6,096				19,284
Commercial			—				32,828				32,828				7,496				—				7,496
CDO			1,038				16,041				17,079				—				4,245				4,245
Total Subordinate Securities			1,612				175,328				176,940				74,530				10,341				84,871
Total Real Estate Securities		$	21,354			$	308,363			$	329,717			$	801,863			$	23,256			$	825,119

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.

For purposes of the table above, the “prime” or “non-prime” designation used to categorize our residential securities is based upon the general credit characteristics of the residential loans underlying each security at the time of origination. For example, prime residential loans are generally characterized by lower LTV ratios, and are made to borrowers with higher FICO scores. Non-prime residential loans are generally characterized by higher LTV ratios and may have been made to borrowers with lower credit scores or impaired credit histories (while exhibiting the ability to repay their loans). Regardless of whether or not the loans backing a mortgage-backed security were designated as prime or non-prime at origination, there is a risk that the borrower may not be able to repay the loan.

We elected the fair value option for certain securities at Redwood and the Acacia entities, now classified as trading securities. The unpaid principal balance of these trading securities was $1.4 billion and $2.1 billion at March 31, 2011 and December 31, 2010, respectively.

AFS Securities

We often purchase AFS securities at a discount to their par principal values. To the extent we purchase an AFS security that has a likelihood of incurring a loss, we generally do not amortize into income the portion of the purchase discount that 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.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 8. Real Estate Securities  – (continued)

The following table presents the components of carrying value (which equals fair value) of AFS securities at March 31, 2011 and December 31, 2010.

March 31, 2011 (In Thousands)		Residential				Commercial				CDO				Total
Current face		$	1,169,378			$	74,782			$	30,587			$	1,274,747
Credit reserve			(280,478	)			(64,717	)			(29,505	)			(374,700	)
Net unamortized discount			(259,469	)			(4,784	)			(520	)			(264,773	)
Amortized cost			629,431				5,281				562				635,274
Gross unrealized gains			152,535				1,765				75				154,375
Gross unrealized losses			(6,973	)			(684	)			—				(7,657	)
Carrying Value		$	774,993			$	6,362			$	637			$	781,992

December 31, 2010 (In Thousands)		Residential				Commercial				CDO				Total
Current face		$	1,257,601			$	89,103			$	89,476			$	1,436,180
Credit reserve			(297,849	)			(76,979	)			(88,394	)			(463,222	)
Net unamortized (discount) premium			(291,093	)			(5,591	)			11,485				(285,199	)
Amortized cost			668,659				6,533				12,567				687,759
Gross unrealized gains			153,125				1,604				—				154,729
Gross unrealized losses			(8,406	)			(641	)			(8,322	)			(17,369	)
Carrying Value		$	813,378			$	7,496			$	4,245			$	825,119

The following table presents the changes for the three months ended March 31, 2011, 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
Three Months Ended March 31, 2011 (In Thousands)		Credit Reserve				Unamortized Discount Net				Credit Reserve				Unamortized Discount Net				Credit Reserve				Unamortized Discount Net
Beginning balance – December 31, 2010		$	297,849			$	291,093			$	76,979			$	5,591			$	88,394			$	(11,485	)
Amortization of net discount			—				(11,967	)			—				(36	)			—				(103	)
Realized credit losses			(22,174	)			—				(9,297	)			—				(3,005	)			—
Acquisitions			1,148				2,489				—				—				—				—
Sales, calls, other			(8,645	)			(11,553	)			(2,653	)			(1,439	)			(55,911	)			11,575
Impairments			1,707				—				356				—				560				—
Transfers to (release of) credit reserves			10,593				(10,593	)			(668	)			668				(533	)			533
Ending Balance – March 31, 2011		$	280,478			$	259,469			$	64,717			$	4,784			$	29,505			$	520

The loans underlying our residential subordinate securities totaled $36 billion at March 31, 2011. These loans are located nationwide with a large concentration in California (44%). Serious delinquencies (90+ days, in foreclosure or REO) at March 31, 2011 were 7.12% of current principal balances. The loans underlying our commercial subordinate securities totaled $20 billion at March 31, 2011, and consist primarily of office (31%),

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 8. Real Estate Securities  – (continued)

retail (35%), and multifamily (12%) loans. These loans are located nationwide with the highest concentration in California (15%). Serious delinquencies (60+ days, in foreclosure or REO) at March 31, 2011 were 5.9% 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 at March 31, 2011 and December, 31 2010.

		Less Than 12 Consecutive Months												12 Consecutive Months or Longer
March 31, 2011 (In Thousands)		Total Amortized Cost				Gross Unrealized Losses				Total Fair Value				Total Amortized Cost				Gross Unrealized Losses				Total Fair Value
Residential		$	29,454			$	(197	)		$	29,257			$	64,760			$	(6,776	)		$	57,984
Commercial			953				(165	)			788				1,751				(519	)			1,232
CDO			—				—				—				—				—				—
Total Securities		$	30,407			$	(362	)		$	30,045			$	66,511			$	(7,295	)		$	59,216

		Less Than 12 Consecutive Months												12 Consecutive Months or Longer
December 31, 2010 (In Thousands)		Total Amortized Cost				Gross Unrealized Losses				Total Fair Value				Total Amortized Cost				Gross Unrealized Losses				Total Fair Value
Residential		$	104,154			$	(1,628	)		$	102,526			$	26,374			$	(6,778	)		$	19,596
Commercial			2,134				(257	)			1,877				1,728				(384	)			1,344
CDO			—				—				—				12,567				(8,322	)			4,245
Total Securities		$	106,288			$	(1,885	)		$	104,403			$	40,669			$	(15,484	)		$	25,185

At March 31, 2011, after giving effect to purchases, sales, and extinguishments due to credit losses, our consolidated balance sheet included 482 AFS securities, of which 48 were in an unrealized loss position and 29 were in a continuous unrealized loss position for twelve consecutive months or longer. At December 31, 2010, our consolidated balance sheet included 509 AFS securities, of which 80 were in a continuous unrealized loss position, of which 46 were in a continuous unrealized loss position for twelve consecutive months or longer.

Of the total unrealized losses at March 31, 2011, none related to securities owned at the Fund. At December 31, 2010, $10 million of unrealized losses related to securities owned at the Fund and the remaining unrealized losses related to securities owned at Redwood.

Evaluating AFS Securities for Other-than-Temporary Impairments

When the fair value of an AFS security is below its cost basis, we evaluate the security for OTTI. Part of this evaluation is based upon adverse changes in the assumptions used to value the security. The table below summarizes the significant valuation assumptions we used for our AFS securities at March 31, 2011.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
March 31, 2011
(Unaudited)

Note 8. Real Estate Securities  – (continued)

Significant Valuation Assumptions

Range for Securities

March 31, 2011

Prime

Non-prime

Commercial

Prepayment rates

4 – 15

%

1 – 15

%

N/A

Loss severity(1)

12&nbs