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

 

FORM 10-Q

 

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

For the Quarterly Period Ended: September 30, 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		78,686,426 shares outstanding as of November 2, 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 September 30, 2011 (Unaudited) and December 31, 2010			1
Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2011 and 2010 (Unaudited)			2
Consolidated Statements of Equity and Comprehensive Income for the Nine Months Ended September 30, 2011 and 2010 (Unaudited)			3
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 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			48
Item 3. Quantitative and Qualitative Disclosures About Market Risk			98
Item 4. Controls and Procedures			98
PART II
Item 1. Legal Proceedings			99
Item 1A. Risk Factors			101
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			101
Item 3. Defaults Upon Senior Securities			102
Item 4. (Removed and Reserved)			102
Item 5. Other Information			102
Item 6. Exhibits			103
Signatures			104

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
CONSOLIDATED BALANCE SHEETS

(In Thousands, Except Share Data) (Unaudited)		September 30, 2011				December 31, 2010
ASSETS
Residential real estate loans		$	4,157,583			$	3,797,095
Commercial real estate loans (includes $12,563 and $19,850 at fair value)			110,624				50,386
Real estate securities, at fair value:
Trading securities			278,391				329,717
Available-for-sale securities			754,862				825,119
Total real estate securities			1,033,253				1,154,836
Other investments			—				—
Cash and cash equivalents			133,446				46,937
Total earning assets			5,434,906				5,049,254
Restricted cash			17,011				24,524
Accrued interest receivable			14,699				13,782
Derivative assets			2,718				8,051
Deferred tax asset			—				3,487
Deferred securities issuance costs			8,819				5,928
Other assets			76,180				38,662
Total Assets(1)		$	5,554,333			$	5,143,688
LIABILITIES AND EQUITY
Liabilities
Short-term debt		$	—			$	44,137
Accrued interest payable			7,607				5,930
Derivative liabilities			127,220				83,115
Accrued expenses and other liabilities			8,413				14,305
Dividends payable			19,624				19,531
Asset-backed securities issued (includes $234,235 and $303,077 at fair value)			4,293,024				3,761,578
Long-term debt			139,500				139,500
Total liabilities(2)			4,595,388				4,068,096
Equity
Common stock, par value $0.01 per share, 125,000,000 shares authorized; 78,494,886 and 78,124,668 issued and outstanding			785				781
Additional paid-in capital			1,695,642				1,689,851
Accumulated other comprehensive income			32,309				112,339
Cumulative earnings			503,841				474,940
Cumulative distributions to stockholders			(1,273,632	)			(1,213,158	)
Total stockholders’ equity			958,945				1,064,753
Noncontrolling interest			—				10,839
Total equity			958,945				1,075,592
Total Liabilities and Equity		$	5,554,333			$	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 September 30,								Nine Months Ended September 30,
		2011				2010				2011				2010
Interest Income
Residential real estate loans		$	20,192			$	17,514			$	57,564			$	47,749
Commercial real estate loans			2,353				323				5,379				895
Real estate securities			30,845				41,083				97,703				125,439
Other investments			—				2				—				14
Cash and cash equivalents			6				93				38				204
Total interest income			53,396				59,015				160,684				174,301
Interest Expense
Short-term debt			(78	)			(2	)			(267	)			(38	)
Asset-backed securities issued			(21,855	)			(21,074	)			(62,526	)			(57,127	)
Long-term debt			(2,384	)			(2,619	)			(7,130	)			(5,875	)
Total interest expense			(24,317	)			(23,695	)			(69,923	)			(63,040	)
Net Interest Income			29,079				35,320				90,761				111,261
Provision for loan losses			(3,978	)			(2,436	)			(8,367	)			(16,233	)
Market valuation adjustments			(12,365	)			1,007				(25,164	)			(11,193	)
Other-than-temporary impairments(1)			(1,083	)			(2,580	)			(5,171	)			(8,742	)
Market valuation adjustments, net			(13,448	)			(1,573	)			(30,335	)			(19,935	)
Net Interest Income After Provision and Market Valuation Adjustments			11,653				31,311				52,059				75,093
Operating expenses			(11,507	)			(12,245	)			(35,107	)			(40,778	)
Realized gains on sales and calls, net			1,145				1,566				10,844				61,985
Net income before provision for income taxes			1,291				20,632				27,796				96,300
Provision for income taxes			(14	)			(202	)			(42	)			(254	)
Net income			1,277				20,430				27,754				96,046
Less: Net (loss) income attributable to noncontrolling interest			(20	)			532				(1,147	)			703
Net Income Attributable to Redwood Trust, Inc.		$	1,297			$	19,898			$	28,901			$	95,343
Basic earnings per common share		$	0.01			$	0.25			$	0.35			$	1.19
Diluted earnings per common share		$	0.01			$	0.25			$	0.35			$	1.18
Regular dividends declared per common share		$	0.25			$	0.25			$	0.75			$	0.75
Basic weighted average shares outstanding			78,470,625				77,901,970				78,275,796				77,794,106
Diluted weighted average shares outstanding			78,470,625				78,961,205				78,275,796				78,763,689

For the nine months ended September 30, 2011, other-than-temporary impairments were $7,339, of which $2,168 were recognized in Accumulated Other Comprehensive Income. For the nine months ended September 30, 2010, other-than-temporary impairments were $16,988, of which $8,246 were recognized in Accumulated Other Comprehensive Income.

 
 
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 Nine Months Ended September 30, 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)			—				—				—				—				28,901				—				(1,147	)			27,754
Net unrealized (loss) gain on available-for-sale securities			—				—				—				(47,049	)			—				—				4,164				(42,885	)
Reclassification of other-than-temporary impairments to net income			—				—				—				3,306				—				—				—				3,306
Net unrealized loss on interest rate agreements			—				—				—				(39,498	)			—				—				—				(39,498	)
Reclassification of unrealized loss on interest rate agreements to net income			—				—				—				3,211				—				—				—				3,211
Total other comprehensive loss															(80,030	)
Total comprehensive loss																															(48,112	)
Issuance of common stock:
Dividend reinvestment & stock purchase plans			310,146				3				4,580				—				—				—				—				4,583
Employee stock purchase and incentive plans			282,458				3				(2,857	)			—				—				—				—				(2,854	)
Non-cash equity award compensation			—				—				6,764				—				—				—				—				6,764
Share repurchases			(222,386	)			(2	)			(2,696	)			—				—				—				—				(2,698	)
Distributions to noncontrolling interest, net			—				—				—				—				—				—				(14,112	)			(14,112	)
Common dividends declared			—				—				—				—				—				(60,474	)			—				(60,474	)
Deconsolidation elimination			—				—				—				—				—				—				256				256
September 30, 2011			78,494,886			$	785			$	1,695,642			$	32,309			$	503,841			$	(1,273,632	)		$	—			$	958,945

For the Nine Months Ended September 30, 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			—				—				—				—				95,343				—				703				96,046
Net unrealized gain on available-for-sale securities			—				—				—				15,090				—				—				2,044				17,134
Reclassification of other-than-temporary impairments to net income			—				—				—				9,695				—				—				—				9,695
Net unrealized loss on interest rate agreements			—				—				—				(31,451	)			—				—				—				(31,451	)
Reclassification of unrealized loss on interest rate agreements to net income			—				—				—				2,604				—				—				—				2,604
Total other comprehensive loss															(4,062	)
Total comprehensive gain																															94,028
Issuance of common stock:
Dividend reinvestment & stock purchase plans			194,017				3				2,995				—				—				—				—				2,998
Employee stock purchase and incentive plans			53,075				—				(156	)			—				—				—				—				(156	)
Non-cash equity award compensation			—				—				9,757				—				—				—				—				9,757
Distributions to noncontrolling interest, net			—				—				—				—				—				—				(8,998	)			(8,998	)
Common dividends declared			—				—				—				—				—				(59,929	)			—				(59,929	)
September 30, 2010			77,984,222			$	780			$	1,686,963			$	60,798			$	460,231			$	(1,193,100	)		$	11,119			$	1,026,791

 
 
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)		Nine Months Ended September 30,
		2011				2010
Cash Flows From Operating Activities:
Net income attributable to Redwood Trust, Inc.		$	28,901			$	95,343
Adjustments to reconcile net income to net cash provided by operating activities:
Amortization of premiums, discounts, and debt issuance costs, net			(24,618	)			(25,508	)
Depreciation and amortization of non-financial assets			768				624
Provision for loan losses			8,367				16,233
Non-cash equity award compensation			6,764				9,757
Market valuation adjustments, net			30,335				19,935
Realized gains on sales and calls, net			(10,844	)			(61,985	)
Net change in:
Accrued interest receivable			(1,405	)			3,967
Deferred tax asset			3,487				1,885
Other assets			(31,672	)			(25,900	)
Accrued interest payable			11,301				9,095
Accrued expenses and other liabilities			(5,892	)			(56,398	)
Net cash provided by (used in) operating activities			15,492				(12,952	)
Cash Flows From Investing Activities:
Purchases of loans held-for-investment			(724,950	)			(300,211	)
Principal payments on loans held-for-investment			282,126				260,493
Proceeds from sales of loans held-for-sale			1,857				—
Purchases of available-for-sale securities			(90,512	)			(235,876	)
Proceeds from sales of available-for-sale securities			72,666				248,491
Principal payments on available-for-sale securities			86,734				104,987
Purchases of trading securities			—				(17,137	)
Proceeds from sales of trading securities			13,588				6,119
Principal payments on trading securities			43,104				45,067
Principal payments on other investments			—				12,513
Net decrease in restricted cash			7,513				70,178
Net cash (used in) provided by investing activities			(307,874	)			194,624
Cash Flows From Financing Activities:
Net repayments on short-term debt			(44,137	)			—
Proceeds from issuance of asset-backed securities			884,771				211,178
Repurchase of asset-backed securities issued			—				(8,639	)
Repayments on asset-backed securities issued			(350,246	)			(330,864	)
Deferred securities issuance costs			(4,598	)			(1,667	)
Net settlements of derivatives			(30,291	)			(39,916	)
Net proceeds from issuance of common stock			1,729				2,842
Net payments on repurchase of common stock			(2,696	)			—
Dividends paid			(60,382	)			(59,865	)
Change in noncontrolling interests			(15,259	)			(8,296	)
Net cash provided by (used in) financing activities			378,891				(235,227	)
Net increase (decrease) in cash and cash equivalents			86,509				(53,555	)
Cash and cash equivalents at beginning of period			46,937				242,818
Cash and cash equivalents at end of period		$	133,446			$	189,263
Supplemental Disclosures:
Cash paid for interest		$	55,809			$	51,807
Cash paid for taxes		$	48			$	186
Dividends declared but not paid at end of period		$	19,624			$	19,496
Transfers from real estate loans to real estate owned		$	8,418			$	13,658

 
 
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
September 30, 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 September 30, 2011 and December 31, 2010, and for the three and nine months ended September 30, 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 also consolidate the assets and liabilities of the resecuritization we engaged in during the third quarter of 2011.

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 and liabilities of the Sequoia and the Acacia securitization entities where we maintain a continuing involvement, as well as the resecuritization entity we engaged in during the third quarter of 2011. Each securitization entity is independent of Redwood and of each other and the assets and liabilities are not owned by and are not legal obligations of Redwood, although we are exposed to certain financial risks associated with our role as the sponsor or manager of these entities. Prior to the third quarter of 2011, we also consolidated the assets, liabilities, and noncontrolling interests of the Opportunity Fund (Fund).

For financial reporting purposes, the underlying loans and securities owned at the Sequoia, Acacia, and resecuritization 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, Acacia, and resecuritization entities and interest expense on the ABS issued by these entities. Prior to the third quarter of 2011, the real estate securities owned at the Fund were shown on our consolidated balance sheets under real estate securities and the portion of the Fund owned by third-parties was shown under noncontrolling interest. In our consolidated statements of income, we recorded interest income on the securities owned at the Fund.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

Note 2. Basis of Presentation  – (continued)

See Note 4 for further discussion on principles of consolidation.

Note 3. Summary of Significant Accounting Policies

Use of Estimates

The preparation of financial statements requires us to make a number of significant estimates. These include estimates of fair value of certain assets and liabilities, amount and timing of credit losses, prepayment rates, and other estimates that affect the reported amounts of certain assets and liabilities as of the date of the consolidated financial statements and the reported amounts of certain revenues and expenses during the reported period. It is likely that changes in these estimates (e.g., valuation changes due to supply and demand, credit performance, prepayments, interest rates, or other reasons) will occur in the near term. Our estimates are inherently subjective in nature and actual results could differ from our estimates and the differences could be material.

Fair Value 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.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

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

See Note 5 for further discussion on fair value measurements.

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 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.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 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 as 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 residential real estate loans. See Note 7 for further discussion on commercial 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 evaluating 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

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

interest rate of a mortgage loan; (iii) forgiveness of a portion of the contractual interest and/or principal amounts owed on a mortgage loan; and, (iv) extension of the contractual maturity of a mortgage loan. We evaluate all loan modifications performed by servicers to determine if they constitute troubled debt restructurings according to GAAP. If a loan is determined to be a troubled debt restructuring (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.

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.

See Note 6 for further discussion on the allowance for loan losses for residential real estate loans.

Commercial Real Estate Loans — Allowance for Loan Losses

For commercial real estate loans classified as held-for-investment, we evaluate the need for an allowance for loan losses on a quarterly basis. We will establish and maintain an allowance for loan losses for any loans we have determined to be impaired as of the reporting date.

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

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

Based on the above review, a loan is impaired when it is deemed probable that we will not be able to collect all amounts due according to the contractual terms of the loan. We record an allowance to reduce the carrying value of any impaired loan to the present value of expected future cash flows discounted at the loan’s effective rate.

Such impairment analyses are completed and reviewed by asset management and finance personnel and reviewed and approved by senior management. Significant judgment is required when evaluating loans for impairment.

See Note 7 for further discussion on the allowance for loan losses for commercial real estate loans.

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.

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 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

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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 reporting 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 at its estimated fair value. 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 served as collateral to cover realized losses on credit default swaps (CDS) entered into by this same Acacia entity.

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 September 30, 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 the Acacia or Sequoia securitization entities or in the resecuritization entity prior to the payments on or redemptions of outstanding ABS issued. At September 30, 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

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

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.

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. (Eurodollar futures contracts, unlike our other derivatives, have maturities of only three months. Therefore, in order to achieve the desired interest rate offset necessary to manage our risk, consecutively maturing contracts are required resulting in a stated notional amount higher than would be needed with our other derivatives.) TBA contracts are forward commitments to purchase U.S. government agency mortgage-backed securities to be issued in the future. Financial futures are futures contracts on short-term benchmark interest rates. We purchase or sell these hedging instruments to offset — to varying degrees — changes in the values of mortgage products for which we have exposure. We account for our risk management derivatives as trading instruments, and record any changes in value (including any associated interest income or expense) in our consolidated statements of income through market valuation adjustments, net.

Credit Derivatives

Credit derivatives that we have historically utilized include CDS, which are agreements to pay (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

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

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 temporary 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, the resecuritization we engaged in during the third quarter of 2011, and the 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.

Other Assets

Other assets include REO, margin receivable, 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. Margin receivable reflects cash collateral Redwood has posted with our various derivative and lending 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 borrowings under master repurchase agreements, bank borrowings, and other forms of borrowings that expire within one year with various counterparties. These facilities may be unsecured or collateralized by cash, loans, or securities.

See Note 11 for further discussion on short-term debt.

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.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
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Note 3. Summary of Significant Accounting Policies  – (continued)

Asset-Backed Securities Issued

The majority of the liabilities reported on our consolidated balance sheets represent ABS issued by bankruptcy-remote entities sponsored by Redwood. Sequoia, Acacia, and the resecuritization assets are held in the custody of securitization trustees and are not owned by Redwood. 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.

Resecuritization ABS Issued

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

See Note 12 for further discussion on ABS issued.

Long-Term Debt

Long-term debt includes trust preferred securities and subordinated notes at Redwood and is carried at its unpaid principal balance. 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 13 for further discussion on long-term debt.

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. As we deconsolidated the Fund in the third quarter of 2011, there is no longer noncontrolling interest.

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

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 15 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.

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.

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

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 limit set forth by the Internal Revenue Service. 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 16 for further discussion on equity compensation plans.

Taxes

We have elected to be taxed as a REIT under the Internal Revenue Code and the corresponding provisions of state law. To qualify as a REIT we must distribute at least 90% of our annual REIT taxable income to shareholders (not including taxable income retained in our taxable subsidiaries) within the time frame set forth in the tax code and also meet certain other requirements 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 18 for further discussion on taxes.

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. 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.

We adopted ASU 2011-02 in the second quarter of 2011. At September 30, 2011, the recorded investment in receivables for which the allowance for loan losses was previously measured under a general allowance for loan losses and are now impaired under ASC 310-10-35 was $5 million, and the allowance for loan losses associated with those receivables, on a basis of current evaluation of loss, was $1 million at September 30, 2011. For additional disclosures related to TDRs, see Note 6.

In May 2011, the FASB issued ASU 2011-04, Fair Value Measurement: Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs. This ASU converges fair value measurement and disclosure guidance in U.S. GAAP with the guidance concurrently issued by the International Accounting Standards Board. While the amendments in ASU 2011-04 do not modify the requirements for when fair value measurements apply, they do generally represent clarifications on how to measure and disclose fair value under ASC 820, Fair Value Measurement. This ASU is effective for interim and annual periods beginning after December 15, 2011 and should be applied prospectively. Early adoption is not permitted. ASU 2011-04 may increase our disclosures related to fair value measurements, but will not have an effect on our consolidated financial statements.

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

In June 2011, the FASB issued ASU 2011-05, Comprehensive Income: Presentation of Comprehensive Income. This ASU eliminates the option to present components of other comprehensive income in the statement of stockholders’ equity and requires entities to present all non-owner changes in stockholders’ equity either as a single continuous statement of comprehensive income or as two separate but consecutive statements. This ASU is effective for fiscal years and interim periods within those fiscal years beginning after December 15, 2011. The amendments should be applied retrospectively and early adoption is permitted. Upon adoption of this ASU, our financial statement presentation will change.

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.

Analysis of Consolidated VIEs

The VIEs we are required to consolidate include certain Sequoia securitization entities, the Acacia entities, and the resecuritization entity. Each of these entities is independent of Redwood and of each other and the assets and liabilities are not owned by and are not legal obligations of ours, although we are exposed to certain financial risks associated with our role as the sponsor or manager of these entities. 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 September 30, 2011

(Dollars in thousands)		Sequoia Entities				Acacia Entities				Resecuritization				Total
Real estate loans		$	3,928,677			$	12,563			$	—			$	3,941,240
Real estate securities			—				256,192				349,764				605,956
Other investments			—				—				—				—
Other assets			21,120				21,734				2,262				45,116
Total Assets		$	3,949,797			$	290,489			$	352,026			$	4,592,312
Asset-backed securities		$	3,826,783			$	234,235			$	232,006			$	4,293,024
Other liabilities			6,387				71,007				72				77,466
Total Liabilities		$	3,833,170			$	305,242			$	232,078			$	4,370,490
Noncontrolling interest		$	—			$	—			$	—			$	—
Number of VIEs			39				10				1				50

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. Since 2010, we have sponsored three residential jumbo mortgage securitizations through our Sequoia program

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Note 4. Principles of Consolidation  – (continued)

totaling $908 million. 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 and liabilities of the entity formed in connection with the resecuritization transaction we engaged in during the third quarter of 2011, as we did not meet the sale criteria at the time the financial assets were transferred to this entity and we are the primary beneficiary. We transferred an aggregate of $365 million ($437 million principal value) of residential senior securities to Credit Suisse First Boston Mortgage Securities Corp., which subsequently sold them to CSMC 2011-9R, a resecuritization entity. In connection with this transaction, senior securities of $245 million were issued by CSMC 2011-9R and sold to third-party investors and we acquired $192 million of subordinate securities issued by CSMC 2011-9R. We also received $243 million in cash and acquired $245 million notional amount of variable rate, interest-only senior certificates.

We engaged in the resecuritization primarily for the purpose of obtaining permanent non-recourse financing on a portion of our residential securities portfolio. Our credit risk exposure is largely unchanged as a result of engaging in the transaction, as we remain economically exposed to the financed securities through the first loss position in the structure.

Prior to the third quarter of 2011, we consolidated the assets, liabilities, and noncontrolling interests of the Fund, as we determined that we were the primary beneficiary of this VIE. Our ongoing asset management responsibilities provided us with the power to direct the activities that most significantly impacted the Fund’s economic performance, and our general and limited partnership interests provided us with the obligation to absorb losses or the right to receive benefits that were significant. In the second quarter of 2011, the Fund sold all of its remaining investments. As all partners received final cash asset distributions in the third quarter of 2011 and there are no remaining assets or liabilities in the Fund, we deconsolidated the Fund and recognized a loss on deconsolidation of less than $1 million in our consolidated statements of income through realized gains on sales and calls, net.

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

Note 4. Principles of Consolidation  – (continued)

Analysis of Third-party 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 our interest in third-party VIEs at September 30, 2011, grouped by collateral type and ownership interest.

Third-Party VIE Summary

September 30, 2011 (Dollars in Thousands)		Fair Value				Number of VIEs
Real estate securities at Redwood
Residential
Senior		$	226,078				62
Re-REMIC			113,100				13
Subordinate			81,222				173
Commercial			5,887				9
CDO			1,010				8
Total Third-party Real Estate Securities		$	427,297				265

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
September 30, 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 September 30, 2011 and December 31, 2010.

		September 30, 2011								December 31, 2010
(In Thousands)		Carrying Value				Fair Value				Carrying Value				Fair Value
Assets
Residential real estate loans (held-for-sale)		$	2,178			$	2,178			$	1,855			$	1,855
Residential real estate loans (held-for-investment)			4,155,405				3,693,867				3,795,240				3,367,340
Commercial real estate loans (fair value)			12,563				12,563				19,850				19,850
Commercial real estate loans (held-for-investment)			98,061				98,533				30,536				30,887
Trading securities			278,391				278,391				329,717				329,717
Available-for-sale securities			754,862				754,862				825,119				825,119
Cash and cash equivalents			133,446				133,446				46,937				46,937
Derivative assets			2,718				2,718				8,051				8,051
Restricted cash			17,011				17,011				24,524				24,524
Accrued interest receivable			14,699				14,699				13,782				13,782
REO (included in other assets)			6,554				6,554				14,481				14,481
Liabilities
Short-term debt			—				—				44,137				44,137
Accrued interest payable			7,607				7,607				5,930				5,930
Derivative liabilities			127,220				127,220				83,115				83,115
ABS issued			4,293,024				3,711,728				3,761,578				3,263,074
Long-term debt			139,500				57,195				139,500				75,330

We did not elect the fair value option for any financial instruments that we acquired in the first nine 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.

The following table presents assets and liabilities recorded at fair value on our consolidated balance sheets 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 September 30, 2011

September 30, 2011 (In Thousands)		Carrying Value				Fair Value Measurements Using
						Level 1				Level 2				Level 3
Assets
Commercial real estate loans		$	12,563			$	—			$	—			$	12,563
Trading securities			278,391				—				—				278,391
Available-for-sale securities			754,862				—				—				754,862
Derivative assets			2,718				302				2,416				—
Liabilities
Derivative liabilities			127,220				2,465				104,755				20,000
ABS issued – Acacia			234,235				—				—				234,235

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

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

The following table presents additional information about Level 3 assets and liabilities for the nine months ended September 30, 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				Derivative Liabilities				ABS Issued – Acacia
Beginning balance – December 31, 2010		$	19,850			$	329,717			$	825,119			$	1			$	—			$	303,077
Transfer to Level 3			—				—				—				—				20,052				—
Principal paydowns			(8,730	)			(43,104	)			(86,735	)			—				—				(68,698	)
Gains (losses) in net income, net			1,443				4,962				28,991				—				1,651				(9,773	)
Losses in OCI, net			—				—				(39,581	)			—				—				—
Acquisitions			—				—				90,512				—				—				—
Sales			—				(13,588	)			(63,525	)			—				—				—
Other settlements, net			—				404				81				(1	)			(1,703	)			9,629
Ending Balance – September 30, 2011		$	12,563			$	278,391			$	754,862			$	—			$	20,000			$	234,235

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 September 30, 2011 and 2010. Gains or losses incurred on assets or liabilities sold, matured, called, or fully written down during the three and nine months ended September 30, 2011 and 2010 are not included in this presentation.

Portion of Net Gains (Losses) Attributable to Level 3 Assets and Liabilities Still Held at September 30, 2011 and 2010 Included in Net Income

		Included in Net Income
		Three Months Ended September 30,								Nine Months Ended September 30,
(In Thousands)		2011				2010				2011				2010
Assets
Real estate loans		$	(184	)		$	3			$	1,358			$	7,347
Trading securities			(5,207	)			46,819				(3,938	)			64,531
Available-for-sale securities			(1,083	)			(2,580	)			(3,551	)			(8,361	)
Derivative assets			—				16				—				16
Liabilities
Derivative liabilities			1,651				19				1,651				129
ABS issued – Acacia			16,530				(25,703	)			9,773				(19,699	)

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

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

The following table presents information on assets and liabilities recorded at fair value on a non-recurring basis at September 30, 2011.

Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis at September 30, 2011

		Carrying Value				Fair Value Measurements Using												Gain (Loss)
																		Three Months Ended September 30, 2011				Nine Months Ended September 30, 2011
(In Thousands)						Level 1				Level 2				Level 3
Assets
Real estate loans (held-for-sale)		$	2,178			$	—			$	—			$	2,178			$	363			$	374
REO			6,554				—				—				6,554				(255	)			(1,416	)

The following table presents the components of market valuation adjustments, net, recorded in our consolidated statements of income for the three and nine months ended September 30, 2011 and 2010.

Market Valuation Adjustments, Net

		Three Months Ended September 30,								Nine Months Ended September 30,
(In Thousands)		2011				2010				2011				2010
Assets
Real estate loans (fair value)		$	(184	)		$	3			$	1,358			$	7,347
Real estate loans (held-for-sale)			363				159				374				335
Trading securities			(5,359	)			47,375				4,963				65,854
REO			(255	)			(620	)			(1,416	)			(1,979	)
Impairments on AFS securities			(1,083	)			(2,580	)			(5,171	)			(8,742	)
Liabilities
Derivative instruments, net			(23,460	)			(20,207	)			(40,216	)			(63,051	)
ABS issued – Acacia			16,530				(25,703	)			9,773				(19,699	)
Market Valuation Adjustments, Net		$	(13,448	)		$	(1,573	)		$	(30,335	)		$	(19,935	)

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
September 30, 2011
(Unaudited)

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

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

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

Note 6. Residential Real Estate Loans

We invest in residential real estate loans that we acquire from third-party originators. These loans are financed through the Sequoia entities that we sponsor or with equity and long-term debt. We do not currently service any residential loans, although we may from time to time acquire the rights to service loans purchased from third-party originators. The following table summarizes the classifications and carrying value of the residential real estate loans at September 30, 2011 and December 31, 2010.

September 30, 2011 (In Thousands)		Redwood				Sequoia				Total
Held-for-sale		$	2,178			$	—			$	2,178
Held-for-investment			226,728				3,928,677				4,155,405
Total Residential Real Estate Loans		$	228,906			$	3,928,677			$	4,157,583

December 31, 2010 (In Thousands)		Redwood				Sequoia				Total
Held-for-sale		$	1,855			$	—			$	1,855
Held-for-investment			253,081				3,542,159				3,795,240
Total Residential Real Estate Loans		$	254,936			$	3,542,159			$	3,797,095

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 September 30, 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.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

Note 6. Residential Real Estate Loans  – (continued)

Residential Real Estate Loans Held-for-Investment

During the three and nine months ended September 30, 2011, we purchased $402 million and $656 million, respectively, of residential loans in connection with our Sequoia securitization program. The following table provides additional information for total residential real estate loans held-for-investment at September 30, 2011 and December 31, 2010.

(In Thousands)		September 30, 2011				December 31, 2010
Principal balance		$	4,181,061			$	3,815,273
Unamortized premium, net			38,341				42,399
Recorded investment			4,219,402				3,857,672
Allowance for loan losses			(63,997	)			(62,432	)
Carrying Value		$	4,155,405			$	3,795,240

Of the $4.2 billion of principal value and $38 million of unamortized premium on loans held-for-investment at September 30, 2011, $1.6 billion of principal value and $24 million of unamortized premium relate to residential loans acquired prior to July 1, 2004. During the first nine months of 2011, 6% of these residential loans prepaid and we amortized 14% of the premium based upon the accounting elections we apply. For residential loans acquired after July 1, 2004, the principal value was $2.6 billion and the unamortized premium was $14 million. During the first nine months of 2011, 7% of these loans prepaid and we amortized 9% 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 $27 million of unamortized premium relate 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.

Allowance for Loan Losses on Residential Loans

For residential real estate loans held-for-investment, we establish and maintain an allowance for loan losses. 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 from Sequoia entities that have been determined to be troubled debt restructurings.

Activity in the Allowance for Loan Losses on Residential Loans

The following table summarizes the activity in the allowance for loan losses for the three and nine months ended September 30, 2011 and 2010.

		Three Months Ended September 30,								Nine Months Ended September 30,
(In Thousands)		2011				2010				2011				2010
Balance at beginning of period		$	62,306			$	61,478			$	62,432			$	54,220
Charge-offs, net			(2,287	)			(4,822	)			(6,802	)			(11,361	)
Provision for loan losses			3,978				2,436				8,367				16,233
Balance at End of Period		$	63,997			$	59,092			$	63,997			$	59,092

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

Note 6. Residential Real Estate Loans  – (continued)

During the three months ended September 30, 2011 and 2010, there were $2 million and $5 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 $15 million of defaulted loan principal, respectively. During the nine months ended September 30, 2011 and 2010, there were $7 million and $11 million of charge-offs, respectively, in our residential loan portfolio that reduced our allowance for loan losses. These charge-offs arose from $23 million and $36 million of defaulted loan principal, respectively. For the three and nine months ended, September 30, 2011, we did not record any interest income on individually impaired loans.

Residential Loans Collectively Evaluated for Impairment

We collectively evaluate most of our residential loans for impairment. The following table summarizes the balances for loans collectively evaluated for impairment at September 30, 2011 and December 31, 2010.

(In Thousands)		September 30, 2011				December 31, 2010
Principal balance		$	4,169,133			$	3,801,921
Recorded investment			4,208,153				3,844,372
Related allowance			60,795				57,804

The following table summarizes the recorded investment and past due status of residential loans collectively evaluated for impairment at September 30, 2011 and December 31, 2010.

(In Thousands)		30 – 59 Days Past Due				60 – 89 Days Past Due				90+ Days Past Due				Current				Total Loans
September 30, 2011		$	61,166			$	14,946			$	133,450			$	3,998,591			$	4,208,153
December 31, 2010			65,708				21,674				133,695				3,623,295				3,844,372

We establish the allowance for residential loan losses based primarily on the characteristics of the loan pools underlying the securitization entities that own the loans, including loan product types, credit characteristics, and origination years. 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.

Residential Loans Individually Evaluated for Impairment

If a loan is determined to be a TDR, it is removed from the general loan pools used for calculating the allowance for residential loan losses and assessed for impairment on an individual basis primarily based on any adverse change in the expected future cash flows resulting from the restructuring. The average recorded investment of loans individually evaluated for impairment for the three and nine months ended September 30, 2011 was $11 million and $12 million, respectively. The average recorded investment of loans individually evaluated for impairment for the three and nine months ended September 30, 2010 was $12 million and $10 million, respectively.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

Note 6. Residential Real Estate Loans  – (continued)

The following table summarizes the balances for loans individually evaluated for impairment at September 30, 2011 and December 31, 2010.

(In Thousands)		September 30, 2011				December 31, 2010
Principal balance		$	11,928			$	13,352
Recorded investment			11,249				13,300
Related allowance			3,202				4,628

The following table summarizes the recorded investment and past due status of residential loans individually evaluated for impairment at September 30, 2011 and December 31, 2010.

(In Thousands)		30 – 59 Days Past Due				60 – 89 Days Past Due				90+ Days Past Due				Current				Total Loans
September 30, 2011		$	710			$	1,023			$	1,331			$	8,185			$	11,249
December 31, 2010			2,604				—				1,046				9,650				13,300

Credit Characteristics of Residential Loans Held-for-Investment

As a percentage of total recorded investment, 99% of residential loans held-for-investment at September 30, 2011, were first lien, predominately prime-quality loans at the time of origination. The remaining 1% of loans were second lien, home equity lines of credit. The weighted average original loan-to-value (LTV) ratio for our residential loans held-for-investment outstanding at September 30, 2011 was 66%. The weighted average Fair Isaac Corporation (FICO) score for the borrowers of these loans (at origination) was 739.

We consider the year of origination of our residential loans held-for-investment to be a general indicator of credit performance as loans originated in specific years often had similar product and credit characteristics. The following table displays the recorded investment and year of origination for residential loans held-for-investment at September 30, 2011 and December 31, 2010.

(In Thousands)		September 30, 2011				December 31, 2010
2003 & Earlier		$	1,806,822			$	1,939,618
2004			1,064,533				1,116,358
2005			128,508				136,481
2006			184,551				191,945
2007			65,364				75,136
2008			—				—
2009			178,683				189,355
2010			403,451				208,779
2011			387,490				—
Total Recorded Investment		$	4,219,402			$	3,857,672

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REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

Note 7. Commercial Real Estate Loans

We invest in commercial real estate loans that we originate and service as well as loans that we acquire from third-party originators. These loans are financed with equity and long-term debt or through the Acacia entities that we sponsor. The following table summarizes the classifications and carrying value of the commercial real estate loans at September 30, 2011 and December 31, 2010.

September 30, 2011 (In Thousands)		Redwood				Acacia				Total Loans
Fair value		$	—			$	12,563			$	12,563
Held-for-investment			98,061				—				98,061
Total Commercial Real Estate Loans		$	98,061			$	12,563			$	110,624

December 31, 2010 (In Thousands)		Redwood				Acacia				Total Loans
Fair value		$	—			$	19,850			$	19,850
Held-for-investment			30,536				—				30,536
Total Commercial Real Estate Loans		$	30,536			$	19,850			$	50,386

Commercial Real Estate Loans at Fair Value

Commercial real estate loans at fair value are owned at the consolidated Acacia securitization entities. At September 30, 2011, there were three commercial real estate loans at fair value with an aggregate outstanding principal value of $14 million and an aggregate fair value of $13 million. At 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

Commercial real estate loans held-for-investment are loans we originate or acquire from third party-originators. At September 30, 2011, there were twelve commercial real estate loans held-for-investment with an outstanding principal value of $99 million and a carrying value of $98 million. Of the $98 million commercial loans held-for-investment at September 30, 2011, 69% were originated in 2011, 31% were originated in 2010, and less than 1% were acquired in 2004. 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. 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.

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 for any loans we have determined to be impaired. At September 30, 2011 and December 31, 2010, there were no delinquent or impaired commercial loans.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 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 September 30, 2011 and December 31, 2010.

September 30, 2011 (In Thousands)		Redwood				The Fund				Acacia				Securities
Residential		$	770,164			$	—			$	199,590			$	969,754
Commercial			5,887				—				39,072				44,959
CDO			1,010				—				17,530				18,540
Total Real Estate Securities		$	777,061			$	—			$	256,192			$	1,033,253

December 31, 2010 (In Thousands)		Redwood				The Fund				Acacia				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 September 30, 2011, there were $4 million of AFS 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.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

Note 8. Real Estate Securities  – (continued)

The following table presents our securities by accounting classification, collateral type, and ownership entity at September 30, 2011 and December 31, 2010.

September 30, 2011 (In Thousands)		Trading												AFS
		Redwood				Acacia				Total				Redwood				The Fund				Total
Senior Securities
Residential prime		$	—			$	3,327			$	3,327			$	276,925			$	—			$	276,925
Residential non-prime			20,756				100,238				120,994				278,161				—				278,161
Commercial			—				11,216				11,216				—				—				—
Total Senior Securities			20,756				114,781				135,537				555,086				—				555,086
Re-REMIC Securities			—				—				—				113,100				—				113,100
Subordinate Securities
Residential prime			328				36,987				37,315				70,277				—				70,277
Residential non-prime			155				59,038				59,193				10,462				—				10,462
Commercial			—				27,856				27,856				5,887				—				5,887
CDO			960				17,530				18,490				50				—				50
Total Subordinate Securities			1,443				141,411				142,854				86,676				—				86,676
Total Real Estate Securities		$	22,199			$	256,192			$	278,391			$	754,862			$	—			$	754,862

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. Of the senior securities owned at Redwood at September 30, 2011, $185 million of prime securities and $165 million of non-prime securities were financed through a non-recourse resecuritization entity, as discussed in Note 4. 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.

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

Note 8. Real Estate Securities  – (continued)

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, and classify them as trading securities. The unpaid principal balance of these Acacia trading securities was $1.14 billion and $1.55 billion at September 30, 2011 and December 31, 2010, respectively.

AFS Securities

We often purchase AFS securities at a discount to their outstanding 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 unpaid principal balance that we do not expect to receive and will not amortize into income as a credit reserve on the security, with any remaining net unamortized discounts or premiums amortized into income over time using the interest method.

The following table presents the components of carrying value (which equals fair value) of AFS securities at September 30, 2011 and December 31, 2010.

September 30, 2011 (In Thousands)		Residential				Commercial				CDO				Total
Principal balance		$	1,135,145			$	54,061			$	10,689			$	1,199,895
Credit reserve			(252,854	)			(47,197	)			(9,607	)			(309,658	)
Net unamortized (discount)			(229,521	)			(2,551	)			(1,082	)			(233,154	)
Amortized cost			652,770				4,313				—				657,083
Gross unrealized gains			112,818				1,788				50				114,656
Gross unrealized losses			(16,663	)			(214	)			—				(16,877	)
Carrying Value		$	748,925			$	5,887			$	50			$	754,862

December 31, 2010 (In Thousands)		Residential				Commercial				CDO				Total
Principal balance		$	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

TABLE OF CONTENTS

REDWOOD TRUST, INC. AND SUBSIDIARIES
  
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
September 30, 2011
(Unaudited)

Note 8. Real Estate Securities  – (continued)

The following table presents the changes for the three and nine months ended September 30, 2011, of the unamortized discount and designated credit reserves on AFS securities.

Changes in Unamortized Discount and Designated Credit Reserves on AFS Securities

Three Months Ended September 30, 2011 (In Thousands)		Residential								Commercial								CDO
		Credit Reserve				Unamortized Discount, Net				Credit Reserve				Unamortized Discount, Net				Credit Reserve				Unamortized Premium, Net
Beginning balance – June 30, 2011		$	240,899			$	243,662			$	48,987			$	4,362			$	10,780			$	1,083
Amortization of net (discount) premium			—				(10,138	)			—				(69	)